Tactical Financial Nuclear Bombs

Pigs are greedy – hogs get slaughtered (famous Wall St adage)

Our entire financial is one giant hog farm – Dave Kranzler, 2015

“Hope and Change.” Remember that campaign slogan? Boy, we sure hope something like the 2008 financial collapse doesn’t happen again. But alas, Obama didn’t change anything. In fact, the financial fraud and risky leverage embedded in the system is worse now than back then.

Among Wall Street’s improvised electronic devices, aka roadside financial bombs, that blew up our financial system in 2008 were Collateralized Debt Obligations (CDOs) which had credit default swaps “wrapped” around them. This was the financial tactical nuke that blew up AIG and Goldman. These securities were cesspools of subprime mortgages thrown into a security that was “sliced up” into various tranches with varying degrees of risk. Goldman would sell these primarily to hedge funds and insurance companies. Goldman would then underwrite credit default swaps which offered other hedge funds and insurance companies the ability to bet on the CDO blowing up and, conversely, allowing investors who bought into the CDO “insurance” against the CDO blowing up.

Goldman itself would retain a piece of the action. The rest is history, as Goldman found itself fatally exposed to AIG’s inability to fund the side of the credit swap in which it guaranteed that the CDO’s wouldn’t blow up. That’s how counterparty default risk operates. In this case, it blew up our financial system, cost the taxpayers directly about $1 trillion in direct funding to bail out Goldman, AIG, et al. The cost of the $4 trillion printed by the Fed has yet to be felt all of us, but rest assured it will be…

Well guess what? The CDO/credit default structure is re-born, only this time in the form of “Bespoke Tranche Opportunities:”

Goldman Sachs Group Inc. is joining other banks in peddling something they’re referring to as a “bespoke tranche opportunity.” That’s essentially a CDO backed by single-name credit-default swaps, customized based on investors’ wishes. The pools of derivatives are cut into varying slices of risk that are sold to investors such as hedge funds. (Bloomberg)

Rather than a securitized trust filled up with junk mortgages and junk corporate bonds, this ugly beast has greasy hair on it. It’s a securitized trust of derivatives in the form of credit default swaps, ostensibly with pseudo high grade and junk corporate debt issues used as the underlying reference securities. And of course this package will be wrapped up with a credit default swap on the entire cesspool of derivatives:

The derivatives are similar to a product that became popular during the last credit boom and exacerbated losses when markets seized up. Demand for this sort of exotica is returning now and there’s no real surprise why. Everyone is searching for yield after more than six years of near-zero interest rates from the Federal Reserve, not to mention stimulus efforts by central banks in Japan and Europe. (Bloomberg)

Whereas the CDO’s of 2008 vintage were portfolios of debt securities gift-wrapped in a credit default swap, the 2014 vintage gift from Wall Street is a portfolio of derivatives wrapped up with another derivative. Sheer. Financial. Insanity.

Our entire system is now significantly more leveraged than it was in 2008 – especially when you factor in the various forms of derivatives which are now – thanks to Dodd Frank/Obama/Eric Holder/etc – even more opaquely embedded into the financial system’s “balance sheet.” When this blows, the financial mushroom cloud will be a sight to behold.

You can read more from Dave Kranzler at his site Investment Research Dynamics, where this article first appeared.