Back to the Crash? CDOs Are Selling Again

Say it ain't so. It wasn't all that long ago the term "collateralized debt obligation" struck fear into the hearts of people everywhere: CDOs being widely known as one of the Wall Street "financial innovations" that helped bring about the crash.

After those dark days, CDOs were largely abandoned as too complex and too risky, but they're beginning to make a return -- and it will be hard for the major banks to resist getting back into them.

I'll have a slice of high risk, please
Bloomberg is reporting that "sales of CDOs linked to everything from hotels to offices and shopping malls are poised to climb to as much as $10 billion this year, about 10 times the level of 2012." The driving force behind this financial regurgitation is the search for yield. With interest rates at or near record lows right now, that doesn't take much.

Ed Shugrue of Talmage, a New York City firm that looks after $2 billion of commercial property debt, told Bloomberg: "Investors are willing to go further afield in their quest for yield. With demand rich, Wall Street is scouring the cupboards to find anything with a cash flow that can be securitized." Scouring the cupboards. Not exactly a confidence-inducing phrase.

And with a resurgent real-estate market, helped merrily along by Ben Bernanke's third round of quantitative easing, there's not only demand for CDOs but also a growing supply of the debt that gets stuffed into them. CDOs can be composed of any kind of debt, but real estate-backed CDOs are pools of property loans, sliced up into "tranches" (fancy for levels) and sold off to investors. Each tranche has its own degree of risk and return. As you would expect, the higher the risk, the higher the return.

It's a tempting offer, but ...
While it was real-estate CDOs that helped crash the economy four years ago, the good news is those CDOs were backed primarily by residential mortgages. The CDOs we're talking about here are backed by commercial properties. In the time leading up to the financial crisis, CDOs backed by commercial-property debt typically performed better than those backed with residential-property debt.

As investors ratchet up their demand for yield -- with banks searching desperately in the post-Dodd-Frank world for ways to turn a profit -- it will be increasingly difficult for banks to resist the temptation to get back into the CDO game. But so many banks were burned so badly in the housing-market crash, there's a wariness I'm seeing -- even to the newly mild-mannered world of home lending -- that was never there before.

In all of 2012, Bank of America (NYSE: BAC  ) -- arguably the most badly burned of all the big banks in the housing bubble -- made only $75.1 billion in home loans, while fellow superbank JPMorgan Chase (NYSE: JPM  ) made $50.1 billion in the fourth quarter alone. Next to JPMorgan, B of A is definitely taking it slow and easy when it comes to getting back into real estate-related products. But with Wells Fargo (NYSE: WFC  ) reporting $125 billion in mortgage originations for Q4, even JPMorgan can't be accused of charging ahead too hard. Wariness is good.

Final Foolish thought
CDOs don't kill economies: What gets stuffed into CDOs kills economies. CDOs aren't in and of themselves evil. So long as the debt they're composed of is good debt, there shouldn't be a problem: Debtors will make their mortgage payments, banks will pay investors their interest, and all -- theoretically, at least -- should be well.

Still, it's not like there's no risk involved with commercial property, and it's not like there can never be another real-estate bubble: QE3 is throwing a lot of money around out there, and the ultimate effect has yet to be seen. And, if commercial-backed mortgage securities are starting to make their way back into the investor pipeline, can residential-backed ones be far behind?

Banks will be careful, at least for a while, but memories can be painfully short, with sound judgment and a remembrance of terrible times past obliterated by the drive for profit. If banks aren't careful, the return of CDOs could be a short-term shot in the arm for banks and a long-term shot in the head for the rest of us.

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