Citi's Bringing Back The Synthetic CDO...But In A Way That "Insulates It From Any Losses"

Tyler Durden's picture

Less than a decade after being forced to take a taxpayer funded bailout to avoid an embarrassing bankruptcy filing, Citibank, proving that they learned precisely nothing from the so-called 'great recession,' has put a 35 year old in charge of once again making the bank into a powerhouse in the Synthetic CDO market.  But please don't worry about the risk because this time Citi says they're building the business in a "way that insulates them from any losses."  Here's more from Bloomberg:

It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system. But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.

 

This time, Citigroup says, it’s doing things differently. The deals are tailored in a way that insulates it from any losses, while giving yield-starved buyers a chance to reap returns of 20 percent or more. The market today is also just a fraction of its size before the crisis, and few see corporate defaults surging any time soon. But as years of rock-bottom interest rates have pushed investors toward riskier products, the revival of synthetic CDOs may be one of the clearest signs yet of froth in the credit markets.

 

Danielle Romero-Apsilos, a spokeswoman at Citigroup, said synthetic CDOs are fundamentally different than they were before the crisis and that banks today aren’t managing market risk any more. That’s because every part of a synthetic CDO deal is distributed to investors, which also helps to prevent the market from growing too fast.

 

“Every single client we talk to always asks the differences pre-crisis and post-crisis,” said Vikram Prasad, who oversees Chen’s team as the head of correlation and exotics credit trading. “Everyone remembers the word CDO. Our clients are thinking the same thing, they are doing the due diligence.”

Of course, at least in our experience, levering a levered product in order to juice returns by 10x is almost always incredibly safe (can you taste the sarcasm?). 

The safest portion, which would typically return 0.6 percent a year, can be levered up to 6 percent in some cases. Equity tranche returns can reach 20 percent.

CITI

 

Meanwhile, it's not just Citibank looking to recreate the financial crisis...other banks, including BNP Paribas, are looking to get in on the action as well...

Other Wall Street banks, which shunned the market since the crisis or struggled to establish a foothold, are angling for a bigger slice of the action. BNP Paribas SA is also active in synthetic CDOs and others are keen to follow suit, according to people familiar with the matter, who asked not to be identified because they aren’t authorized to speak publicly.

For those who have forgotten how Synthetic CDOs work, below is a quick primer.  To summarize, you go out and find a bunch of suckers willing to backstop trillions of dollars worth of credit risk in return for a few bps in annual premium payments.  You then tranche out the risk being taken by the CDO investors so that those at the top can get a AAA-rating and, in return, tell their investors that they're taking no risk at all.  Those investors then lever up their capital another 10x so they can make 8% returns on a 'risk-free' investment...it's basically as safe as having you're own printing press from the U.S. Treasury.

Typically, these CDOs pool together about 100 different credit-default swaps tied to various companies, which are then sliced into varying levels of risk called tranches -- senior, mezzanine and equity. Over the life of a deal, which generally lasts two to three years, the swaps generate a steady stream of income for “long” investors (and are paid by “short” investors on the other side of the trade who want insurance against a potential default).

 

The equity tranche has the biggest risk of getting wiped out if losses from defaults exceed roughly 5 to 7 percent, and nets the highest returns.

Synthetic CDO

 

And guess who's buying?  If you guessed 20-something year old pension and insurance fund investors who were in middle school during the last financial crisis then you're absolutely right...congratulations.

Yet after years of rising markets, declining corporate defaults and tighter credit spreads, the trade is finally attracting greater interest. Increasingly, pension funds and endowments have become senior tranche investors in many of Citigroup’s synthetic CDOs. And because the CDOs are derivatives, they have small upfront costs and amplify returns.

 

“There is a whole generation of people in finance who never knew or forgot what the problems were with synthetic CDOs,” said Janet Tavakoli, a 30-year veteran of the financial markets who runs a consulting firm and has written books on structured credit and CDOs. “Just as derivatives can lever up the upside, they can lever up the downside.”

Conclusion:  "Short everything that guy has touched."

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mily's picture

They did learn from last crisis: all banks will be bailed out of taxpayer/future generations pockets time and time again 

Juggernaut x2's picture

Bailed out in what? worthless US dollars?

Haus-Targaryen's picture

From my [limited] understanding of this product...

I wonder -- what happens per se if these new collateralized securities' returns outstrip the consolidated results of their underlying derivative assets? Further, how would this influence the valuation of the CDOs when said underlying assets' prices are not a function of price discovery? 

It seems this system, albeit reducing one form of risk has opened itself up to a different form of risk, making them inherently more dangerous than their predecessors. 

Previously - underlying assets' prices (and thus the initial valuation of the CDO, respectively) were a function of price discovery of cherry-picked assets. 

Now - underlying assets' prices (and thus the initial valuation of the CDO, respectively) are a function, not of price discovery of cherry-picked assets; but set prices of cherry-picked assets. 

The problem, is obviously -- set prices (e.g., prices dictated by something other than price discovery) only actually function if you have a willing buyer for that price.  Currently, asset prices underlying these securities are inflated above price-discovery via monetary policy -- thus inflating the initial value of the CDOs. What happens when buyers at set prices dry up?  Asset prices fall, and thus the CDO prices fall, but fall exponentially. 

Seems to me these things have a lot farther to fall (in both real and nominal terms) than they did last time (if you remember last time, value went to zero for most of these products). 

TL;DR - This is the equivalent of too big to fail making themselves even more susceptible to shock to attract returns due to low yields on other assets; but the value of these CDOs only remain where they are as long as the yields remain low -- further pushing the financial services industry into these products. 

We're completely fucked.  

Paul Kersey's picture

The only way to stop the money changers is to send them to prison and keep them there.

johngaltfla's picture

This is going to be so fucking awesome.

Re-naming Grape Kool-Aid with cyanide Strawberry Kool-Aid with cyanide works every time.

BennyBoy's picture

 

 "Insulates It From Any Losses"

You can't make this shit up.

YUNOSELL's picture

but this time is different, right?

 

well if people buy this shit, then it's their own damn fault. A sucker born every minute.

Reichstag Fire Dept.'s picture

Don't be such a "Debbie downer"...try to be positive so as to not hurt the Special Snowflake Fund Managers!

Losses are just inverted gains!

JRobby's picture

That is all they learned

They are addicts

Lordflin's picture

20%... damn... better jump on top of these...

Haus-Targaryen's picture

Remember, returns should, in theory, compensate the investor for risk assumed. 

When overnight rates are 125-150 bps and you're earning 2000 bps -- any reasonable person should pause re; the level of risk assumed. 

BennyBoy's picture

 

...But In A Way That "Insulates It From Any Losses" US taxpayer will do the insulating.
Telemakhos's picture

Pronouns are important.

Insulates It From Any Losses

"It" in that phrase refers to Citi.  Citi is the only one insulated from loss in these new CDOs.  The bottom-rung investors seeking that fabled 20% are assuming a massive amount of risk, just like in 2007.  Citi is selling long-shots.  The difference this time is that Citi thinks it will not take any losses if the assets underlying the CDO fail — only the investors will take those losses.  Citi gets its cut through arranging the deal and fees for selling the CDOs.

Risk exists to check stupidity.  Abstracting the risk so far that the vendor of CDOs feels itself insulated from any risk in them simply encourages the vendor to sell more and more CDOs without any regard to the soundness of the underlying capital allocations.

malek's picture

You mean to say "High Yield" funds are actually "high risk" funds?

Heresy! /s

ElTerco's picture

"20%... damn... better jump on top of these..."

Sounds a lot like BitCoin.

Juggernaut x2's picture

Janet has the whole world trying to squeeze out a few basis points of yield.

Ethereal's picture

Blockchain is coming...  The value of a blockchain is proportional to the square of the number of people that are willing to except it as settlement. The number of people that are willing to except it is based on how fast an idea can spread which can be exoonential. So the rate law dictating the proper price appreciation of Bitcoin is the square of an exoonential.

Ethereal's picture

Blockchain is coming...  The value of a blockchain is proportional to the square of the number of people that are willing to except it as settlement. The number of people that are willing to except it is based on how fast an idea can spread which can be exoonential. So the rate law dictating the proper price appreciation of Bitcoin is the square of an exoonential.

css1971's picture

Why just bankers?

Any business with regular and steady clients can create CDOs or equivalent.

Electricity companies for example. Millions of customers they provide credit to and who pay regularly. Bundle the credit into tradeable notes and sell for immediate cash.

fajensen's picture

Yes? How do you think the flatrate mobile rates became so popular? Anyting as a Service .... ?? 

Catahoula's picture

Them was the days

Mewa's picture

Now you know the market is about ready to crash....due dilligence - sure with other people's money and fat fees to look the other way....US peddling this crap....get the hell out from all the corruption....buy some farmland and wait out the collapse....get the fuck out of paper assets...

JailBanksters's picture

If it sounds too good to be true, it's because somebody else is paying for the loses.

 

Mewa's picture

Now you know the market is about ready to crash....due dilligence - sure with other people's money and fat fees to look the other way....US peddling this crap....get the hell out from all the corruption....buy some farmland and wait out the collapse....get the fuck out of paper assets...

cstu7011's picture

Sounds like financial heroin. Keep your bank accounts as empty as possible. The overdose is not going to be pretty.

gmak's picture

There is no such thing as a free lunch.

shizzledizzle's picture

"Insulates It From Any Losses" = Nobody will see this coming until we've passed the event horizon, then the FED will step in and absorb the losses leaving the working americans holding the bag.

artvandalai's picture

These people are just a might bit full of themselves.

Bazinga's picture

To think that the ones buying these for their funds were children during the last blow-up is a bit scary. What's the saying about those who don't know history being doomed?

cheeseheader's picture

'starved for yield'....

 

Why not just make the fed raise (normalize) rates a couple/three/four points to where they should be?

Hold the starvation....

el buitre's picture

Too late.  If the abnormal rates were raised to historical levels, all the IRS vig would go to interest.  No more free Obomba phones or F-35 Flying Trash Heaps.

DipshitMiddleClassWhiteKid's picture

all of this is being done on purpose to crash the economy

 

same thing that happened in weimar germany

 

they are going to run this fucking thing into the ground and make a handsome profit doing so

 

 

silverer's picture

Wow. Progress. First we had the Ponzi, now we have the synthetic Ponzi.

nsurf9's picture

Yes, Alex Trebek, I'd like "What is sell a ton of naked ponzi puts and bet it all on a ton of ponzi calls?" for the win and I'll be a billionaire by morning.

Ink Pusher's picture

I am starting to think that  these cockroaches have the impression that every trader is an absolute fucking moron.

This laughable new initiative will only serve to shield the banksters from prosecution when they fire up the old 2008 Crash ReDux machine up this weekend.

I'd like to see these fucks collateralize the blood flowing in their veins.

A. Boaty's picture

This worked so well last time. What could go wrong?

Farqued Up's picture

Take it from a Rapee, run from this shit. I was lucky I won my suit against Ken Lewis's Charlotte Whores. This is testament to just how sorry the USCorp has become, I.e., allow the absolute crookedest vermin to fleece the people, destroy the country, and then go back for seconds.

Collapse, bitch, collapse. Preppers better prep harder, it's coming, the final phases are the vermin grabbing everything not nailed down, we are there.

George W greased the skids by putting it in FINRA's admin and removed it from juries in Federal District Court. Grandpappy Hitler financer Prescott would be proud.

Master Toms Dog's picture

I love the taste of sarcasm in the morning.

Drop-Hammer's picture

The jews have a lot of chutzpah (and a lot of hava-nagila).  They will package dog-shit and sell it to us as an investment.  Wait, they started doing that 50 years ago.