Toxic Assets strike back.

Dear,

As I explained here some weeks ago, speculation is one of the causes of the current Financial and Economic crisis, but not the main one.

http://sapbank.blogspot.fr/2013/05/why-bankers-play-casino-dear-common.html

The root cause is Capital scarcity which has generated a systemic problem, and the solution requires a Systemic Change; from a Financial System based in Volume to a Financial System based in Efficient Capital Management.

In fact, 5 years after the official start of the Great Recession some of the toxic and risky assets, publically condemned at the time, are back in the Capital Markets.

http://www.ft.com/cms/s/0/76778796-cebe-11e2-ae25-00144feab7de.html#axzz2WAS0jtrr

One of the most criticized products after 2008 crash were the Synthetic CDO’s; let’s see why.

A Synthetic CDO is a form of Collateralized Debt Obligation in which the investor takes long positions betting some referenced securities will perform. In a standard CDO the investor is paid with the interests of borrowers paying their mortgages loans, while in a Synthetic CDO, the investor is paid with the fees of Credit Default Swap insuring financial assets from a default event.

Simplifying, if the asset protected by the Credit Default Swap performs well, the investor in the Synthetic CDO will receive a portion of the fees paid by the client who has bought the CDS. In case the issuer of the insured asset defaults, the investor will have to pay his portion of the insured asset to the buyer of the Credit Default Swap.

For investment banks, synthetic CDO’s are like a securitization of Credit Default Swaps, which helps them to reduce their exposures and Capital consumption. On the other hand, for the investors, Synthetic CDO’s are a financial instrument which lets them participate in the derivatives business by selling Credit Default Swaps and receive a portion of the fees paid for the insurance.

The main advantage for an investor taking a long position in a synthetic CDO, instead of directly selling the CDS, is risk diversification. The seller of a Credit Default Swap takes all the default risk on a specific security, while investing in a Synthetic CDO the investor will be able of diversifying the risk with a portfolio of securities, with even different tranches of ratings (Probabilities of Default).

Synthetic CDO’s were severely criticized after the Financial Crisis of 2008; the main reason was their capacity for multiplying losses, with standard CDO’s the limit of the exposures is determined by the total volume of the securitized mortgage loans. This limit does not exist for synthetic CDO’s, as the investing banks can issue an infinite numbers on Credit Default Swaps on the existing securities, as long as investors agree to take the other part of the bet.

While economy is performing well, Synthetic CDO’s are generating liquidity which feeds the economic engine and helps to maintain high valuations in the Capital Markets.

But as it happened in 2007, when the economy slows down the probability of default of the insured securities will rise. If a default event activates the Credit Default Swaps, a payment obligation will be triggered for the Synthetic CDO’s, generating enormous losses for their holders.

After the event, we will probably blame Bankers for not learning the lesson; but Banks are private companies whose objective is generating dividends for their shareholders and bonus for their executives. On the other side investors are moved by greed and the low interest rates are incentives for them to invest in more risky, purely speculative, assets.

Once again, the exit strategy of this Financial Crisis is Efficient Capital Management. Growing by inflating bubbles (Real Estate, Gold, Public Debt, Derivatives, etc.) is a waste of Capital that we could afford when Capital was abundant, but this is not the case anymore.

Looking forward to read your opinions.

K. Regards,

Ferran.