naked capitalism

Aha, the level of financial innovation spurred by super low interest rates is starting to have that “I love the smell of napalm in the morning” feel to it.

The Financial Times reports that there is a frenzy to create synthetic junk bonds, ostensibly to satisfy the desire of yield-hungry investors. Any time you see a lot of long money flowing into synthetic assets rather than real economy uses, it’s a sign that Keynes’ casino is open for business (“When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done.”)

The author compare this development to that of the asset backed securities CDO market, one of our betes noirs which blew up spectacularly in the crisis. There are some similarities and differences.

The amusing bit is that the article focuses on the demand from the longs and conveniently fails to mention that the people who want to short this market have to be at least as active. In fact, demand for synthetic assets almost always starts with the short side. That means the structures are devised to suit their needs. As Satyajit Das wrote to us:

It is exactly the same structure as a synthetic CDO – a la Magnetar. The smart money is shorting corporate and high yield credit – they just can’t see how the Ponzi scheme can carry on for much longer. I differ in that I think everyone is underestimating how long the governments can keep the illusion going.

So your outrage is well justified. The more things change the more they stay the same.

Despite the reference to Magnetar (a Chicago based hedge fund that devised an extremely large and destructive subprime short program that played a large role in extending the subprime mania, see here and here for more background; we broke the story of the impact of its Constellation program in ECONNED), these synthetic junk bonds do not have as much embedded leverage, and hence may not be as prone to catastrophic fails, as subprime CDOs, where the real risk was largely the so-called “cliff risk” or “waterfall risk” of BBB subprime bonds. Subprime (technically “mezzanine”) CDOs consisted nearly entirely of the risk of BBB subprime bonds. If the underlying loan pool of a particular bond had losses of less than 6% (the exact number varied by pool, but this is a good representative number), the CDO would be money good. If the losses increased to 9% of the pool, it was worth zero. So a not-very-large change in losses would have a very big change in outcomes.

But you can achieve the same nasty outcomes via leverage. In the old collateralized obligation market (the CLO is confusingly another type of CDO), investors would do correlation trades (going long one tranche and short another) and would borrow against the trade to enhance returns. So don’t assume the overall activity is less risky because the instruments aren’t as intrinsically dodgy.

Further detail from the Financial Times:

The move into junk bond derivatives also reflects the plunge in yields on actual bonds to record lows. “With the Federal Reserve providing liquidity, default rates low and yields falling, the synthetic market is a way to increase returns,” said a derivatives trader at another US bank. “Investors are looking to take credit risk.”

The derivatives are sold as “tranches” that represent different slices of default risk in an index of high-yield bonds compiled by Markit called “CDX”.

The exact level of activity is hard to pin down. The Depository Trust & Clearing Corp, which compiles credit derivative data, says the net notional exposure in all credit default swap tranches on February 25 was $5.9bn, up from $5.4bn four weeks earlier. It does not make public how much of this is in junk bond or other tranches.

There are differences between the current junk bond derivatives and the pre-crisis mortgage structures, dealers said. Banks’ pre-crisis off-balance- sheet investment vehicles are now defunct, limiting the investor base. Second, the tranches are linked to one, standardised index, rather than tailor-made.

I’m not keen about an index based on a small number of names of story paper, but I don’t have a vote in these matters.

Das has not seen a term sheet for these particular instruments but his inquires today suggest that they are credit linked notes. The investor pays up the money is put into cash deposits or some security (high grade) and simultaneously the dealer sells protection on CDX index (which as the Financial Times indicates is a high yield index like the famous ABX). See his note below for details.

Satyajit Das Credit Linked Note Primer