Bernanke gets his wish, comeback of financial system's most toxic securities

The Retirement Plan Death Spiral has been overtaken as the most toxic side effect of Fed Chairman Ben Bernanke's zero interest rate policies by the comeback of the financial system's most toxic securities: synthetic collateralized debt obligations.

Regular readers will recall that these synthetic CDOs were at the heart of the financial crisis.  These were the securities that let Wall Street ,which knew that subprime mortgages were going bust faster than was assumed in the investors' pricing models, successfully "bet" on this knowledge.

The fact that these opaque, toxic securities which the regulators and market cannot value have re-emerged is the direct result of 5 years of zero interest rate policies.

Surely, investors and the financial system will have a better experience gambling on these securities this time around.

As reported by Bloomberg,

Derivatives that pool credit- default swaps to make magnified bets on corporate debt, popularized in the last credit bubble, are making a comeback as investors search farther afield for alternatives to bonds at record-low yields....

Synthetic credit, which amplified the financial crisis five years ago, is enticing investors after corporate-bond yields dropped to less than half the 20-year average. 

By betting on the degree to which a group of companies will default, a CDO may pay relative yields of more than 5 percentage points, four times that of a typical credit-swaps transaction on similar debt.

Please note the use of the word "betting".  An opaque security cannot be valued.  Therefore, buying it is simply an exercise in betting.

“That’s a valid strategy for this part of the credit cycle: Don’t stretch on credit quality, but rather leverage your exposure to better-quality credit,” Ashish Shah, the head of global credit investment at New York-based AllianceBernstein LP, which oversees $256 billion in fixed-income assets, said ....

Betting is not a valid investment strategy.  Betting is gambling.

The distinction between gambling and betting is subtle.

Gambling involves buying opaque, toxic securities and guessing what the value of their contents is.  Investing involves have transparency into all the useful, relevant information in an appropriate, timely manner so as to independently assess this information and make a fully informed decision.

“Investors are in a desperate search for yield,” said David Knutson, a credit analyst at Legal & General Investment Management America. “CDO products offer incremental yield to plain-vanilla transactions.”...

Bernanke's zero interest rate policies deliberately make investors desperate when it comes to yield.  They are designed to be coercive and force investors to take more risk.

However, there is a real difference between taking more risk while investing and simply taking risk by gambling.

Sales of bespoke synthetic CDOs are climbing after the market all but shut down during the financial crisis in 2008.

Bernanke's legacy is the revival of the synthetic CDO market that produced the following spectacular results:

After the amount of credit protection sold through CDOs in that period climbed to about $1 trillion, investors took losses of up to 90 percent on deals that bet heavily on financial firms that failed during the crisis, including Lehman Brothers Holdings Inc. and Icelandic banks. 

In the mortgage market, CDOs that packaged home-loan securities and were given top AAA ratings by S&P wiped out investors in a matter of months, according to a lawsuit by the Justice Department filed Feb. 4 in Los Angeles. 

Synthetic CDOs “enabled securitization to continue and expand even as the mortgage market dried up and provided speculators with a means of betting on the housing market,” the Financial Crisis Inquiry Committee wrote in a 2012 report. “By layering on correlated risk, they spread and amplified exposure to losses when the housing market collapsed.”

And thanks to Fed Chairman Bernanke's policies, this particularly toxic security has, like Dracula, come back to life to suck the lifeblood out of the real economy.

As the Federal Reserve holds its benchmark interest rate near zero for a fifth year, investors including pension funds and hedge funds are again seeking out more structured debt or derivatives that offer greater yields than the bonds or loans underlying them....

Your humble blogger doesn't mind if hedge funds gamble on these opaque, toxic securities.  This is what investors in hedge funds expect.

However, pension funds and insurance companies should never be allowed to invest in opaque, toxic securities.  Regulators for pension funds and insurance companies have had 5 years to adopt regulations that would prevent this from occurring.

Trading in synthetic CDOs will continue to rebound even after global bank capital rules and the U.S. Dodd-Frank Act make derivatives more expensive to trade and hold, Peter Tchir, founder of New York-based TF Market Advisors, said in a March 15 e-mail to clients. 

“There’s going to be this bigger search for yield and spread, and tranches are a natural way to do it,” he said.

As previously pointed out by your humble blogger, global capital rules do not stop gambling on opaque securities.  

As previously pointed out by your humble blogger, Dodd-Frank also did nothing to restore transparency to all the opaque corners of the financial system.  

As a result, investors have been coerced by the Fed to return to opaque areas where Wall Street can handsomely profit off of the investors inability to price the securities.