The Decoder: “Synthetic junk bond” frenzy hits Wall Street

People protest outside of the New York Stock Exchange October 13, 2008 in New York City.</p>

People protest outside of the New York Stock Exchange October 13, 2008 in New York City.

Synthetic junk bonds. That’s what Wall Street is peddling these days.

As we have learned so painfully over the past several years, what happens on Wall Street matters on Main Street, as well as everywhere else across the globe.

So. Synthetic junk bonds. That may ring a bell. It sounds of like the toxic triplets that dominated the news during the Great Recession: collateralized debt obligations. Mortgage backed securities. Credit default swaps. You are fired.

Last week, exactly two years after global stock markets hit bottom, wiping out trillions of dollars in savings, the Financial Times — the salmon-colored campus paper of global money movers — ran a bolded headline declaring, “demand grows for ‘synthetic junk bonds.’”

In the first paragraphs of the article, the esteemed paper noted that synthetic junk bonds “resemble transactions linked to U.S. mortgages,” whose collapse “when mortgages turned sour was a big feature of the crisis.”

Translation: After a brief hibernation caused by All That Pain, high-risk financial innovation is back. How quickly we forget.

So is this AIG all over again? Or are we safe this time? And what exactly are synthetic junk bonds?

Let’s unpack that last question first. Bonds are loans that people with money give to companies or governments. The borrowers pay the lenders interest (think of it as rent) on that money, and promise to give it back on an agreed upon date.

A junk bond investor loans her money to a risky company — one with a higher chance of going bankrupt. This investor knows there’s a realistic chance that she may not get her money back. But if the company stays healthy, she’ll be rewarded for bottom feeding by receiving a higher interest rate. She may get, for instance, between 6 and 13 dollars annually for every $100 she puts down. That’s a lot more than the dollar or so you’d get these days from a safe bet, such as a savings account or certificate of deposit.

Because of this wide spread between a safe bet and a risky one, there’s a rapidly growing market for these junk bonds. Last year, companies issued about $2 billion globally. In the first two months of 2011, that number jumped to nearly $10 billion, the Financial Times reports.

Here’s another way of looking at junk bonds: a typical, old-fashioned bond holder is like the owner of a sports team. He buys the asset (the bond or the team) and profits from the proceeds it delivers — interest (in the case of the bond) or revenues (the sports team).

Investing in junk bonds is like buying the Washington Wizzards: there’s a good chance they’ll do poorly. You may lose money on the purchase. But imagine how sweet it will be if they win — and how much more you’ll earn from that investment when fans and sponsors return to the arena. (The difference, of course, is that bonds pay a fixed rate of interest, while an investment in a sports team is more unpredictable.)

So what’s a synthetic junk bond? It’s exactly what it sounds like: a junk bond that's artificial. A synthetic junk bond — like any synthetic investment — only exists because people on all sides of the deal have agreed to make it exist. No company asked for or received a loan from investors.

In simple terms, it’s somewhat like betting on the Nets without actually owning them.

Here’s a better (albeit more complex) analogy for a synthetic junk bond: imagine you’re wealthy, and there’s a million dollar apartment building you want to buy, because you want to make a profit collecting rent from the tenants. You ask your sister if she wants to go into partnership. She says “no way, that place is a firetrap. It’s going to burn down any day.”

Your sister, in other words, would prefer to bet against the building (to "short" the building, in Wall Street parlance). In the meantime, you find out that the apartments are owned by many different people, making a purchase difficult.

Since you're eager to invest in the building, and your sister is eager to invest against it, you have a perfect partner for a synthetic deal.

Here's how that deal works: your sister pays you a fee every month for five years — a premium, approximately equal to rent money the building earns — as an insurance policy on the building. If the building burns, you owe your sister the million dollars it's worth, the same way she would get reimbursed from All State if she owned the building and had insured it.

Before the deal begins, to make sure you can pay, you transfer the million dollars to your uncle, to hold, as if you're buying the building. If it doesn’t burn by the end of the five years, you get your million dollars back, and you keep the premium your sister paid (less a small fee that your uncle demanded as part of the deal). This is a synthetic investment: no one in your family owns the building, but you profit more or less as if you did.

For synthetic junk bonds, instead of betting that the building will burn down, your sister thinks a pool of bonds are going to fail to pay their investors. So she takes out an insurance policy that will pay out if that happens. Meanwhile, you put up the collateral for the bonds (as if you had bought them), and you get the interest (just as you got the rent in the real estate deal). And your uncle, a Wall Street bank, keeps part of your sister’s payments as a fee for setting up the deal. Presto, you invest in something you don't own.

Pretty neat, eh?

Well, maybe. That insurance policy that your sister is buying has an ominous name that may ring familiar to attentive readers: it’s called a credit default swap.

That’s what got AIG in trouble. So will the taxpayers be on the hook once again, for synthetic junk bonds?

That might be the trillion dollar question.

In AIG’s case, its credit default swaps insured an eye-popping fortune in debt. The problem was that AIG was considered such a trustworthy company — and regulators were so far out of the loop — that there was no uncle (or Wall Street intermediary) assuring that AIG could pay up if the unthinkable happened. As we now know, the company's reserves turned out to be far too small. It basically assumed that while a building or two might burn down, the whole city wouldn’t.

Then the city did burn: the mortgage market and Lehman Brothers collapsed. When that happened, the folks who had been paying the premiums came to collect — and, well, that’s where the taxpayers came in, to keep the spiral of debt from spinning out of control and sending us back to pre-monetary times.

The situation with synthetic junk bonds is different, at least so far. Unlike in AIG’s case, “If the intermediary, [meaning Wall Street, or your uncle], has done this right, it has no skin in the game and has taken a fee from both sides in the process,” writes Gordon M. Bodnar, professor of international finance at the Johns Hopkins School of Advanced International Studies, in an email to GlobalPost. If so, that would prevent another AIG. 

“Two words of caution,” he continues. “One is that buyers should be thinking about why some other party is so interested in shorting junk bonds that they will go to all this trouble. (Obviously they must really think these junk bonds are going to tank). And second, which investor group do we think is driving this market? Do they have an informational advantage over the other investor group? This was the case in the mortgage version of this game.”

As a final word of caution: it's still not clear whether the high-risk trades in these complex, synthetic investments will be adequately supervised. The Securities and Exchange Commission is currently writing new rules to be implemented under the Dodd-Frank Wall Street Reform and Consumer Protection Act. (They SEC declined to discuss the matter, as it is currently in a public comment period.)

For the moment, in other words, this may not trigger the next crisis. People who bet right will make money, and people who don’t will lose, but there’s nothing about this arrangement that would affect the rest of us.

Here's the problem with financial innovation: as the business cycle picks up steam and bankers get hungrier for bonuses, safe and efficient inventions can evolve, creating a monster.

Stay tuned.

Follow David Case on Twitter: @DavidCaseReport