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Ghost of ‘The Big Short’ Haunts Wall Street

It only takes about 15 seconds to scan an on-screen warning at the close of “The Big Short,” Adam McKay’s Oscar-winning film that recalls the insanity behind the housing market crash of 2008. It’s almost an asterisk – but then again, you can’t spell asterisk without “risk.”

It describes an investment vehicle called a “bespoke tranche opportunity,” which surely qualifies as an uber-exotic chunk of jargon in best (or worst) Wall Street tradition. Behind the mysterious moniker – and the so-called “opportunity” – lies an investment potion that conjures the ghost of the housing crisis.

The formula goes like this: BTOs equal CDOs (or collateralized debt obligations). And CDOs, in case your wiped-out portfolio didn’t remind you, helped kill America’s housing market. Put another way, this is the same investor maze with a shiny new “For Sale” sign, experts say.

“As the late, great, baseball philosopher Yogi Berra once said, ‘It’s like deja-vu, all over again,'” says Robert R. Johnson, president and CEO of the American College of Financial Services in the Philadelphia area.

First, here’s the translation of the B-word: “The ‘bespoke’ title refers to the fact that the investor essentially designs the instrument – much like a bespoke suit is tailored to the customer’s wishes,” Johnson says.

And now, the second: “Tranche” is a portion of something. Of course, it’s not as though you’re going to say, “Pass me a tranche of spuds” at the dinner table. But the hot potato that is a piece of the private securities market could be enough to lure hungry investors weary of the low-yield interest rate market.

Yes, all this could be built on the same kind of shifting sand that caused CDOs and mortgage-backed securities to sink – in large part the result of new homeowners, approved for mortgages they couldn’t afford, falling short on even their first payment.

So has anything changed? Perhaps. For starters, any finagling to inflate investment ratings looks to be a distant memory – for now, anyway.

“The difference between now and prior to the financial crisis, in my opinion, is that there is a much higher level of awareness of the risk level involved in these kinds of securities,” Johnson says. “The problem then was that these securities were marketed, and rated by the rating agencies, as AAA quality. Then they were purchased by unsophisticated investors who didn’t know what they were buying.”

And in that sense, some investors will undoubtedly get sucked into a scenario where they’re in way over their heads, as well as their minds.

“No one is putting a gun to anyone’s head and making them invest in these kinds of securities,” Johnson says. “If investors learned anything from the financial crisis of 2007-’08, it should’ve been to invest only in financial instruments you understand.”

Those bulls and bears don’t bite, do they? Depends on how you look at it.


Regardless, anxious tremors can be felt as far away as Milan. That’s where Dominika Wawrzyniak, a senior author with The Market Mogul website, asks the multi-billion dollar question in a January article: Would a potential default of BTOs lead to greater losses than the world saw in 2008?

Here’s a potentially heartbreaking, bank-breaking clue: “No requirement to report CDOs or BTOs to government agencies makes the financial engineering unregulated and uncontrolled,” she writes.

The specter of the bespoke tranche “raises discrepancies and suspicions over reliability of the persistent financial system,” Wawrzyniak says in an interview with U.S. News. “From $5 billion in transactions in 2013, the market for BTOs increased to $20 billion by the end of 2014.”

Yes, that represents a quadrupling of investment. But is it really a sign of another investment cyclone? Not everyone thinks so.

“There’s still a good use for the creation of bespoke tranche opportunities,” says Mark Zittman, chairman of Tuatara Capital in New York City. “For an investor, they’re a great opportunity.”

Pittman says that purchasing bespoke tranche securities in a secondary market, sometimes at distressed prices, “can lead to a very high yield. However, average investors should stay away, as BTOs are complicated and there are many nuances within the documents.”

“What we know is that the private securitization market has not come back since 2007, and they’re a reason for that,” says David Dayen, Los Angeles-based author of “Chain of Title: How Three Ordinary Americans Uncovered Wall Street’s Great Foreclosure Fraud.” “Investors were ripped off in 2007, they’re still being ripped off today, and they didn’t get the kind of covenants that they deserved.”

 

Thus this result: “Until that market is improved with real assurance and real reforms, they’re just not going to come back,” Dayen says. “They’ve chosen to sit on the sidelines and take their investments elsewhere.”

Yet that doesn’t mean the landscape is absent of schemes. “One that is worrisome is rental-backed securities, where Blackstone Group (ticker: BX) picked up tens of thousands of properties that were foreclosed and spun them out into the rental market.”

It translated to Blackstone selling the first-ever single-family rental securitization, a $479 million bond offered in 2013. While that could create substantial profit in cities with rental unit shortages, it also raises inescapable questions.

“What if there are high vacancies and people are late on their payments?” Dayen says. “Or of you have an economic downturn and evictions go up? Is that an issue for the capital markets?”

Blackstone has packaged its activity under a cheery company name: Invitation Homes. Yet complaints are already pouring in from housing advocates on a range of issues from mid-month rent increases to failures to refurbish acquired properties.

“Companies like Blackstone are not set up to be landlords, let alone good landlords,” Dayen says.

But if the endgame is to build up Blackstone stock, it’s nothing doing so far. Over the last year, share prices have dropped 42 percent to just shy of $26.

Meanwhile, it remains to be seen whether government watchdogs have enough backbone to provide proper oversight of these new plays – and head off a replay of the mortgage-backed securities meltdown. But take heart, confused investors: There may be a no-nonsense way to translate “bespoke tranche opportunity” from Wall Street’s lingua obscurum.

Wawrzyniak cites a quote attributed to Edmund Burke. The British-Irish statesman lived in the 18th Century, when Wall Street was a literal wall built to protect Dutch settlers from pirates.

Hundreds of years later, the pirates are still there – even if dressed these days in sharkskin suits – and Burke’s quote more than applies: “Those who don’t know history are destined to repeat it.”

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