NC contributor Michael Crimmins flagged a Bloomberg article yesterday that described the proliferation of complex synthetic structures, depicting it as return to some of the bad risk-shifting of the blowout phase of the last credit bubble.
The amusing bit is the headline was toned down after the post was launched (you can tell by looking at the URL, which almost certainly tracks the original). The current version is the anodyne “JPMorgan Joins Goldman in Designing Derivatives for a New Generation.” But the very first paragraph flags the troubling resemblance to the last hurrah of the pre-crisis credit mania:
Derivatives that helped inflate the 2007 credit bubble are being remade for a new generation.
JPMorgan Chase & Co. is offering a swap contract tied to a speculative-grade loan index that makes it easier for investors to wager on the debt. Goldman Sachs Group Inc. is planning as much as 10 billion euros ($13.4 billion) of structured investments that bundle debt into top-rated securities, while ProShares last week started offering exchange-traded funds backed by credit-default swaps on company debt.
Wall Street is starting to return to the financial innovation that helped extend the debt rally seven years ago before exacerbating the worst financial crisis since the Great Depression. The instruments are springing back to life as investors seek new ways to boost returns that are being suppressed by central bank stimulus. At the same time, they’re allowing hedge funds and other investors to bet more cheaply on a plunge after a 145 percent rally in junk bonds since 2008.
“The true sign of a top is when you have these new structures piling up,” said Lawrence McDonald, a chief strategist at Newedge USA LLC…”These products are a clear risk indicator.”
Yves here. While true, this article manages to miss a critical point: the driver of the toxic innovations that started in 2005 and really gained steam in 2006 and 2007 were short side players who used complex, highly synthetic structures to place their wagers far more cheaply than they could have otherwise. As the subprime market cracked a couple of times before its final swoon, these same structures were used by banks to dump risks on their balance sheets onto clueless customers. For instance, the first product described clearly has investors taking on the risk of being credit default protection sellers, as standing ready to take losses if the value of reference assets fall:
JPMorgan is marketing total-return swaps that are tied to Markit’s iBoxx USD Liquid Leverage Loan index, a benchmark for the $750 billion leveraged loan market, according to a July 11 Morgan Stanley report. The swaps allow an investor to pay a fee in exchange for receiving the total return on the index at the expiration of the trade. If the measure posts a loss, the investor compensates the counter-party to the trade.
Hhhm. JPM is laying off leveraged loan risk. And a July 24 Bloomberg article (before the junk bond market nosedived) on the same total return product made clear that it dumped the risk on the buyer and the targets were retail, meaning chumps:
Here’s how the derivatives work: an investor pays a fee to a counterparty, who promises to deliver the equivalent of the total gains on a specified basket of debt. If the debt gains value, the bullish investor receives income without having to own the underlying loan. If the debt loses, the investor will have to make the counterparty whole.
Some smaller investors aren’t in a position to buy junk-rated loans and may want to go long through such a synthetic wager, according to the Morgan Stanley analysts.
Crimmins confirmed our reading:
So it looks like the TRS includes a short CDS position. The short side pricing should factor CDS risk, I think, in addition to the normal TRS pricing factors. I imagine the TRS default premium will be mispriced in favor of the bank.
It looks like the hawking of this short-seller product was timed brilliantly. The junk bond market, which has fallen out of bed, is pretty much the same risk as leveraged loans (they are mainly the debt of private equity portfolio companies that have borrowed big time to increase returns. Yes, individual names matter, but they trade in relationship to market levels). A reader at Wolf Richter’s blog gave an idea over the weekend of how bad the disarray is:
Wolf here: This comment by VegasBob on my article, Junk-Bond Turmoil just Preliminary, “The Real Panic Will Come With…” nailed it. It describes what happens to junk bonds you have in your portfolio – or stashed away in bond funds – when liquidity dries up, rates rise, and spreads rise. It’s a real predicament. The mainstream press rarely discusses it. The losses, even this early in the stampede out of junk, assuming you can sell it all, can be steep. Here it is:
Yes, liquidity in the junk bond market has more or less dried up, and prices are plummeting.
I have one 10K junk bond left in my portfolio.
It was at 83 in the beginning of May, when I should have sold it; now it’s down to 51, and trying to catch a bid for it is harder than pulling hens’ teeth.
I tried to sell it on Tuesday. My broker put out a ‘bid-wanted’ request that came back ‘no response,’ meaning not one dealer in the country was willing to buy it.
My thought is that what’s coming down the financial pike is going to be much worse than 2008.
Now perhaps some traders are brave and fast-footed enough to be keen about the JPM product because they think they can use it to trade a bounce. And I’m sure the pitch, whether the investor is savvy or not, is that junk bond/leveraged loan risk is oversold and this is a great way to play it.
Thus, the article looks with well founded alarm as to the complexity of these deals, based on the logical surmise that yield-desperate investors aren’t giving these deals the level of scrutiny they deserve. But it is remarkably lacking in curiosity as to whose interests are really being served by these transactions.
It is also important to point out that not all complex deals are plots by banks (or their clever customers) to snooker the hapless. David Stockman, who is generally sound, went a off-beam yesterday. Here was Stockman’s breathless summary:
So Reuters Hedgeworld reported of margin calls on hedge funds that had piled into a 12 month old product called “risk sharing RMBS bonds”. It seems that Wall Street dealers had provided 80% leverage on these new fangled securities issued by the nation’s accomplished market wreckers, Fannie and Freddie. Various tranches of this new variant of synthetic CDOs—the Wall Street created toxic waste that blew-up in 2007-2008—offered yields of 200-700 basis points over LIBOR, but so great was the demand for an alternative to the Bernanke-Yellen ukase of zero return that prices of the first Freddie Mac issue were driven up by 30% over the past year.
Lordie. Stockman even quotes the Journal, which undercuts his claim that these instruments were toxic:
But, the rally was overextended by investors’ search for yield as Federal Reserve stimulus cut returns on safer assets, some investors said. Prices on Freddie Mac’s first issue of July 2013 had soared more than 30% through May, reducing yield premiums over the one-month London interbank offered rate to 2.5 percentage points from 7.15 percentage points.
“Investors got too complacent,” Mr. Hentemann said. “They kept buying high-yielding assets to a point where prices and yields didn’t compensate you for the risk.”
So what really went on here? Fannie and Freddie were required to offload risk as preparation for a possible wind-down. Savvy Wall Street pros love being on the other side of a forced sale, since the pricing is pretty much assured to be favorable to them. Plus the leverage was not embedded in the structure; this was hedge funds borrowing against a product with high yield to goose their returns. Fannie and Freddie had nothing to do with the gearing; this was something the hedge fund investors did all on their own. Let’s turn the mike over to MBS Guy:
I actually like the Stacr deals – they force the GSEs to have more transparency about how the underlying loans perform historically and currently. That is much needed and healthy for the market.
I also though the deals were a good investment when issued – no brainer is what I told several people at hedge funds who were looking at them. That seems to have been a good call- they were up 30%.
It has long been the nature of low volatility, prime credit quality borrower MBS to have investors use a lot of leverage. My impression was that the recent correction in these bonds hasn’t been credit related (if it were credit/performance driven that would be kind of interesting). This article describes it as a liquidity issue, which my be – though there’s no real explanation of why it would hit stable, performing bonds that had been popular with investors.
I suspect there is some other trigger for the correction, but I don’t know what.
Of note, Freddie just sold a big pool of non performing loans for the first time last week. A number of market participants I spoke to were surprised there wasn’t more prep or fanfare for the deal – annoyed they didn’t have more notice for a chance to bid.
I wonder if Freddie panicked a bit about the Stacr price correction and unloaded the delinquent loans quickly out of fear the window may be closing? The prices for HUD non-performing loans have been through the roof – hedge funds like Lone Star and Ellington have been bidding up the price for these nonperforming pools to crazy levels in just the last 18 months (70-80 cents on the dollar, vs 30-40 cents 18 months ago). Mom and pop investors and non-profits can’t get near the current bids.
In other words, this example is the polar opposite of the JPM total return swap. The Fannie/Freddie deals were bought by hedge funds, while the JPM deal targets retail. These hedge funds routinely lever up these deals; contra Stockman, this is business as usual for them. Some later buyers bid the price up way too high and got caught with all that leverage when the market moved against them. Fannie and Freddie if anything were the victims, not the victimizers, by having priced the deals way too cheaply, as the runup in price attests.
In other words, investors can blow themselves up, as opposed to being blown up by a product structurer/short seller that is shifting lots of hidden risk onto the buyer. Not all train wrecks are the same, and it’s important to understand whether the party that took losses understood the risks they were taking before assigning blame.