The Wall Street Journal has a story today on a new type of credit market transaction described as “nonlinear finance”. That label alone should send off alarms, since one assumes it is truth in advertising, a rare commodity in Big Finance. “Nonlinear” says that under certain scenarios, the price of the instrument goes “nonlinear,” as in behaves in a radically different, ungraceful manner or can be expected to have its price gap out if particular conditions are met. That would also suggest the instrument would be hard to hedge.
One of the reasons I can’t be as specific as I’d like, as Wall Street Journal readers pointed out, is the actual article is thin on details. However, that isn’t as surprising as it should seem. These trades sound a lot like the old CDOs, the ones that blew up so spectacularly in the crisis. Technically, those were asset-backed securities, or ABS CDOs.1 If you were reading the financial press before the crisis, the only reporter who recognized the importance and riskiness of CDOs was the Financial Times’ Gillian Tett, who doggedly kept after them and managed to ferret out critical bits of information. CDOs also became large enough as a product that there was some aggregate data, but it wasn’t terribly reliable (one huge problem was the potential for double-counting).
And it also makes sense that financiers would find a new bottle for the old CDO wine, since any investor would probably have a lot of ‘splaining to do if he were to invest in something that was sold as a CDO, even if that was a straight up description.
First to the critical bits of the Journal story, then more discussion as to how worried to be about this development. From the Journal:
Putting together deals in what some dub “nonlinear finance” is a growth business for investment banks’ big bond-trading arms and is helping clear unwanted assets off some balance sheets. However, such private deals, which aren’t publicly traded and don’t have public credit ratings, are a challenge for regulators keeping track of the growth of shadow banking and understanding whether such activity is driven by regulation or its avoidance.
The business isn’t new, but it is heating up as banks hire specialists and commit balance-sheet capacity to feed investor demand. Goldman Sachs Group GS -1.51% said in September that it could double its financing of “bespoke collateral” by giving its fixed-income trading arm an extra $5 billion of balance-sheet capacity. This would bring in at least an extra $100 million of revenue, which likely only counts the net interest income Goldman would earn on debt it keeps and not all the other deal fees involved.
Deutsche Bank is a market leader in this business, earning roughly €400 million ($464 million) each quarter from all the financing linked to fixed-income trading, including nonlinear trade, while others such as Credit Suisse Group and BNP Paribas are more focused on certain products or regions.
So what is this business? It starts with lending to private-equity or hedge-fund clients who want to buy assets that are hard to value, hard to sell, or low quality. Such assets can’t be financed in markets by fixed-income trading arms in the traditional way that liquid, high-quality assets are.
The hot assets right now include pools of European bad loans; other private loans; large property deals, especially in the U.S.; and things like infrastructure assets in emerging markets. Some come from weaker banks’ balance sheets, but many are being found by investment bankers, or the hedge funds and private-equity firms that anchor the deals. Investor demand for such assets is outstripping investment banks’ ability to find the assets, according to one banker in the field.
Banks slice the financing into tranches. The riskiest equity slice is owned by the anchor hedge fund or private-equity firm and gets the biggest payoff if the assets perform well. The safest slice pays steady coupons and gets paid first.
Yves here. This is clearly a structured finance product. A bunch of what sound like pretty drecky loans are throw into a legal entity, and then the cash distributions are tranched. The investors do not have ownership rights to the assets. They have claims on the cash flows. The most senior tranche gets the first payment (say X% return per annum, after meeting any fees or costs) and only when the investors in that tranche have gotten everything they are supposed to does the next person in line get anything. This “waterfall” process continues all the way to the bottom, most junior layer, usually called the equity tranche. Note that there are usually separate waterfalls for interest and principal payments.
Even though the rating agencies comported themselves badly, the lack of rating agency involvement is a mixed bag. Rating agencies imposed some discipline on the process. More important, they kept RMBS and CDOs from being an opaque market by issuing ratings on them, providing market commentary and downgrading them, admittedly after the market had already started repricing them, but that was still an important communications mechanism to people who were really behind the eight ball, like the Fed. The fact that they were rated also allowed for the compilation of aggregate data.
However, the lack of ratings will presumably constrain the size of the market. A lot of institutional investors have tight limits on how much they can invest in non-rated paper.
Here are the things to watch:
Will this “non-linear finance” get to be anything other than a niche product? Recall that there was both a subprime RMBS and a related CDO market in the 1990s. They both blew up. They didn’t do much damage because they weren’t that big.
Will the structures have too many correlated risks? We don’t know. These deals sound like they are stuffed with so much exotica that particular deals might wind up with unexpected correlations and go spectacularly bust, but the premise seems to be that enough of the constituent assets are so exotic that they won’t trade in a highly parallel manner, save in a Big Crisis where everything risky falls off a cliff all together.
Will the packagers introduce additional leverage? One of the big reasons CDOs became such a destructive product was that there was so much demand for them that there weren’t enough real economy subprime loans to begin to satisfy the appetite. So the cleverest sponsors and packagers (you could “sponsor” a deal if you provided the equity tranche funding, then you got a big say over what went into the deal) began creating CDOs that consisted mainly of derivatives instead of mortgages. We described long-form how this worked in ECONNED. Effectively, the originators were creating synthetic borrowers to stand in the place of live ones. The result was that they created economic exposure to subprime risk that was 4-6x the amount that existed in the real economy. The financial crisis is widely misunderstood as a housing crisis. A housing bust would have been very harmful to the real economy, but it would not have nearly destroyed the global financial system. The 2008 crisis was a derivatives crisis.
Will these deals be a Ponzi scheme? Again as we explained in ECONNED, both the 1990s and 2000s CDO markets were Ponzi schemes. Despite all the seeming demand for the product, what investors wanted were the most senior tranches. For reasons too long to go into here, there was also demand for the equity tranche. Due to the high structuring costs, the interest payments weren’t high enough to adequately compensate the risk of investing in the junior tranches. CDO salesmen were very adept at finding stuffees (really dumb investors) as well as making liberal use of hookers and drugs to make sales at somewhat less clueless investors. But even then, they had parts they couldn’t sell.
Banks didn’t want this dreck on their balance sheets. It was permissible to put a portion of the unsold garbage in a supposed first generation CDO. This makes me wonder how much of the assets in these “nonlinear” deals are effectively CDOs squareds, which also means risky and blow-up prone. The junior tranche of a CDO can easily fail 100%, so if CDO contains 20-30% of junior CDO tranches as its assets, its supposed most senior tranche has a pretty high risk of having that 20-30% of its payout not materialize.
The other way those tranches got “placed” were in “CDO squareds” where the constituents were mainly junior tranches of other CDOs, with some better quality assets mixed in to make it look a bit better.
The large point is that this development is a sign of how desperate search for yield has become. In and of itself this “new” product appears not to be significant in aggregate terms, so in isolation it is not too alarming. But it is the sort of thing that can burn the unwary badly. If it becomes a meaningful-sized activty, the large-scale hazards go up too. Stay tuned.
1 The ones made of corporate loans, called CLOs, have similar structures (as in are also technically CDOs). Even though people have also been worrying about an increase in CLOs, they only performed garden-variety badly during the crisis. The models for measuring the diversification of risk in the CLOs worked pretty much as expected. The big problem was that the banks were still stuck with a lot of them on their balance sheets, and the tranches they held did fall meaningfully in value (there was no reliable reporting on this since the banks didn’t want this exposed, and they were trading microscopic amounts with friendly hedgie counterparties so they could mark them at much higher values than what they would have sold at). The sense I had was the CLOs went to 80-85 cents on the dollar when the banks weren’t prepared for that (due to the severity of the crisis, not due to the CLOs performing out of line with what investors understood about the structures). And they were in no position then to show any additional losses. So even though CLOs are highly levered structures, they were nowhere near as highly leveraged as CDOs, which were resecuritizations and hence were mind-bogglingly geared. So while they are in the “watch with some concern” category, since “innovative” financiers could find ways to amp up the risk of CLOs, they have to date performed in line with what