"They're Ba-ack!" - Citi Says Synthetic CDOs May Reach $100 Billion In 2017, 5x Increase In 2 Years

35-year-old Jia Chen of Citibank probably has no idea where that title quote above came from.  That's because she was roughly 4 years old when Poltergeist II hit theaters back in 1986...

...that said, Citibank, as we noted a few weeks back, has every confidence that Jia is the perfect person to put in charge of once again making the bank into a powerhouse player in the Synthetic CDO market...perhaps because she was barely out of college when the same product nearly tanked the global financial system less than 10 years ago.

Be that as it may, Jia seems to be succeeding admirably in her mission to once again massively overlever the global financial system as Citibank reports that Synthetic CDO new issues are expected to exceed $100 billion this year, up 5x in just two years.  Per Bloomberg:

The comeback in complex credit derivatives blamed for exacerbating the global financial crisis is picking up pace.


That’s according to new research this week from Citigroup Inc., one of the biggest arrangers of so-called synthetic collateralized debt obligations. Sales of the products may jump to as much as $100 billion this year from about $20 billion in 2015, Citigroup analysts wrote in an Oct. 31 report.


While investors suffered billions of dollars in losses on similar bets a decade ago, the leverage offered by synthetic CDOs is luring back buyers in an era of low yields and dwindling volatility.


“It would seem as if the low spread-low vol environment, similar to back in 2006-2007 (when investors couldn’t get enough of levered synthetic tranches) has revived some interest in portfolio credit risk,” Citigroup analysts led by Aritra Banerjee wrote. “Investors may not have necessarily wanted to add leverage, but, simply put, they have had to, given the lack of alternatives.”


But don't worry too much about the ballooning risk associated with these products because Citibank says they've solved the problem that made them dangerous back in 2008 by reducing duration...and we all know that credit risk is equally to exactly 0 on the short end of the curve, right?

There are some key differences in today’s synthetic CDOs versus the pre-crisis vintage. Citigroup said it has created over 50 “full capital structure” deals in recent years, which vary from the single-tranche bespoke deals that dominated before and just after the crunch.


Such full capital structures -- which typically include junior, mezzanine, and senior tranches -- have historically proved harder to sell because banks must find buyers for all the pieces at once. Senior tranches are more insulated from potential losses but also come with lower yields -- one reason that banks created the infamous “leveraged super seniors” before the financial crisis.


New banking rules, including higher capital charges, have dented the market for single-tranche deals, according to Citigroup. While full-capital structures may reduce exposures for banks selling the deals, they effectively shift all of the risk to investors.


“Banks operating in the market now seek to buy protection from investors across the entire capital structure,” the Citigroup analysts said. “Once this is done, banks can fully hedge out their risk using single name and index positions, which is far less punitive from a capital perspective.”


Recent deals also have lower duration. Maturities of just two to three years compare with the 8.5-year average from 2000 to 2010, according to Citigroup. Long maturities spooked the market during the credit crisis, when leverage embedded in the products forced investors to book outsized losses on their positions.

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:  Seems like we're getting to that point in the cycle when it once again makes sense to "short everything that guy [or girl in this case] has touched."