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Salmon: Synthetic CDOs Rise From the Dead

Stocks in this article: C

NEW YORK ( Reuters Blogs) -- Remember synthetic CDOs, the monsters of the financial crisis? Well, according to Mary Childs, they're "making a comeback":

Citigroup (C) is among banks that have sold as much as $1 billion of synthetic collateralized debt obligations this year, following $2 billion in all of 2012, according to estimates from the New York-based lender.
These numbers come from Mickey Bhatia, the head of structured credit at Citigroup, and they're in stark contrast to the official numbers from Sifma, which show precisely zero synthetic CDOs in 2012, and a total of just $713.4 million in CDOs over the past four years. Read a bit further on, however, and you'll see that Bhatia is talking about the notional amount of the trades in question; the actual dollar value of the synthetic CDOs being sold is unclear.

As you can tell from the fact that these deals aren't showing up in the Sifma database, they're not exactly the same as the creatures which helped to blow up the world in 2008. For one thing, as Childs notes, these new deals don't bother taking derivatives and turning them into rated securities which can be bought and sold: they're just bilateral deals with sophisticated clients looking for certain types of exposure.

One such client, quoted in Childs's piece, is Ashish Shah, the head of global credit at New York-based AllianceBernstein. Encouragingly, he was previously head of credit strategy at Lehman Brothers, which I'm sure reassures everybody who's entrusting their life savings to the kind of person who says that "a valid strategy for this part of the credit cycle" is to "leverage your exposure to better-quality credit".

Tom Davidson of Creditflux explained in an article on March 7 that these products — he calls them "single tranche corporate collateralised swap obligations" — are being pushed by "dealers who retain an active correlation book, with Citi leading the charge". If you don't know what a correlation book is, my article "Recipe for Disaster: The Formula That Killed Wall Street" might help you out; basically, it's a place to make bets on whether you think correlations are rising or falling, and/or a place to lose billions of dollars which you never thought were really at risk in the first place.

All of which raises a couple of interesting questions: Why does Citigroup, of all banks, have Wall Street's largest correlation book? And does anybody think that Citigroup has the risk-management chops to ensure that it doesn't blow up, a la the London whale?

It seems that what's going on here is that Citi is trying to hedge its loan book by using credit derivatives; in turn, its credit-derivatives wonks are creating recondite structured products to sell to the buy-side in an attempt to mold their credit risk into exactly the shape they want.

I, for one, don't trust Citigroup -- or anybody, really -- to be good at this kind of thing: the lesson of the financial crisis, and for that matter of the Senate report into JP Morgan's Chief Investment Office, is that everybody on Wall Street systematically overestimates the quality of their risk-management skills. If you want to manage risk, do it in simple and obvious ways, rather than by the use of highly-illiquid credit derivatives.

If I were Citigroup's regulator, then, I'd be asking a lot of questions about whether any of this activity is really necessary or a good idea. Because all of this smells very much like 2006 to me.

-- Written by Felix Salmon in New York.

Read more of Felix's blogs at Reuters.

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