Beware the Return of Synthetic CDOs

 | Jun 05, 2013 | 2:15 PM EDT
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You have to be kidding me. That was my reaction today to the story headed "One of Wall Street's Riskiest Bets Returns," about the return of synthetic collateralized debt obligations.

You may not know what these pieces of paper are, but these abstruse financially engineered bonds are created to meet the demand from fund managers who want to reach for yield to get a better return for their investors. In the peak year of 2007, right when housing was about to plummet in value, The Wall Street Journal reminds us that $634 billion in synthetic mortgage CDOs were created, and they were at the heart of the entire financial fallout of the Great Recession.

The article claims that investors are demanding these risky pieces of paper, no doubt so they can borrow money, levering up their assets, to buy these bonds and magnify the returns.

Now, I am not against pooling mortgages to get a bigger yield. That's just plain old securitization, and without it we would not have a functioning mortgage market.

But as my colleague David Faber pointed out this morning, these synthetic collateralized debt instruments are basically risky bets on housing made riskier by the amount of leverage funds use to juice their returns.

I understand when sophisticated investors want to try to get more reward with more risk, but last time around, these pieces of paper had so much risk that when housing went sour, they wiped out the investors, the companies that insured these papers -- think the old American International Group (AIG) -- and even the issuers themselves, which included Bear Stearns and Lehman Brothers. If the government is really interested in being sure that we ban the notion of "too big to fail," then the government should just ban these CDOs outright, as they were huge contributors to the near downfall of the entire system.

Now, the defenders of these bonds will say that the underlying mortgages are in much better shape than they were. Believe me, I heard that same argument, particularly from executives at Bear and at Countrywide, who endlessly assured me that there could not be a huge number of defaults in mortgages. They were dead wrong.

The sellers of these bonds will tell you that they are terrific ways to get a little more juice, or return, for their investors over all other fixed-income alternatives. But they will sell them to both the smart money and the so-called dumb money -- less sophisticated investors who don't know any better -- and the latter will be destroyed by them just like last time.

In the interim, the salespeople, who right now are just supposed to be meeting the demand from these customers, will soon start force-feeding this stuff to everybody who can take it down, charging immense but hidden fees in the process. They used to call it jamming, meaning fixed-income brokers jammed unsuspecting customers with pieces of paper that seemed safe and were blessed by the ratings agencies that were paid for by the issuers, and the salespeople were able to make fortunes doing so. They could jam the customers, because these CDOs are what are known as structured products. While that sounds highfalutin, they are simply a terrific way to bang customers, because gigantic fees are often embedded into the total cost of the instruments.

The salespeople can afford to jam the customers and not worry about how the customers fare with this toxic junk, because the fees are so big that after you've sold a few of them, you've made millions upon millions of dollars, and you can simply retire or move on to another firm with no accountability for the destruction you just wrought.

The government has to wise up right now and stop this financial engineering before it gets out of hand again.

That's why I am on a mission, a mission to shame all who sell these lethal pieces of paper and to warn all those who might buy them. We need to stop this travesty before we get a repeat of 2007 to 2009.

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