December 3, 2013 5:28 pm

Boom-era credit deals poised for comeback

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Last month Citigroup placed an unusual job advertisement. The bank was seeking an analyst able to crunch the numbers on an obscure financial security: synthetic collateralised debt obligations.

Four weeks later, job applicants would find the position filled. Such has been the clamour among investors for the higher yields from higher-risk products that big banks including Citi, JPMorgan Chase and Morgan Stanley are turning again to the more esoteric parts of the financial markets. Hence the need to hire.

Synthetic CDOs are a type of structured credit product blamed by critics for exacerbating the global financial crisis. Wall Street manufactured billions of dollars of these securities at the peak of the credit boom. They have all but disappeared since.

The road to recovery, though, has been a bumpy one for synthetic products. The stigma of buying into such boom-era assets remains strong for investors, particularly when leverage – or borrowing – is used in an effort to enhance returns.

“Investors have learnt the use of leverage can create losses when they are not expected,” says Ashish Shah, head of global credit at AllianceBernstein. “Investors have to be conservative when applying leverage to less liquid assets.”

That has prompted some banks to tweak the structure of new synthetic deals. Citi has begun marketing an unusual $100m senior slice of a four-year synthetic CDO to investors.

Since their creation in the early 2000s, synthetic CDOs have allowed investors to make amplified, or leveraged, bets on portfolios of credit ranging from subprime mortgage bonds to corporate loans. The products buy derivatives known as credit default swaps and divide them into “tranches” with varying risk and seniority.

Finding investors to buy the most senior pieces of such deals has tended to be difficult because the top slices generate the lowest yields. So banks invented a so-called “leveraged super senior” tranche, which allowed investors to pay only a fraction of the senior tranche’s total value and, by doing so, juice their returns.

But leveraged super seniors caused massive losses during the crisis as declines in the market value of the products triggered contract clauses that required investors to stump up billions of dollars of collateral or walk away.

To assuage investors’ concerns about possible losses, Citi has changed the structure of its proposed senior synthetic CDO deal, which is tied to a pool of investment-grade corporate credits.

Instead of asking investors to put up more collateral as the market value of the underlying portfolio falls, investors will have to pay up only if actual losses on the portfolio exceed 15 per cent. “It’s very easy to call it a leveraged super senior but what it really is, is a vanilla super senior plus financing,” said an executive at a rival bank.

While synthetic CDOs with a “full capital structure” – including junior, “mezzanine” and senior tranches – have yet to return to the market, banks have been selling “bespoke” or “single-tranche” CDOs in recent years. Citi, in particular, has been offering customised single-tranche deals notable for attractive-looking yields.

Such unrated deals are typically tied to corporate credit, rather than mortgages. Average trades have two-year terms instead of the 10-year deals that were common before the crisis. The bank is believed to have sold as much as $1bn of these bespoke single-tranche CDOs so far this year.

“They [Citi] have been reasonably active in junior parts of the capital structure,” says one bank executive. Selling off the bank’s senior credit risk to new investors is “the best way for them to risk manage” overall credit exposure.

It is unclear whether Citi will be able to find buyers for its proposed deal, which it has been marketing to potential investors including big pension funds and endowments for a month in Europe and the US, according to people familiar with the transaction.

Some big institutional investors have criticised the product for yielding only 3.5 per cent – or about one percentage point more than regular investment-grade bonds. They reckon the deal should yield about 5 per cent.

Investors have learnt the use of leverage can create losses when they are not expected

- Ashish Shah, AllianceBernstein

That could prove a stumbling block. A previous attempt to resuscitate a pre-crisis-like, “full capital structure” CDO by JPMorgan and Morgan Stanley failed after the two banks were unable to line up investors to take on the most senior part of the deal.

Still, people familiar with the deal say Citi could prepare the ground for a wider revival in demand for structured credit in the new year, once investors have a clearer view of interest rates and when the Federal Reserve starts to pare back its $85bn-a-month bond-buying programme.

Bankers are hopeful that, once the dust settles from the Fed “taper”, investors will feel more comfortable buying investment-grade credit at higher interest rates and, moreover, leveraging the returns against a low risk of high-quality companies going bust. Citi, for its part, believes a super senior revival will be the story of 2014.


Letter in response to this report:

Citi’s attempts to market CDOs are just a distraction / From Mr Christopher Townson

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