Connect to share and comment

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

Analysis: Exactly two years after the stock market nadir, high-risk financial innovation is back.

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