Summer 2007 Deja Vu: Banks and Short Sellers Dump Risk on Chumps Via Complex Products

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.

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  1. vlade

    I thought it’s dejavu only when it comes back, not when it’s running all the time.. Maybe more of a continuous-loop of “find the next muppet” movie.

  2. toldjaso

    The Psychopathic Finance System should be cut adrift, left to move far, far away into another realm, APART from any nation/People’s economic system. The “wager on debt” to the nth every which way is the *tell* of the Great Gamers of The City. The Psychopathic Finance System of these Destroyers Of Worlds, filled with their stupendous phallic grandiosity have NOTHING to do with “Economy” or “Economics” so that the PFS System must be entirely a SEPARATE from our Sane Economic System.

    The return of “Glass-Steagall on steroids” is insufficient. There are SANE women in finance and economics who have a truly “better idea” — Yves Smith, Ellen Webb, et al. There IS an Alternative to the Psychopathic Finance System, and it must be implemented APART by the SANE: Yves Smith, Ellen Webb, Michael Hudson, for example. It’s a “BIG IDEA” without the psychopathy and fraud. “Just do it.”

    1. toldjaso

      Yes, “Ellen Brown” author of “Webb of Debt” — thanks for the correction of my conflation of surname and work.

  3. Lambert Strether

    I, for one, welcome our old overlords.

    * * *

    Seriously, I know commenters are gonna comment on what they want, but the lack of comments on topics like this looks like a very successful case of ruling class misdirection, to me. Guys, this is what the people who own the state (“deep” or not) are doing! So of course “Look! Over there!” is what they do.

    And yet when Yves writes about this — that is, deploys her world-class subject matter expertise in the operations of the people who are actually running the country and stealing from you whenever you hear the cheery thunk of cash in an out-of-network ATM machine, or, more to the point, look at how fees melt your 401k, if you have one — she can’t buy a comment!

    Follow the money, guys! It’s not the state, it’s the money, and the monied interests that own the state. You can’t see this, what are you? Libertarians?

    You may now resume your regular programming….

    1. sd

      Fwiw, I read NC daily to desperately try to understand what to me in simple terms looks like a rigged game. The acronyms, terminology and semantics change almost as soon as I learn them. Speaking for myself, lack of comments is not lack of interest. It’s lack of confidence that I really understand what the hell is going on because as I said, from where I sit it just looks like a rigged game at a casino where the Ivy League gangsters wear Brooks Bros. suits.

      1. tg


        I have nothing like enough knowledge of the world of high finance to comment on articles like this. In truth I don’t understand the half of it.

        But as someone who ekes out a frugal living on the income from a few investments I follow NC avidly in order to gain what insight I may, and to constantly remind me that if someone tries to sell me an investment I don’t understand it’s safe to assume it’s best avoided.

    2. participant-observer-observed

      Lambert, although personally I am penniless, so have no direct connection to Wall St investments other than residing amongst humanity w/ student loan debt, it is this very topic & substantive reporting that draws me to NC every day.

      When I see reports such as this here, I forward them to professionals I know working in banks, financial advisers, relatives & friends, etc., and thus participate in the broader consciousness-raising effort.

      I also understand and appreciate the awareness that in understanding reports such as this (as best as possible, for a physicist-educator-theologian), the salience of political events whirring around such phenomena reported here also becomes increasingly evident!

      I too would like to see more comments! Here are a few of my questions:

      How does this news connect to VP’s son peddling arms in Ukraine?
      The new BRICS bank?
      Is it the innards of the current (and rejuvenated) campaign to never repay borrowing from social security by brute force (already very much hedged by student loan debtors)?
      How much of Taiwanese, (Saudi?), etc. largess of USD cash reserves is involved?
      Do Russian oligarchs have exposure?
      How many state pension funds still entertain such toxic sludge?
      Would this state of affairs put holdings of Dick/Liz Cheney or Billary R/Chelsea Clinton at risk?

      Comments welcome indeed!

    3. MichaelC

      This stuff does get pretty dense, so its hard to tell if the volume of comments is due to lack of interest (which I think those who commented (and I suspect they are representative) to your comment vote no) or don’t grasp the labyrinthine connections, or if its a studied avoidance by those who understand. The presence ( or absence in this case ) of trolls may be another indicator that Yves is on target.

      Ideally, all these arcane posts make the detailed case for distilling the whole pot of crap product marketing into credible layman’s language reporting like this.

      Just Walk Away From Credit-Default Swap ETFs
      Retail investors can bet on CDSes via funds … but shouldn’t

      The SEC should make it a requirement to attach this article to the marketing materials for the ProShares (and their ilk’s) funds.

    4. ChrisPacific

      Lots of comments doesn’t necessarily mean a high quality post – more often it means a topic that excites strong opinions and argument, like Ukraine, Gaza or MMT.

      Personally this is exactly the kind of post I hope to find at NC, and I will always open these first and read them thoroughly. However I often find I don’t really have anything to add, hence the lack of comment on my part. We’ve always known this was coming ever since the opportunity to clean house after the GFC was missed, so the only question has been when and in what form.

      1. Fíréan

        + 1.
        Lack of comment does not necessarily indicate lack of interest in the artile subject matter nor indicate the count of how many persons read the article.
        On my own behalf, i comment when believing that i have information or opinion, constructive, to offer up or to add,or to pose (or provoke with) a question with intent to gain further knowledge, or to other wise just refrain. Thank You for this article ! :-)

        Does the blog format not have a page/thread “view” count somewhat like the forum format, if only viewable to the blog/website owner ?

  4. bruno marr

    @ Lambert:

    I understand “comment responses” are a form of “currency”. But the real value of NC should be seen in the total viewer numbers and the quality of commenters. I read the detailed post by Yves and concluded that the legalized “skimming” operation that is the US (global?) financial system has little chance of reform except for physical revolution (not likely, and also unpleasant). At some point it will collapse, but when is not clear; and again the lifestyle disruption will NOT be unlike what the refugees in Iraq are experiencing: disorder gets ugly, fast.

    Most of us are helpless in our servility to the banking system. When the economic system implodes and goes “local” then maybe trading the vegetables in the garden for other goods will help us through. But I assure you, the folks with lots of resources now (money, land, etc) will survive longer than most.

    I’ll harken back to a comment I made a few days ago. An American culture that despises “the other” is not likely to discover unity of purpose; like the “bankers”.

    1. kevinearick


      never underestimate the stupidity of civil marriage, to seek the lowest energy level…as leverage…hoping you will take the gun…institutions nimble, relative to retail investors; I love that one…

      buy your war bonds right here folks, before we switch sides, discount them, and then take you to the cleaners, to begin another round…

  5. MichaelC

    .Worry not! the SEC is on the case. Interesting timing.

    The Securities and Exchange Commission has launched a broad examination of alternative mutual funds, according to people familiar with the matter, kicking off regulatory scrutiny of one of the hottest and most controversial investment products to be offered to small investors.

    Alternative funds, or “liquid alternative funds,” describe a class of mutual funds that employ hedge-fund-like strategies, including betting on some stocks and against others, trading futures contracts and using derivatives to increase leverage.

    Fund companies have marketed them as a way to hedge against market risk and as a cheaper way for individual investors to gain access to strategies once available only to sophisticated investors. Skeptics say some of the funds are watered-down versions of hedge funds and that some individual investors may not understand what they are getting.

    Alternative funds have surged in popularity. The category saw inflows of $40.2 billion in 2013, up from $14.5 billion the previous year, according to fund research firm Morningstar Inc. MORN +0.87% The amount of money in the funds jumped by 63% last year, from $158 billion to $258 billion, with new funds launching regularly, according to the SEC. So far this year through July, investors have poured $16.8 billion into the funds.
    Some other firms that have boosted their offerings in the space or are launching such funds for the first time include Goldman Sachs Group Inc., GS +0.21% Blackstone Group BX +0.51% LP, Bank of New York Mellon Corp. and Pacific Investment Management Co.

    A bevy of prominent hedge-fund firms has signed on to start or help advise the funds, encouraged by the prospect of attracting what they view as a relatively stable base of money. The funds can help firms grow: When AQR Capital Management LLC, a pioneer in the space, launched its first such mutual fund in 2009, it managed $20 billion. It managed $113 billion at the end of June, including roughly $15 billion in both traditional and alternative mutual funds.

    On the other hand ,
    the SEC is poised to approve a new type of ETF, a non-transparent actively managed mutual fund which can include derivatives. If that description doesn’t raise the hairs on the back of your neck, you’re not paying attention. Is the SEC?

  6. Blurtman

    Think of it as a career advancement transaction. Criminals on the selling end, and return seeking sociopaths on the buying end, who will in the future be employed at the seller. Win-win for all, except the bag holders.

  7. Larry

    So I have two take aways from this article, and correct me if I’m wrong:

    1. Banks are beginning to sell products that are going to fail, and soon. The retail investors buying them are going to be held to pay the counter parties on the short end. Those counter parties aren’t paying an appropriate premium for their side of the bet, and the retail investors aren’t getting enough of a return to justify their risk.

    2. Some investors are buying products without assessing risk appropriately and the entities structuring the financial products aren’t always to blame.

    I missed the part where Wolf’s commenter was spot on in his assessment of what was coming down the pike was going to be worse than 2008. I assume what he means is that the music will suddenly stop while everybody is holding overpriced assets like his mentioned junk bonds. But will this episode do the same damage as we witnessed in the massive and overleveraged mortgage market? It’s not clear to me from the article.

  8. MichaelC

    But will this episode do the same damage as we witnessed in the massive and over leveraged mortgage market?

    No. It will do different damage.

    Re 1.

    Alternative mutual funds have exploded in popularity in recent years. Offering hedge fund strategies to retail investors often shut out of the real thing by asset requirements, alternative mutual funds’ assets jumped 63% last year to $258 billion, and investors have added a further $16.8 billion this year.

    Alternative mutual funds are expected to double their share of total mutual fund assets, according to research from Cerulli Associates.

    And not to put too fine a point on it

    The future of Liquid alternatives looks very promising according to a new survey. Liquid Alternatives will be one of the most significant drivers of U.S. retail asset-management growth over the next five years, according to a new report from McKinsey & Company that refers to the “dovetailing” of traditional and alternative assets as a “trillion-dollar convergence.” Liquid alts could account for up to half of new retail revenue, according to McKinsey, with absolute return, long/short equity, and multi-alternative mutual funds projected to see disproportionate growth over the next two to three years.

    I don’t have access to the McKinsey report, but its probably worth a read.

    1. Larry

      But these mutual fund alternatives seem to pale in size to the MBS market that nearly ground the whole world to a halt in 2008. I think I’m still missing the point of Wolf’s commenter. Yes, assets are overheated, but who is going to take the bloodbath and by how much? How can his foreshadowed event possibly be worse than 2008? I just don’t see it this time.

      1. MichaelC

        Perhaps this will help.

        Almost half of the mutual funds called “alternative” by Bloomberg have launched since 2011, and Boston Consulting Group estimates alternative assets have risen from $2 trillion to $7 trillion in the last decade. That growth has the attention of the Securities and Exchange Commission, which is examining alternative mutual funds.
        I don’t know if this pales in comparison, since I don’t have the 2008 MBS market figures handy.

  9. griffen

    Question on the top half – JPM is offering TRS (total rate of return swap) on an independently priced index of Levered Loans. Those products are not new, at least what I can recall (unless it is being placed to non-institutional end buyers, then that would be a different animal).

    TRS on a LEHM/BARC index of investment grade CMBS (Commercial MBS) were being used 10-11 years ago. Back then the contracts had a defined end date, typically a 6 months from the contractual start date. There wasn’t a fee but rather a funding spread charged that would index to a short-maturity index.

    1. griffen

      I’d like to note a key distinction, and would welcome feedback on it. What is the state of the Repo markets, and non-bank financing levels? One of the key starters to problems in mid-2007 was the Commercial Paper and the Asset-Backed CP financing markets experienced headwinds on maturing CP debt. That was not the only thing, of course.

      Reason I bring this up – all that Asset-Backed CP, or a goodly portion of it, went to funding the purchase of investment securities (originally investment grade) in the so-called SIV investment vehicles. It was the leverage at the time, but also how the leverage was being funded. If the CP market levels have recovered enough ground since then, then the volumes should reflect it.

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