As we said yesterday, the massive bubble resulting from central bank financial repression is hiding in plain sight in the structured finance space. All of these exotic products—like the new Freddie Mac “bonds” which amount to bottled equity risk—- are designed to produce “yield” where our Eccles Building overlords have decreed there shall be none. And even then, the going is tough. Invariably, the “return” on speculator equity is achieved by leveraging-up the freshly minted synthetic “asset” in question.
The trouble with this game is that the value of most structured finance products is opaque and subject to sharp and violent change under conditions of financial stress. So when they are “funded” in carry trade manner via repo or other prime broker hypothecation arrangements, the hedge fund gamblers who have loaded up on these newly minted structures are subject to margin calls which can spiral rapidly in a financial crisis. And that, in turn, begets position liquidation, plummeting prices for the “asset” in question, and even more liquidation in a downward spiral.
Perhaps as a signal that the bubble’s end is near, The Wall Street Journal has now debuted the ultimate in structured finance opacity. Apparently Goldman will soon be offering a new structure called “Fixed Income Global Structured Covered Obligation” (FIGSCO ?) that may come to market in September. The nifty feature for this synthetic “asset” is that the reference pool of securities on which it is based can apparently change anytime and without the approval of investors. As the WSJ described it:
And investors won’t know what exactly is in the pool. They will get a breakdown of the kinds of assets included, but not the exact composition. And what is in the structure can change. Crédit Agricole notes the pool could be predominantly residential-mortgage backed securities at one point, sovereign debt at another and corporate bonds at yet another.
Well, blind pools have been around for a long time, but undoubtedly the intention here is that FIGSCO will come complete with repo financing. Yet it apparently has another feature that well reflects the brazen attitude toward risk that has erupted in the Fed’s free money Wall Street casino. Namely, it will be marked-to-market every day by a third party.
Now there’s a “panic” waiting to happen! And as the balance of the WSJ story indicates, there’s a lot more like and similar bursting bubble risk where that came from. The ZIRP-induced scramble for yield has literally booby-trapped the entire financial system. One of these days, even the monetary politburo will find that out.
By Richard Barley at The Wall Street Journal
The search for yield may be approaching the final frontier.
Ultra-loose monetary policy has prompted investors to take more risk in exchange for yield. For some, that means buying lower-rated bonds or debt with longer maturities. Another route is to invest in more complex deals.
That is an unwelcome echo of developments that helped fuel the precrisis credit bubble. And conditions in markets today could prove fertile ground for ever-greater risk-taking. Yields are very low and credit spreads are tight. Moreover, there is a dearth of high-quality securities. Yet there is still a global glut of capital seeking a home. And fresh geopolitical angst is again pushing yields lower on benchmark government debt.
All this creates incentives for financial engineering. In credit derivatives markets, there are signs investors are delving back into esoteric structures. Citigroup reports a “large increase” in trading of products that slice and dice exposure to defaults in credit-default-swap indexes. The bank says this is mostly driven by hedge funds, but that other investors who may struggle to meet return targets could be drawn in.
Another example: Goldman Sachs has been marketing a new structure: a so-called Fixed Income Global Structured Covered Obligation that may come to market in September. It borrows elements of covered bonds, a structure with a long history in Europe. Investors will have a claim on a pool of dedicated assets and against two guarantors, Goldman and Mitsui Sumitomo Insurance.
But in many ways, the deal isn’t a covered bond. Instead of funding mortgages or public-sector loans, it will provide funding for a portfolio of fixed-income securities sourced from Goldman. The deal is structured via a derivative, a total-return swap entered into by Goldman Sachs Mitsui Marine Derivative Products.
And investors won’t know what exactly is in the pool. They will get a breakdown of the kinds of assets included, but not the exact composition. And what is in the structure can change. Crédit Agricole notes the pool could be predominantly residential-mortgage backed securities at one point, sovereign debt at another and corporate bonds at yet another.
Even if the deal performs well, there is still a risk. The crisis showed opacity and uncertainty lead investors to sell first and ask questions later in stressed markets.
To assuage concerns, securities will be marked to market daily—a rarity for covered bonds—and those marks will be verified by a third party. As well, the pool will have to be topped up with cash or additional securities to make up for losses.
Investors should remember, though, that in roiled markets it can be hugely difficult to assign accurate values to securities.
S&P has rated the deal triple-A. Rival Fitch says the investor protections don’t meet its standards for triple-A ratings.
Elsewhere, regulators are becoming concerned about so-called contingent-convertible bonds sold by banks, which convert into equity if capital levels fall. These are complex and their performance in a crisis is unknown; the meltdown of Portugal’s Banco Espírito Santo has shown just how quickly a bank can unravel.
The common themes running through these instruments: yield and scarcity. Credit-derivative products offer investors leverage, higher returns and the ability to take bets even in an illiquid bond market. The Goldman structure is likely to offer a higher yield than traditional covered bonds, issuance of which is in decline partly due to central-bank largess in providing cheap funding. Contingent-convertible bank bonds offer yields hard to find elsewhere.
Precrisis, low yields and seemingly benign market conditions led to the creation of instruments that ultimately few understood. The longer the reach for yield persists, the greater the chance that investors revisit that unhappy past.
http://online.wsj.com/articles/heard-on-the-street-yield-hunters-new-tune-echoes-financial-engineerings-past-1407697786?mod=_newsreel_3
