Show Of Hands: Who's Interested In A CDO Backed By A Pool Of Subordinated Community Bank Debt?

It’s no secret that the global hunt for yield is herding investors into riskier and riskier assets fueling demand not only for traditional HY bonds, but for more esoteric paper as well such as auto- and student-loan backed ABS. 

This is the inevitable consequence of seven years of ZIRP and now NIRP. With nowhere to run and an ocean of liquidity at their fingertips, investors search out opportunities in corners of the market where they might not normally have dared to tread. 

Earlier this year, we noted that Goldman was set to resurrect the synthetic CDO with a marketing pitch that included the phrase “bespoke tranche opportunity.” Of course any time Goldman pitches you something as an “opportunity” it’s best to ask: “Yes, but is that for you or for me?” In other words: “Am I about to get muppetized here?”

But the main draw for Goldman (and others) on these deals is that the underwriting fees are higher. What they’re essentially doing is allowing investors to try their hand at picking individual credits to bet on/against and if you’re good at that sort of thing, there might indeed be a chance for you to pick up a nice CDS premium. But if it turns out you aren’t as good as you thought you were when it comes to judging idiosyncratic credit risk in a dicey environment (see the Valeant case for an example of what can go wrong), well then you could get yourself into trouble. 

In any event, the longer investors remain mired in ZIRP, the louder the calls will be for the creation of products that offer some semblance of yield. 

As we said back in February, the Bloomberg piece that announced the Goldman deal was the latest installment in a series of articles that pop up every so often in the financial news media touting the resurgence of structured credit and, more specifically, CDOs. Cue another in this series. Via Bloomberg:

Joshua Siegel is bringing back one of the most toxic financial vehicles ever devised and arguing that this time it’s going to be different.

 

His StoneCastle Financial is among the hedge funds that are reviving the collateralized debt obligation, or CDO.

CDOs stuffed with mortgages and their derivatives caused billions in losses around the world during the 2008 crisis.

 

The CDO that StoneCastle put together is a little different. 

Oh, really? How so?

It’s backed by subordinated debt issued by about 35 community banks, some of them so small they don’t have credit ratings.

Great. A collateral pool full of subordinated community bank debt. Sounds promising.

But don’t worry, Siegel has done this before:

This isn’t the first time Siegel pooled small-bank debt into a structured financial product. At Salomon Smith Barney in the late 1990s, he proposed bundling banks’ trust-preferred securities, a predecessor to subordinated debt, into so-called TruPS CDOs.

 

The trick to doing it right, according to Siegel, is regional diversification.

 

In a 2001 research report, Siegel divided the U.S. into five regions and wrote that the geographic diversity of the banks whose TruPS he used -- picking debt from different areas -- would make the CDOs safer.

Yes, “geographic diversity would make it safer.” 

You see this is just a derivative (no pun intended) of the same old argument everyone used to justify the supposed “safety” of anything backed by a mortgage in the lead up to the crisis. The contention is that while individually, the loans in the collateral pool may be crap, and while crap in isolation is just, well... crap, a bunch of crap pooled becomes “investment grade” and is thus “safer.”

Of course that all fell apart in 2008:

But banks failed all over the country in the 2008 credit crunch, throwing shade on Siegel’s original theory about regional diversification. Larry Cordell, a vice president at the Federal Reserve Bank of Philadelphia, said that’s because too many banks’ portfolios were concentrated in real estate and mortgages. They weren’t diversified enough, he said. The market for TruPS CDO collapsed. Some investors are still waiting to be repaid.

But that’s not going to stop Siegel from doing the exact same thing again: 

TruPS issuance has fallen to zero while publicly traded banks sold $12.3 billion of sub-debt, as it’s called, in 2013, about four times what they issued between 2009 and 2012, according to SNL Financial.

 

Brett Jefferson, president of Hildene Capital Management in Stamford, Connecticut, said that sub-debt CDOs are simply a retooling of TruPS CDOs.

 

“It’s a flavor of the old deals,” Siegel said. 

It sure is, and we won’t blame anyone for whom that flavor has left a bad taste.