Chris Whalen On The CDO-Redux & Inevitable “Catastrophic Systemic Risk Event”

Sunday, October 1, 2017
By Paul Martin

by Chris Whalen via The Institutional Risk Analyst,
Oct 1, 2017

“The great wheel of circulation is altogether different from the goods which are circulated by means of it. The revenue of the society consists altogether in those goods, and not in the wheel which circulates them”

Adam Smith, 1811

This week in The Institutional Risk Analyst, we return to one of our favorite topics – namely credit spreads – as we consider the most recent statement from the Federal Open Market Committee. Fed Chair Janet Yellen made a presentation last week to the National Association of Business Economists illustrating that while she is puzzled by low inflation, Yellen is entirely clueless as to the workings of the financial markets.

For some time now, we have been concerned that the FOMC’s overt manipulation of credit spreads has embedded future credit losses on the balance sheets of US banks. But now we are starting to see even greater signs of stress as the large Wall Street banks again return to derivatives in order to manufacture the appearance of profitability.

The leader of this effort is none other than Citigroup (NYSE:C), which has surpassed JPMorganChase (NYSE:JPM) to become the largest derivatives shop in the world. Citi has embraced the most notorious product of the roaring 2000s, the synthetic collateralized debt obligation or “CDO” security, a product that fraudulently leverages the real world and literally caused the bank to fail a decade ago.

“It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system,” reports Bloomberg.

“But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages.

Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.”

As we note in a new working paper appropriately entitled “Good Banks, Bad Banks,” large financial institutions are not particularly profitable. In times of tight credit spreads, the pressure on these banks to “cheat” when it comes to risk taking and disclosure becomes irresistible.

The dilemma large banks face when credit spreads are very low is similar to retailers that cannot compete, for example, with the efficiency of Amazon (NASDAQ:AMZN). Low cost competitors compel other retailers to match prices, even if that forces them to lose money on each sale. Trying to “make up” the loss by increasing sale volume is the obvious path to retailer insolvency.

In banking, high spreads eventually force borrowers to default and must be cured before the economy fails. Low spreads force banks to “match or lose customers” by cutting prices. When a “matching” bank’s costs are greater than the spread borrowers pay, the correct result is to shrink the number of deals done, eventually causing spreads to rise. But that’s disastrous for bank managers. As in retail, therefore, the initial reaction of bank managers is to make up for the “low yield” on each transaction by writing more deals.

As long as government is willing to “insure” deposits of banks that speculate in this manner, it creates an obvious condition of “heads managers win” and “tails shareholders and taxpayers lose.” The most obvious use for a “synthetic CDO” is to generate a lot of fictional (“synthetic”) transactions that increase the bank’s “deal flow” without need to find actual customers that want “real” loans.

The Rest…HERE

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