Risk

The Troubling Return of Credit Bubble Factors Like CDOs


The Troubling Return of Credit Bubble Factors Like CDOs

Weegee (Arthur Fellig)/International Center of Photography/Getty Images

Data point No. 1: Banks are back to hawking complex derivatives that magnify bets on corporate debt. Data point No. 2: For the first time since the financial crisis, JPMorgan Chase (JPM) is set to resume selling securities tied to home loans that aren’t backed by the government. Add a third development—the feverish revival of the U.S. housing market, with new home sales surging to levels not seen since August 2008—and a meltdown-minded observer could reasonably get to thinking, Here we go again.

The return of financial products that played a role in the 2008 credit bubble provides a measure of how far the economy has come since then—and how tempting it is for Wall Street and investors to return to old habits. It may also provide grist to lawmakers and commentators pushing to end the “too big to fail” era and break up the big banks before they require another public rescue.

Banks have sold about $1 billion of synthetic collateralized debt obligations (CDOs) so far this year, according to Citigroup (C), and the JPMorgan securities are backed by $616 million in mortgages. While the numbers may be relatively small, that banks are returning to these products at all is cause for concern, says Neil Barofsky, who was inspector general of the Treasury Department’s Troubled Asset Relief Program and wrote a book, Bailout, castigating the $700 billion fund. “History is repeating itself on a minor scale,” Barofsky says. Because bankers profited from the credit bubble, and then faced no jail time when it popped, “there’s little reason to think that [these instruments] are going to be significantly better this time around,” he says.

The list of those opposing a “too big to fail” banking system has grown in recent months to include Federal Reserve Governor Daniel Tarullo, Dallas Fed President Richard Fisher, as well as senators Sherrod Brown (D-Ohio) and David Vitter (R-La.), who sponsored a nonbinding budget amendment on March 22 that called for ending subsidies to the six largest banks. The subsidies come in the form of lowering borrowing costs because of market perceptions that the government won’t let the banks fail. The bipartisan measure passed, 99 votes to 0. Vitter and Brown say they will introduce a bill in April that will encourage banks to shrink, reducing the implicit guarantee of a government backstop. Democratic Senator Elizabeth Warren (Mass.) said in a statement, “I’m glad that Republicans and Democrats can agree: ‘Too big to fail’ needs to end, and these big-bank subsidies make no sense.”

Meanwhile, the Fed’s program to keep interest rates low is seen as creating demand for byzantine products from banks. Synthetic CDOs are made up of credit default swaps—contracts that, in return for regular payments, provide insurance against companies defaulting on their debts. By pooling credit default swaps on a group of companies, synthetic CDOs allow investors to earn higher yields than they would from individual credit default swaps. “Synthetic CDOs are sort of the natural evolution, and in many respects the final frontier, of investors’ search for yield against a backdrop of historically low interest rates,” says Richard Hill, an analyst at RBS Securities. “I think the big takeaway here is, ironically, the Fed and regulators are forcing investors to the darkest corners of the structured finance market and the structured credit market to find yield.”

The bottom line: Risky, complex investment products, along with a revival of the housing market, bring uncomfortable reminders of the financial crisis.

Summers_190
Nick Summers covers Wall Street and finance for Bloomberg Businessweek. Twitter: @nicksummers.

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Companies Mentioned

  • JPM
    (JPMorgan Chase & Co)
    • $59.44 USD
    • 0.28
    • 0.47%
  • C
    (Citigroup Inc)
    • $51.61 USD
    • 0.22
    • 0.43%
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