Last month we noted that Goldman’s “hawking” (to use Bloomberg’s rather derisive terminology) of an “opportunity” in synthetic CDOs symbolizes the culmination of central bankers’ and Wall Street’s collective effort to return the financial world to the pre-crisis glory days of Dr. Frankenstein-like financial engineering. To truly understand how we’ve come full circle since the collapse, we need to look at exactly what it is Goldman is pushing (and what Citi is still, as of last Friday, pitching as a good opportunity for 2015).
Goldman is marketing what the bank calls a “bespoke tranche opportunity”, which is in many ways financial engineering taken to its logical extreme, as it allows the customer (or, as banks will call him/her, the “investor”) to actually participate in the creation of Frankenstein by choosing the credits that are included in the tranche on which protection is being bought/sold. Why would anyone want to do this? Well, there are a few reasons, but it basically comes down to whether you, the investor, think you either have a particularly good read on the outlook for a specific set of credits, or believe that a customized basket of credits offers a better risk/reward profile than standardized IG/HY indices, or both. As Citi notes, if you can find a mix of credits you’re comfortable with, you can juice the yield well above what you’d be getting on a pure IG portfolio and still be happy with the level of risk. If you’re in the equity tranches and you’re good at selecting credits that hold up, you can take advantage of structural leverage.
So, in a nutshell, this is the synthetic CDO equivalent of a Build-A-Bear Workshop.
The problem for the investor here is that this hinges almost entirely on the ability to select credits, which, like picking stocks, isn’t always easy. Don’t worry though, today’s investors (who have learned their lesson post-crisis), are focused on fundamentals, not on maximizing yield (i.e. no one is greedy anymore).
In the pre-crisis era, bespoke tranche investors cared less about the underlying names in the portfolio, and more about the spread pickup for a given rating and/or relative value across tranches…
Pre-crisis investors were focused less on the credit quality of the underlying portfolio so long as their objectives (spread pickup for rating or relative value) could be satisfied. In contrast, bespoke tranche investors today are more focused on credit fundamentals.
Another problem here is that these deals are almost impossible for banks to hedge.
Here’s Citi again:
Dealer correlation books in the pre-crisis era were risk managed using a combination of index tranches, index, and single name CDS. Dealers typically tried to close the “holes” in the capital structure for each bespoke portfolio using index tranches followed by selling protection on a combination of single names (for the bespoke portfolios) and index (for the index tranches) to zero out delta risk. However, during the crisis, as markets turned more volatile, the single name deltas changed significantly on a day-to-day basis, and the wide bid/ask spreads in the single name market resulted in very punitive hedging costs. Furthermore, as the synthetic structured credit market shut down, there was not enough “day one” P&L (a combination of fees and wide bid/ask spreads) to mask the losses from high hedging costs, which further exacerbated the situation.
So basically, these structures created systemic risk which was realized during the crisis. Of course this time is always different and we can of course trust that banks who do these deals will definitely place the rest of the capital structure after designing a customized equity tranche.
As one might imagine, investors’ appetite for this type of instrument is being fueled by the now ubiquitous “hunt for yield,” brought to you by NIRP (formerly ZIRP), and sponsored by your favorite central bank. In terms of growth, demand for synthetic CDOs doubled to $20 billion in 2014, and as FT notes, Q€ is set to drive further gains in structured credit:
Yield-starved European investors are helping to drive a resurgence of structured credit securities that were blamed for worsening the global financial crisis six years ago…
“It’s still below the radar screen of most investors, but [QE] could pop up volumes,” said [one] structured credit banker.
Indeed, we’re already seeing the effects of the re-emergence of bespoke tranches. Have a look at the following chart which shows that Citi and Goldman’s marketing efforts appear to have had a dramatic effect on individual name CDS:
But at the end of the day, no one should worry because as one commentator told FT, the bad name synthetic CDOs have gotten since the crisis is “regrettable [as they] are a fairly simple and straightforward way of hedging credit exposure.”
We’re reminded of Jamie Dimon: "It wasn’t a bet, it was a hedge."