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Banks Return to the Same (Poisoned) Well

Michael Santoli
Daily Ticker
Banks Return to the Same (Poisoned) Well

Chekhov said a gun seen in a play’s first act will surely be used by the end. On Wall Street, a financial instrument once engineered won’t go unused for long -- no matter how much damage it helped inflict before.

Or so it seems, given the reappearance of “synthetic collateralized debt obligations,” a vehicle created by banks that gives investors exposure to the creditworthiness of companies through derivative agreements. The pool of securities are sliced up by risk grades and sold to institutional investors.

Synthetic CDOs based on dicey mortgages were a key transmission mechanism for the financial contagion that drove the 2008 financial crisis -- and the resulting bank failures, bailouts and extreme monetary stimulus in response.

And, coming full circle, we have central banks’ ultra-low interest-rate policies to thank (or blame) for the reawakening of the synthetic CDO market. As the Wall Street Journal reports, the hunt for returns by a handful of JPMorgan Chase & Co. (JPM) and Morgan Stanley (MS) clients has led the banks to begin constructing the instruments.

Of course, this represents only the modest stirrings of a once-huge market that has been essentially dormant since 2009. A total of $1 trillion in synthetic CDOs were concocted and sold from 2006 to 2007, many of them winning misleadingly stellar ratings from the big credit agencies as investment funds and insurance companies sought income in a low-rate environment.

Related: Sallie Krawcheck: Your 'Safe' Investments Aren't So Safe

And, importantly, the root cause of the meltdown was the underlying collateral -- piles of subprime mortgages fueling a raging housing bubble -- going very bad. Some of those rotten mortgages are still causing indigestion, as $1 billion in previously undisclosed losses were recently passed on to some investors in pools of bubble-era loans.

Today, credit-rating standards are stricter, corporate creditworthiness is at least stable and – hopefully – regulators are more attentive about the hidden risks embedded in opaque financial instruments.

Yet the re-emergence of these derivatives underscore a central element and potential risk of the Federal Reserve’s determined campaign to keep short-term interest rates at zero indefinitely. Central banks are starving the world of safe assets and reliable income -- something a whole class of investors need to fund long-term liabilities or finance retirement.

Articulating the hazards of such a policy, Yahoo! Finance Editor-in-Chief Aaron Task says in the attached video, “I’m concerned the Fed is basically going to re-inflate a credit bubble as long as they keep rates at zero.”

This certainly is a relevant worry -- the Fed’s powerful medication could start being used for reckless “recreational” purposes and lead to an addiction with bad long-term health effects.

Indeed, this very fear might be driving Fed officials to inject some ambiguity about their intentions into investors’ minds, allowing markets themselves to readjust and skim off some of the froth. The recent selloff in Treasuries, corporate bonds and other overheated “yield plays,” and the related volatile setback in stocks, could involve the Fed attempting to jawbone away some of the excesses without having to actually change policy.

The true nightmare, worst-of-both-worlds scenario, after all, might be if heedlessly speculative financial markets forced the Fed to reduce its monetary stimulus even as the real economy remains sluggish.

At minimum, risk appears to have become mispriced, with “junk” bond issuers able to lock in rates near 5%, half the level of many outstanding issues, and investment-grade companies able to borrow at levels the most fiscally secure governments could only dream of several years ago.

The takeaway for investors is that the investments that appear safe and prudent -- such as high-yield corporate debt and other bond funds, and real-estate investment trusts -- are very likely offering insufficient compensation for the unappreciated level of risk they might impose down the road.