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As Credit Booms, Citi Says Synthetic CDOs May Reach $100 Billion

(Bloomberg) -- The comeback in complex credit derivatives blamed for exacerbating the global financial crisis is picking up pace.

That’s according to new research this week from Citigroup Inc., one of the biggest arrangers of so-called synthetic collateralized debt obligations. Sales of the products may jump to as much as $100 billion this year from about $20 billion in 2015, Citigroup analysts wrote in an Oct. 31 report.

While investors suffered billions of dollars in losses on similar bets a decade ago, the leverage offered by synthetic CDOs is luring back buyers in an era of low yields and dwindling volatility.

“It would seem as if the low spread-low vol environment, similar to back in 2006-2007 (when investors couldn’t get enough of levered synthetic tranches) has revived some interest in portfolio credit risk,” Citigroup analysts led by Aritra Banerjee wrote. “Investors may not have necessarily wanted to add leverage, but, simply put, they have had to, given the lack of alternatives.”

As Credit Booms, Citi Says Synthetic CDOs May Reach $100 Billion

While post-crisis deals are typically tied to corporate credit as opposed to the mortgage debt that helped spur the credit crunch, the return of synthetic CDOs is likely to generate unease among investors who worry that markets are too frothy. The controversial product’s resurgence coincides with a boom in other types of credit wagers, including options on credit derivative indexes and exchange-traded funds that provide quick and easy access to a broad swath of credit.

There are some key differences in today’s synthetic CDOs versus the pre-crisis vintage. Citigroup said it has created over 50 “full capital structure” deals in recent years, which vary from the single-tranche bespoke deals that dominated before and just after the crunch.

Such full capital structures -- which typically include junior, mezzanine, and senior tranches -- have historically proved harder to sell because banks must find buyers for all the pieces at once. Senior tranches are more insulated from potential losses but also come with lower yields -- one reason that banks created the infamous “leveraged super seniors” before the financial crisis.

New banking rules, including higher capital charges, have dented the market for single-tranche deals, according to Citigroup. While full-capital structures may reduce exposures for banks selling the deals, they effectively shift all of the risk to investors.

“Banks operating in the market now seek to buy protection from investors across the entire capital structure,” the Citigroup analysts said. “Once this is done, banks can fully hedge out their risk using single name and index positions, which is far less punitive from a capital perspective.”

Recent deals also have lower duration. Maturities of just two to three years compare with the 8.5-year average from 2000 to 2010, according to Citigroup. Long maturities spooked the market during the credit crisis, when leverage embedded in the products forced investors to book outsized losses on their positions.

As Credit Booms, Citi Says Synthetic CDOs May Reach $100 Billion

But even shorter durations can come back to bite buyers by effectively suppressing yields on the underlying shorter-term credit default swaps. That leaves CDO investors vulnerable to losses if the appetite for credit risk were to drop over the next few years.

“Utterance of phrases such as ‘synthetic CDO’, ‘bespoke tranche’ or ‘collateralised synthetic obligation’ are often accompanied by some uneasy looks amongst some investors that we speak to,” the Citigroup analysts wrote. “There has been a sizeable pick up in issuance and trading this year, though volumes still remain a fraction of those seen pre-crisis.”

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