Shades of 2007: Synthetic Junk Bonds

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

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  1. Ina Deaver

    You mentioned something the other day that has been puzzling me since the crash — no one seems to be acknowledging that this is the second time that derivatives have crashed the universe. I distinctly remember the “ragnerok” type predictions that were being made about the incredible leverage that had been built up in derivatives during the early 90s crash. Of course, that came to look so quaint and conservative.

    The fact that, after two examples of how using derivatives to create unlimited leverage (rather than as a legitimate hedge position or some such) crashing the world, there STILL is not meaningful regulation of this practice — clear evidence of cancer.

    And now we hear the rackety-ratchet of the roller coaster car climbing the hill – yet again.

  2. Matt S

    big finance players create complicated synthetic financial products with little turns but large risks. sadly, investors are always attracted by short term returns and they may never know the substantial potential risks until the crisis come.

  3. ella

    History repeats itself. Recent news proclaims, retail investors back in the stock market, oil and other commodities on the rise allegedly driven by speculators, Gas in the US approaching $4.00 a gallon, assumed TBTF American banks and insurance co’s. confirmed with bailouts, GSE’s implicit guarantees confirmed with actual guarantees, Greenspan put turns into Bernanke put, Reaganomics makes a come back and on and on.

    Does anyone feel like we are on a merry-go-round?

    1. monday1929

      “rackety ratchet”
      All aboard the groundhog day roller-coaster!
      It is all “unforeseeable”, each and every time.
      each and every time
      each and every time

  4. Schofield

    What a wonderful invention of Neo-Liberalism derivatives truly are. Money can finally be used to undermine money and create economic collapse. Bingo! Now we are truly Masters of the Universe!

    1. vlade

      I’m glad that someone established that some of the Mesopotamia civilizations were neo-liberal….

      Not to mention that bloody speculator Thales cornering that olive-oil press market – Miletians were rightly very pissed off, he should have stuck to his philosophy and not show off! On the second thought, serves them right, the neo-liberal Greeks, shouldn’t have done derivatives, it’s surely what caused their downfall…

      I’d just like to know what was the original liberal movement if we had “neo” a few thousands of years ago…

  5. Gerald Muller

    Just a French spelling detail. It should be “bête noire”. Funnily enough, bête (beast) is feminine in French.

  6. Further Comment

    Oh, Yves, dear. Today you are featured in the headlines on another one of my daily reads. Check it out, at your own risk.

    The problem here is that the author – as most libertarians seem to – believes that deceiving a party to a deal is a completely legitimate business practice, except of course when it has to do with his precious metals.

    Puh-lease. Although I agree with that particular author on certain other things, his defense of caveat emptor is a bit revolting in the length to which it expects the buyer to assume deviousness on the part of the seller. That is not a confidence-boosting expectation. And being that the economy is largely effected by people’s confidence, his attitude is a sure-fire path to more stagnation. BTFD, dudes.

  7. Random Blowhard

    You would think that all the idiots who were nuked by these Financial Weapons of Mass Destruction in 2007/2008 would have learn’t something from the experience but by bet is no. Human Stupidity – the only infinite resource in the universe.

  8. PCB

    Hi Yves,

    I apologize for ‘hijacking’ this thread with a non-germane comment but I don’t know how else to ask you about this.

    I have a friend who was telling me today about “real estate contracts”, which are something I never heard of before this conversation. This friend succumbed to the real estate frenzy of the Bush years, and now is trying to get out from a bunch of investment properties he bought with option ARMs.

    Anyhow, he explained to me that there was this new form of bottom-feeding in the real-estate world, the aforementioned ‘real estate contracts’. The idea is that people can ‘sell’ their houses to investors notwithstanding the fact that there are still outstanding mortgages. The purchasers pay the original owners to continue the mortgage payments, while somehow generating income from the houses.

    This is one of several aspects to this that I frankly don’t understand, but my friend said that the idea was to allow people who can’t qualify for mortgages on their own to ‘buy’ houses. When I asked how you can sell something you technically don’t own (until the mortgage is paid off, the bank/mortgage owner owns title – MERS notwithstanding, right?) he couldn’t explain (he’s not a sophisticated investor, which explains how he bought six houses w/ option ARMs ;-)

    He did say that he’d been warned that banks will ‘call’ a mortgage if they get wind of a real estate contract, but I don’t understand how a contract can even be drawn, let alone enforced, in this situation.

    Mostly, however, the part about ‘allowing people who otherwise can’t get a mortgage’ to buy a house set off my alarm bells as this is redolent of the whole sub-prime phenomenon, but only worse. Have you heard of these real-estate contracts? Is this the new subprime, only worse? Is this widespread? BTW, this conversation took place about New Mexico property.

    As far as I can tell, this is fraud pure and simple, but it appears to be catching on at the low end of the real estate market. You’ve done such an admirable job throwing light on earlier shenanigans in the real estate and financial markets, I thought this might pique your interest.



    PS: I loved the “Le Show” interview!

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