Are ETFs the New CDOs?

As if the wizards of finance hadn’t done enough already. Remember when collateralized debt offerings (CDOs) entered common usage? Mortgages were sliced up, repackaged, and re-sold into “synthetic” products barely resembling the underlying property on which they were supposedly based. Sounds a lot like how bologna is made. When the housing market went bust CDOs transmitted and amplified the effects of the downturn taking some venerable banks along with them. Now exchange traded funds (ETFs) are racing to take the place of their derivative cousins.

In the simple version an investor buys shares in a publicly traded fund that say indexes to the U.S. Fortune 500. As money flows in, the fund then buys actual shares of those companies and the investor owns a small percentage of that diversification.

Synthetic ETFs,  however have bet money on collections of other ETFs without ever actually owning the underlying stocks. The interconnected nature of the financial markets means that if ETFs stumble they not only affect the holders of those securities but ripple across the murky derivatives markets as well.

Jodi Xu in the FT’s Debtwire noted recently that money provided by ETFs accounted for 41% of the high-yield retail space for the first 19 weeks of 2012, up from a previous 10%. In some weeks they accounted for over 80%. Some bond fund managers chased ETF performance as the fast money ran in and out exposing yet another sector to a potential fall should the financial merry-go-round suddenly stop spinning.

Concerns surfaced back in 2011, especially for banks looking to boost profits, and in particular European banks. Those risks have turned into a present-day problem. The FT reported on May 23rd: “More than three-quarters of the synthetic exchange traded funds listed in Europe are at risk of closure after failing to attract sufficient inflows in their first three years since launching, according to Rick Genoni, global head of ETFs for Vanguard. . . [Genoni] noted that half of all ETFs, including synthetic and non-synthetic, launched in Europe in the last five years were in the “danger zone”.

At some point maybe banks will get back to lending real money to actual companies that sustain and create much needed jobs, all for a reasonable profit. That doesn’t take financial wizardry, just common sense.

Photo credit: Brian P. Klein, 2012 – Industry lost along the rails, east coast U.S.