Wall Street’s Second Act

Robert Lucas

Now is the time to get rich. The volume of money idling on the side lines for lack of yield now stands at an all-time high. It is estimated that globally anywhere between three and four trillion dollars languishes on corporate balance sheets, bloats the books of family offices, and stuffs the accounts of the too-rich-to-care.

The possessors of this idle cash are not an enviable lot for they dwell in a world of zero returns. Sheer desperation already drove some down the rabbit hole to an upside down land of negative interest rates. Here, debtors demand payment for the privilege of accepting a creditor’s money.

Thus, anyone offering a safe bet of modest returns is sure to get the full attention of the world’s cash hoarders. A vast new industry has come into being dedicated to the promotion of investment solutions that chip away at the stockpiles of idle cash. Its largest sector comprises the climate change doomsayers who argue that carbon-neutral investments will not only save the world from meltdown, but are likely to produce above average returns as well. Others seek to rally the world’s excess savings for the eradication of poverty.

Taking their cue from a handful of good-hearted American billionaires, nearly all investment solution providers appeal to the conscience of cash hoarders who are told they hold the key that unlocks a cool future of plenty. However, cash usually has few, if any, scruples and will flow to wherever risk is deemed lowest in relation to rewards. In today’s low-to-no-yield world (no rewards), money simply moves to the safest havens – those select few jurisdictions already awash in cash.

As such, the world has rediscovered the perversities inherent to the Lucas Paradox which offers a twist on conventional economic theory that predicts capital should flow from developed to emerging markets due to the former’s tendency to produce diminishing returns. First observed and described in 1990 by macroeconomist Robert Lucas of the University of Chicago, the Lucas Paradox attributes the suspension of economic logic to adverse business conditions, sovereign risk, and information asymmetry in emerging markets. While the returns are significantly higher, the perceived risk of investing in these markets is higher still. Hence, the money stays at home.

Unless the root causes of the Lucas Paradox are addressed, the vast sums of money now confined to the margins will not become available to help underwrite development or finance the fight against climate change. That is more of a problem than it would seem at first glance: the dearth of yield has set the idle hands of Wall Street financiers at work to replenish the devil’s toolkit. Their latest invention: the bespoke tranche opportunity – an exotic derivative product offering serious leverage and cobbled together from collateralised debt obligations (CDOs) backed by credit-default swaps in a mix fine-tuned to suit the buyer’s risk tolerance profile.


According to data gathered by BNP Paribas, bespoke tranche opportunities are fast becoming the next big thing: in 2014, as much as $20bn worth of bespoke tranche opportunities (aka collateralised swap obligations) were issued – up from barely $5bn in the previous year. Last year’s numbers have not yet been compiled but early indicators point to a massive increase in volume.

Investment bankers have fallen in love with their latest offering which produces higher profit margins than plain treasury or corporate bonds and allow them to offload almost all risk to investors on either side of the swap.

Late last year, a Goldman Sachs trader recommended his clients via email to take a closer look at the exciting opportunities available through the new-fangled instrument: “A tranche of a bespoke portfolio of credits can offer exposure to diversified risk with the possibility of leverage, credit enhancement, and enhanced returns.” Meanwhile Citigroup promoted the deals as “attractive for credit-savvy investors in the post-QE [quantitative easing] credit picker’s market.”

Collateralised debt obligations (CDOs) gained notoriety as the instrument co-responsible for the 2008-09 financial meltdown. The derivative was used to bundle and upgrade tranches of non-prime assets deemed too toxic for inclusion in slightly less complex investment products. Soon, the buoyant market for CDOs also spawned its own derivative of a derivative – the CDO Squared.

Bespoke tranche opportunities take the CDO carousel a step further still, allowing investors to pick and choose the derivative bets they are willing to make. Banks then put together a one-off product containing a single tranche that dovetails precisely with the investor’s individual preferences. As an added bonus, and due to their unique nature, bespoke tranche opportunities are exempt from most of the regulatory constraints imposed by the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act.

Realising full well that taxpayers stand ready to rescue them from any serious mishap – with the US Federal Reserve unlikely to repeat its disastrous decision to allow a major bank to fail (Lehman Brothers 2008) – Wall Street’s investment bankers are sliding back to their old, and lucrative, ways of unsurpassed financial engineering. Those skills are currently in high demand as record-high excess savings need returns beyond the paltry average of 3.3% annually generated by corporate bonds.

With the Lucas Paradox firmly in place and interest rates set to remain depressingly low for the foreseeable future – notwithstanding the Fed’s brave attempts to alter this reality – exotic financial instruments promising solace to numbed investors could not have stayed behind. Their appearance merely follows a logic – one that has been observed before, and did not augur happy times.