Risk Recycling, the New Mortgage-Backed Securities (MBS)

Remember how in the last crisis, banks like UBS, Morgan Stanley, and Goldman Sachs created mortgage-backed securities, known as MBSs, then sold slices of those securities to their customers?

The COVID-19 pandemic has exposed how big bank financial engineers are at it again. Over the past ten years, the banks have created and sold to retail clients billions of dollars of complex, structured products and then offloaded their risk to institutions and hedge funds in a process called “risk recycling”.

Sounds like Wall Street is trying to tidy up after itself, right? Recycling is good for the environment, right? Unfortunately, the process is filthy.

A recent Wall Street Journal article explained how it works. “Dealers transform bets on global stock-market indexes and tech darlings such as Apple Inc. and Amazon.com Inc. into fixed-income notes paying low but steady interest.”

“Along the way, banks dispose of the risks accumulated by bundling stocks and options into a security by selling volatility-linked derivatives to investors, mostly hedge funds.”

The products work well in a rising or sideways moving market, where investors recover the initial investment and the coupon owed, which could be as high as 12%. But the interest-bearing notes, linked to the performance of underlying assets, open holders to the risk of steep losses if those assets fall below a preset level.

Here’s the kicker.

“In a bull market, investors keep collecting coupons on these notes and they feel it’s a great investment,” according to a banker cited in a recent Bloomberg article. “When the market turns, they get stuck with unimaginable losses.”

Demand soared for the retail product—structured notes dubbed “autocallables”, which deliver capped stock-market returns to purchasers while giving the issuing bank the right to “call” or retire the note when the underlying shares hit certain levels.

A typical one is sold to retail investors via an independent financial adviser or large wealth management firm. If the price of the linked asset trades at or above its starting level, the notes are called, and investors receive a hefty coupon. But if the underlying asset drops, the product can continue until maturity without paying another coupon.

If the price declines enough, it can breach a barrier where the investor starts suffering one-for-one losses all the way to zero.

As we saw in the last crisis, the banks made hefty profits on structured products, offloaded the risk, and left investors holding the bag.

Funny how some things never change on Wall Street.