Jia Chen was in London again this summer -- just one of the many trips she’s recently made across the Atlantic -- to peddle a product left for dead in the ruins of the financial crisis.
The 35-year-old Citigroup Inc. director has spent the past two years meeting clients, speaking at industry panels and becoming the face of a resurgent market for synthetic CDOs -- complex derivatives that let buyers make big, leveraged bets on the health of corporate America. Along the way, she’s helped establish Citigroup as its dominant player.
It’s an astonishing comeback for the roughly $70 billion market for synthetic CDOs, which rose to infamy during the crisis and then faded into obscurity after nearly destroying the financial system. But perhaps the most surprising twist is Citigroup itself. Less than a decade ago, the bank was forced into a taxpayer bailout after suffering huge losses on similar types of securities tied to mortgages. Now, many in the industry say Citigroup is responsible for over half the deals that come to market, though precise numbers are hard to come by.
This time, Citigroup says, it’s doing things differently. The deals are tailored in a way that insulates it from any losses, while giving yield-starved buyers a chance to reap returns of 20 percent or more. The market today is also just a fraction of its size before the crisis, and few see corporate defaults surging any time soon. But as years of rock-bottom interest rates have pushed investors toward riskier products, the revival of synthetic CDOs may be one of the clearest signs yet of froth in the credit markets.
For more on synthetic collateralized debt obligations (CDOs), click here.
Other Wall Street banks, which shunned the market since the crisis or struggled to establish a foothold, are angling for a bigger slice of the action. BNP Paribas SA is also active in synthetic CDOs and others are keen to follow suit, according to people familiar with the matter, who asked not to be identified because they aren’t authorized to speak publicly.
“There is a whole generation of people in finance who never knew or forgot what the problems were with synthetic CDOs,” said Janet Tavakoli, a 30-year veteran of the financial markets who runs a consulting firm and has written books on structured credit and CDOs. “Just as derivatives can lever up the upside, they can lever up the downside.”
Danielle Romero-Apsilos, a spokeswoman at Citigroup, said synthetic CDOs are fundamentally different than they were before the crisis and that banks today aren’t managing market risk any more. That’s because every part of a synthetic CDO deal is distributed to investors, which also helps to prevent the market from growing too fast.
“Every single client we talk to always asks the differences pre-crisis and post-crisis,” said Vikram Prasad, who oversees Chen’s team as the head of correlation and exotics credit trading. “Everyone remembers the word CDO. Our clients are thinking the same thing, they are doing the due diligence.”
Center of Attention
Whatever the case, there’s little doubt that few have captured the market’s attention like Chen, who leads Citigroup’s credit correlation trading desk with Davy Kim. (Citigroup declined to make Chen available for this article, which was based on interviews with more than a dozen people familiar with her work, including investors, colleagues and competitors.)
A Citigroup lifer, she joined the firm’s correlation trading desk as an analyst in 2005 after getting her bachelor’s degree from the Massachusetts Institute of Technology. Those who spoke with Bloomberg say Chen is a numbers-focused wonk with an uncanny understanding of the ins-and-outs of structured credit. They also describe her as a hard-nosed negotiator, who’s often brought in to explain and close particularly tough deals.
For Chen, things could have turned out very differently. As synthetic credit dried up after the crisis, she, like many in the industry, left Wall Street. In 2009, she moved home to China to help the family business.
But less than a year later, she wanted back in. When she returned, she mainly traded deals that got roughed up in the meltdown and helped Citigroup unload its old positions. Toiling away into the late hours of the night, Chen established herself as one of the few on Wall Street still deeply involved in the product, convinced structured credit would one day shake off its tarnished reputation, according to investors who have worked with her.
As her reputation has grown, so has Citigroup’s business. Since wading back into the market in 2013, the correlation trading desk has quickly expanded its presence, posting double-digit growth in its synthetic CDO business this year. Demand has remained robust even as some other parts of the bank’s structured credit franchise have recently lagged.
There’s also the 15 percent return on equity that Citigroup can generate by offloading different pieces of the product on its books to various investors, which it does over a period of two or three months.
At roughly $100 million a year in revenue, synthetic CDOs have yet to make a huge dent in Citigroup’s overall trading business. That’s not to say the bank doesn’t have big ambitions.
In the past year or so, senior management has enlisted the bank’s global sales force to promote the synthetic CDO business and help win over wary investors. Chen and others on the team regularly join meetings held by macro, rates, investment-grade bond and even equities salesmen, among others, to urge them to offer CDOs to their clients.
“There’s a tremendous amount of residual skepticism about this product,” said David Knutson, the head of credit research for Americas at Schroder Investment Management, which oversees more than $500 billion. “If you are out there trying to sell it, you better know what you are talking about.”
Typically, these CDOs pool together about 100 different credit-default swaps tied to various companies, which are then sliced into varying levels of risk called tranches -- senior, mezzanine and equity. Over the life of a deal, which generally lasts two to three years, the swaps generate a steady stream of income for “long” investors (and are paid by “short” investors on the other side of the trade who want insurance against a potential default).
The equity tranche has the biggest risk of getting wiped out if losses from defaults exceed roughly 5 to 7 percent, and nets the highest returns.
During most of the post-crisis era, synthetic CDOs proved to be a tough sell. There were few takers for the lowest-yielding, senior tranche to anchor the deal. New capital requirements also made it costly for banks to hold onto the riskier portions, something they routinely did pre-crisis. That meant they needed to find buyers for every piece of the deal, in what’s known as a full capital-structure CDO.
“It’s a very targeted audience,” said David Stryker, a principal at research firm Greenwich Associates. “For the dealers that are involved, it’s a targeted hand-to-hand combat approach to finding each investor.”
Yet after years of rising markets, declining corporate defaults and tighter credit spreads, the trade is finally attracting greater interest. Increasingly, pension funds and endowments have become senior tranche investors in many of Citigroup’s synthetic CDOs. And because the CDOs are derivatives, they have small upfront costs and amplify returns.
The safest portion, which would typically return 0.6 percent a year, can be levered up to 6 percent in some cases. Equity tranche returns can reach 20 percent.
Citigroup’s success didn’t come overnight. The bank began testing the waters in earnest in 2013, but demand only started to pick up in 2015. That’s when Chen helped spearhead an effort to make the market more transparent by setting up Citigroup’s own benchmark portfolio, composed of default swaps that would most likely be bundled into a CDO. Known as Bravo, the basket could be traded, but the main goal was to provide reference prices for custom deals. It served, in effect, as visible proof of an existing market.
Since then, Citigroup has also made information on past deals available online and given clients access to the proprietary tool it uses to come up with prices of various tranches. That’s helped the bank gain market share and fuel its improbable comeback in the synthetic CDO market.
“If you think about what happened to them during the crisis,” said John Karabelas, the former head of credit sales at BNP Paribas, “the fact that they are even in this business is incredible.”
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