One of my favorite scenes from The Big Short was when they described a weird and obscure financial product called "synthetic CDO's".

Surely The Powers That Be would never allow Wall Street to do this again, right? Wrong.

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.

...

“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.

Wait. I know what you are thinking.

"That's f*cking insane.It's simply not possible."

Welcome to 2017.



Rocket-scientist financiers buy up billions of dollars of risky loans and repackage them into complex investments with multiple layers of debt. Credit rating agencies classify the top layers as triple A. Institutional investors, including pension funds and charitable organisations, flock to buy these apparently risk-free yet high-yielding investments. Tension builds. But the year is not 2006 or 2007. It is today. While the US administration talks of repealing Dodd-Frank, the reality is that regulators have been flouting that law for years and now the shadow financial markets are frothing. Almost a decade after the global financial crisis, the sequel has arrived. The central culprit this time is the collateralised loan obligation. Like its earlier esoteric cousins, a CLO bundles risky low-grade loans into attractive packages and high credit ratings. In May, there were two deals of more than $1bn each, and experts estimate that $75bn worth are coming this year. Antares Capital recently closed a $2.1bn CLO, the largest in the US since 2006 and the third-largest in history. Although most of the loans underlying these deals are of “junk” status, more than half the new debt is rated triple A. Sound familiar?

...

Because loan defaults can come in waves, mathematical models should account for “correlation risk”, the chance that defaults might occur simultaneously. But the models for CLOs assume correlations are low. When defaults occur at the same time, these supposed triple-A investments will be wiped out. CLOs are just CDOs in new wrapping.

CDO. CLO.

You say "tomato". I say "institutionalized fraud".

You say "potato". I say "systemic risk".

OK. So we got CDO's and synthetic CDO's, but at least we don't have those damn CDS (collateralised default swaps) that brought down AIG, amirite?

Well, guess what? We now have synthetic CDSs.



With corporate default rates at historic lows and with stimulus increasing correlation between asset classes, use of so-called CDS indexes has boomed as both a trading and hedging tool, allowing investors to create an "overlay" on their portfolios to protect against a systemic rise in defaults at a time when liquidity is said to have deteriorated.

Further complicating matters is the explosion in alternative derivatives or 'derivatives of derivatives,' with investors now served an expansive menu of exotic synthetic credit products including options on total return swaps (TRS) and options on CDS indexes.

Such 'swaptions,' as they're sometimes known, give investors the right to buy or sell the index at a particular date and for a certain price, and are said to have surged in popularity in recent years. Analysts at Citigroup Inc. estimated that about $24 billion of CDS index options traded in 2005, rising to $1.4 trillion in 2014 — a more than a 5,000 percent jump in activity in just under a decade.

Yeehaw!

Don't worry, because the regulators have decided that Wall Street can regulate itself.

You know, like it does with drug cartel money.