When a restaurant fails a health code inspection, sometimes the easiest thing to do is to close up shop, let people forget what happened, then slap a new sign on the door and reopen under a new name. That’s essentially what the world’s biggest banks are doing with a complex, high-risk investment product that helped destroy the global economy less than eight years ago.
Goodbye, “collateralized debt obligations.” Hello, “bespoke tranche opportunities.” Banks including Goldman Sachs are marketing that newfangled product, according to Bloomberg, and total sales of “bespoke tranche opportunities” leaped from under $5 billion in 2013 to $20 billion last year.
Like other derivatives, these “BTOs” allow investors to place wagers on the outcome of various loans, bonds, and securities in which they are not directly invested. Hedge funds and other sophisticated financial industry actors use derivatives both as a form of insurance to manage the total risk they are exposed to across their whole investment portfolio, and to gamble on real-world economic events such as mortgage payments, municipal bonds, and the price of physical commodities. The resulting web of complicated contracts can be very difficult to untangle, and can involve impossible-sounding amounts of money. The Financial Crisis Inquiry Commission concluded that derivatives “were at the center of the storm” and “amplified the losses from the collapse of the housing bubble by allowing multiple bets on the same securities.” In 2010, the total on-paper value of every derivative contract worldwide was $1.4 quadrillion, or 23 times the total economic output of the entire planet.
Collateralized debt obligations (CDOs) are a form of derivative that breaks one pool of financial assets — either direct loans or securities that are based on groups of loans — into multiple layers of riskiness. Those layers care called tranches, and investors who buy the least-risky tranche of the derivative will get paid before those who buy the second tranche, and so on. Banks selling traditional CDOs had to create these multiple risk tranches based on a given set of loans or securities, and then hope that someone would buy each of them.
The new “bespoke” version of the idea flips that business dynamic around. An investor tells a bank what specific mixture of derivatives bets it wants to make, and the bank builds a customized product with just one tranche that meets the investor’s needs. Like a bespoke suit, the products are tailored to fit precisely, and only one copy is ever produced. The new products are a symptom of the larger phenomenon of banks taking complex risks in pursuit of higher investment returns, Americans for Financial Reform’s Marcus Stanley said in an email, and BTOs “could be automatically exempt” from some Dodd-Frank rules.
This is not the first time that large banks have tried to reboot the CDO machine since the financial crisis made those products a much-reviled household name. In early 2013, JP Morgan Chase and Morgan Stanley tried and failed to find buyers for a new set of CDOs. The nature of that failure helps illuminate the rationale behind the new version of the product. Finding buyers for the various different layers of risk was “like trying to line up boxcars,” one investor told the Financial Times after the 2013 reboot effort fizzled. Many of the firms that used to buy such products prior to the crisis “no longer exist, and those that survive have very bad memories” of the experience, another analyst said.
Since then, those same old characters seem to have found a way to get back into the business. In addition to Goldman, which narrowly avoided criminal charges after a Senate investigation revealed its shady pre-crisis mortgage dealings, sellers of “bespoke tranche obligations” now include Citigroup and the french banking giant BNP Paribas. BNP’s recent notoriety doesn’t relate to the financial crisis, but rather to the bank’s violation of various U.S. sanctions against Iran, Cuba, and Sudan. And while Citigroup’s past leadership now says financial deregulation was a mistake and that megabanks like Citi should be broken up to protect the economy, its current leadership is chipping away at key Dodd-Frank reforms. Citi was also heavily involved in the “robosigning” scandal that lead to hundreds of thousands or even millions of unjust foreclosures.