By David Stockman, Budget Director under President Reagan and author of the bestseller, The Great Deformation: The Corruption of Capitalism in America. This article originally appeared on David Stockman’s Contra Corner.
The massive bubble resulting from central bank financial repression is hiding in plain sight in the structured finance space. All of these exotic products—like the newfangled Freddie Mac “bonds” we discussed yesterday that amount to bottled equity risk—are designed to produce “yield” where our Fed overlords have decreed there shall be none. And even then, the going is tough. Invariably, the “return” on speculator equity is achieved by leveraging-up the freshly minted synthetic “asset” in question.
As The Wall Street Journal reports:
All this creates incentives for financial engineering. In credit derivatives markets, there are signs investors are delving back into esoteric structures. Citigroup reports a “large increase” in trading of products that slice and dice exposure to defaults in credit-default-swap indexes. The bank says this is mostly driven by hedge funds, but that other investors who may struggle to meet return targets could be drawn in.
The trouble with this game is that the value of most structured finance products is opaque and subject to sharp and violent change under conditions of financial stress. So when they are “funded” in carry-trade manner via repo or other prime broker hypothecation arrangements, the hedge-fund gamblers who have loaded up on these newly minted structures are subject to margin calls which can spiral rapidly in a financial crisis. And that, in turn, begets position liquidation, plummeting prices for the “asset” in question, and even more liquidation in a downward spiral.
Perhaps as a signal that the bubble’s end is near, The Wall Street Journal has now debuted the ultimate in structured finance opacity. Apparently Goldman will be offering a new structure called “Fixed Income Global Structured Covered Obligation” (FIGSCO?) that may come to market in September. The nifty feature for this synthetic “asset” is that the reference pool of securities on which it is based can apparently change anytime and without the approval of investors. As the WSJ described it:
And investors won’t know what exactly is in the pool. They will get a breakdown of the kinds of assets included, but not the exact composition. And what is in the structure can change. Crédit Agricole notes the pool could be predominantly residential-mortgage backed securities at one point, sovereign debt at another and corporate bonds at yet another.
Even if the deal performs well, there is still a risk. The crisis showed opacity and uncertainty lead investors to sell first and ask questions later in stressed markets.”
Blind pools have been around for a long time, but undoubtedly the intention here is that FIGSCO will come complete with repo financing. Yet it apparently has another feature that well reflects the brazen attitude toward risk that has erupted in the Fed’s free money Wall Street casino. Namely, it will be marked-to-market every day by a third party. Now there’s a “panic” waiting to happen!
S&P slapped a triple-A rating on the deal, the WSJ reported. “Rival Fitch says the investor protections don’t meet its standards for triple-A ratings.”
And as the balance of the WSJ story indicates, there’s a lot more like and similar bursting bubble risk where that came from. The ZIRP-induced scramble for yield has literally booby-trapped the entire financial system. One of these days, even the monetary politburo will find that out. By David Stockman. This article originally appeared on David Stockman’s Contra Corner.
They’d piled into the new “risk sharing RMBS bonds” issued by Fannie and Freddie. Wall Street provided 80% leverage. Buying frenzy ensued. But it didn’t last long. Read…. Financial Bomb Blows up, Margin Calls Hit Hedge Funds