Just over a decade ago, as the S&P was hitting all time highs and there was a line around the block of 30-some year old hedge fund managers, desperate to put other people’s money in various ultra risky investments just so they could pick a few excess bps of yield over Treasurys – a situation painfully familiar to what is going on now – Goldman had an epiphany: create new synthetic products that have huge convexity, i.e., provide little upside (such as a few basis points pick up in yield) versus unlimited downside, link them to the shittiest assets possible and sell them to gullible, yield-chasing idiots (collecting a transaction fee) while taking the other side of the trade (collecting a huge profit once everything crashes). The instruments, of course, were CDOs, and not long after Goldman sold a whole of them, the financial system crashed and needed a multi-trillion bailout from which the world has not recovered since.
Ten years later, Goldman is doing it again, only instead of targeting subprime mortgages, this time the bank has focused on quasi-insolvent European banks.
And just like right before the last financial crash, Goldman is once again allowing its clients to profit from the upcoming collapse, or as Bloomberg puts it, “less than a decade after the last major banking crisis, Goldman Sachs and JPMorgan are offering investors a new way to bet on the next one.”
The trade in question is a total return swap, a highly levered product which is similar or a credit default swap but has some nuanced differences, which targets what are known as Tier 1 , or AT1 or “buffer” notes issued by European banks, and which usually are the first to get wiped out when there is even a modest insolvency event (just ask Banco Popular), let alone a full blown financial crisis.
Goldman and JPM are offering the derivative trades that enable investors to bet on or against high-risk bank bonds that financial regulators can wipe out if a lender runs into trouble. Other banks are also hoping to get in on the fun, and start making markets in the contracts, known as total-return swaps, or TRS, in the coming weeks, according to Max Ruscher, the London-based director of credit indexes at IHS Markit Ltd., which administers the benchmarks that the swaps are linked to.
Why now? Bloomberg explains:
At a time when financial markets are racing from one high to another, and even the new Nobel laureate in economics is wondering aloud about investor behavior, the development is at once a sign of the headlong global race for investment returns and nagging worries that the investors may be getting ahead of themselves.
Just like with CDS, the security underlying these trades is debt, in this case what is known as additional Tier 1 notes, or AT1s, which banks started issuing after the European debt crisis. Since they were created to protect taxpayers from bearing the cost of government bailouts – and are therefore the first instrument to get bailed in (usually alongside the equity) – they pay generously high yields. And just like CDOs ten years ago, in today’s era of near-zero interest rates, they’ve become sought after by debt investors around the world, ballooning into a $150 billion market: according to BofA index data, the average yield on AT1 debt is about 4.8%, around 10 times that for senior bank bonds.
To be sure, it’s not just yield-chasing fanatics: as shown in the chart below…
… at least some of the demand for the new derivatives is coming from investors looking to hedge their exposure and protect themselves should prices of the debt drop… or in the case of another banking crisis erupt. Those risks became apparent in June, when AT1s issued by Banco Popular Espanol were wiped out as part of a bank rescue, after trading at part just months earlier.
The good news for Goldman is that whether for hedging or prop trading, the TRS is in great demand:
“Some participants are looking to get exposure to an asset class while others are hedging their positions,” according to a report on IHS Markit’s website. “On one side of the TRS trade, the index buyer anticipates that the total return of the index will rise. The index seller on the other side takes the opposite view.”
But if all the TRS does is payoff in the event of a technical default, why not just buy CDS to hedge AT1 exposure (or simpy to naked short)? The answer is that unlike with conventional trigger events, banks can skip coupon payments on the bonds without triggering a CDS default.
So they needed something new, and that’s where Goldman’s TRS emerged. As for the similarities to CDS, total-return swaps allow investors to hedge a single name or a basket of AT1s, and traders can make amplified gains – or potentially outsized losses – without having to own the underlying notes or tie up large amounts of collateral.
The good news – for Goldman clients – is that they can now start putting on a very, very cheap hedge with almost no negative carry ahead of the next financial crisis. And just like before the last financial crisis, Goldman is delighted to make the markets, in this case in swaps tied to an iBoxx index of dollar-denominated bank-capital notes and a gauge of similar euro bonds. The two indexes include AT1s issued by lenders such as Banco Santander SA, Deutsche Bank AG and HSBC Holdings Plc. In other words, anyone who shorts the product will make out like a bandit should some of Europe’s biggest banks suffere an “unexpected” financial crisis.
Just like Lehman.
Explaining the need for the TRS, Manav Gupta, Goldman’s co-head of European credit flow trading, who confirmed to Bloomberg the bank is making markets for the trades said that the swaps on bank-capital note indexes “will be a very useful addition to the toolkit that our clients use in managing risk and taking broad-based exposure to the AT1 market.” Similarly, a spokesman for JPM also confirmed the bank is offering swaps on iBoxx indexes. Other have also jumped on board: Deutsche Bank started trading total-return swaps referencing Bloomberg Barclays indexes last month and plans to trade on iBoxx gauges, a spokesman said. Which is ironic: the biggest payoff to the TRS would come if Deutsche Bank suffers another liquidity, or solvency, event and its AT1s get wiped out.
Which begs the question: will vindictive Deutsche Bank traders bet the bank, so to speak, that their bank will be the next to tank? Of course, if they are right, there will be no middle or back office to collect the funds.
As for everyone else, now that both Goldman and JPM have once again announced it is “open season” for hunting banks, you may want to keep a close eye on unexpected risk-flaring episodes, first out of European banks and then everywhere else.