An Investment Blast From the Past: Synthetic CDOs

Synthetic collateralized debt obligations (CDOs). They’re those risky, complex financial products that many blame for causing the financial crisis of 2008. Now, in the face of low interest rates, CDOs apparently are staging a comeback.

Collateralized debt obligations pool bonds and offer investors a slice of the pool. The higher the risk, the more a CDO pays. By comparison, synthetic CDOs pool insurance-like derivative contracts on the bonds.

As reported June 4 by the Wall Street Journal, the re-emergence of CDOs may have to do with attempts on Wall Street to satisfy the ever-growing demand for higher returns. So far this year, more than $38 billion of collateralized loan obligations have been sold in the United States, up from $15.6 billion in the same period last year, according to Royal Bank of Scotland Group PLC.

And big investment firms are taking notice.  Case in point: J.P. Morgan Chase & Co. and Morgan Stanley bankers in London are now trying to assemble new synthetic CDO deals.

Like their 2008 financial crisis predecessors, the new CDOs would be sliced up into different levels of risk and returns. Investors who want a chance at the highest returns would have to buy the riskiest slice. In the case of synthetic CDOs, the risk can also multiply if companies fall behind on their debt payments.

Specifics on the deals being developed at J.P. Morgan and Morgan Stanley aren’t clear, including the size of the CDOs and which investment firms have expressed an interest in buying slices of them.

According to the WSJ story, several institutional investors recently approached the two banks and asked them if they would put together the synthetic CDOs.

J.P. Morgan and Morgan Stanley apparently are now trying to line up more investors as buyers for the instruments. An investor typically buys one slice of a CDO, which is generally divided into about six pieces. The banks likely won’t proceed with the CDOs unless they can sign up enough investors, the Wall Street Journal article said.

Before the crisis, CDOs and synthetic CDOs were a popular fixture on the structured finance scene of Wall Street, bringing in substantial fees for the securities firms behind the deals.

In 2007, Goldman Sachs Group created a CDO called Abacus 2007-AC1 for hedge-fund firm Paulson & Co., which wanted to magnify a bet against the U.S. housing market.

The deal delivered big profits to the hedge-fund firm and founder John Paulson. But things became less than stellar in 2010, when Goldman paid $550 million to settle accusations by the Securities and Exchange Commission (SEC) that other investors in the deal had been misled and misinformed. In agreeing to the settlement, Goldman didn’t admit any wrongdoing but said it had made mistakes in its marketing of the deal.