Investors are once again clamoring for a risky investment blamed for helping unleash the financial crisis: the synthetic CDO

June 4, 2013, 9:06 p.m. ET

One of Wall Street’s Riskiest Bets Returns

Before the financial crisis, CDOs and synthetic CDOs were a big cog in Wall Street’s so-called structured-finance machine, bringing in substantial fees for securities firms that put together the deals.

By KATY BURNE

Investors are once again clamoring for a risky investment blamed for helping unleash the financial crisis: the synthetic CDO. In a sign of how hard Wall Street is trying to satisfy voracious demand for higher returns amid rock-bottom interest rates, J.P. Morgan Chase JPM -1.22% & Co. andMorgan Stanley MS -1.28% bankers in London are moving to assemble so-called synthetic collateralized debt obligations.

CDOs give investors a chance to bet on the creditworthiness of a basket of companies. Basic CDOs pool bonds and offer investors a slice of the pool. Synthetic CDOs pool, instead of the bonds themselves, insurance-like derivative contracts on the bonds.Like their crisis-era predecessors, the new CDOs would be sliced up into different levels of risk and returns. Investors who want a chance at the highest returns would have to buy the riskiest slice.

While spreading risk in some ways, synthetic CDOs also can multiply the financial damage if companies fall behind on their debt payments.

During the financial crisis, CDOs pegged to soured mortgage loans caused losses to careen around the world.

Their catastrophic impact was denounced by many lawmakers and investors, and the market for all kinds of highly engineered financial instruments evaporated.

Some details of the deals being worked on at J.P. Morgan and Morgan Stanley aren’t clear, including the size of the CDOs and which investment firms have expressed an interest in buying slices of them.

The banks declined to comment.

A small number of institutional investors recently approached the two banks and asked them if they would put together the synthetic CDOs, according to people familiar with the discussions.

The requests were made in London, a global center of derivatives trading.

J.P. Morgan and Morgan Stanley now are trying to line up more investors as buyers for the instruments, said a person familiar with the talks. An investor usually buys just one slice of a CDO, which usually is chopped into about six pieces.

The banks likely won’t proceed with the CDOs unless they can sign up enough investors.

J.P. Morgan and Morgan Stanley aren’t expected to invest in their own deals because of postcrisis rules that require banks to set aside large amounts of capital against possible losses on these types of investments.

The interest by potential investors in new synthetic CDOs shows that demand for higher returns is intense, said Brian Reynolds, chief market strategist at brokerage firm Rosenblatt Securities Inc. “Wall Street will create new, more complex, more risky structures to satisfy that demand,” he said.

In the peak year of 2007, financial firms issued $634 billion of synthetic CDOs, according to data provider Creditflux. Sales fell to $98 billion in 2009. Since then, some hedge funds and banks have worked together to bundle derivatives into custom-made trades, but those private deals were often small and weren’t evaluated by credit-rating firms.

A CDO driven by a different aim is also in the works. Citigroup Inc. C -1.95% now is selling a CDO using derivatives tied to the bank’s portfolio of loans to shipping companies, but this deal isn’t motivated by investor demand for higher returns.

Instead, the impetus for the roughly $500 million deal, being pitched only outside the U.S., is Citigroup’s desire to make room on its balance sheet for new loans and hold less capital as a cushion against potential losses on the shipping loans, said a person familiar with the transaction.

Investors in the deal will be on the hook for some losses. In return, the deal is expected to pay an annual yield of 13% to 15%, according to the person familiar with the offering. Citigroup declined to comment.

It isn’t clear how much investors would stand to earn on the synthetic CDOs being assembled by J.P. Morgan and Morgan Stanley. Investment-grade corporate bonds now yield less than 5%.

Efforts to pull off the deals show that banks and investors battered by CDOs during the financial crisis are increasingly willing to ignore bad memories in order to reach for higher returns. In markets ranging from commercial mortgage-backed securities to junk bonds, investors are eager to buy even the very riskiest investments, some of which now deliver yields of more 20% per year.

Before the crisis, CDOs and synthetic CDOs were a big cog in Wall Street’s so-called structured-finance machine, bringing in substantial fees for securities firms that put together the deals.

In 2007, Goldman Sachs Group Inc. GS -1.27% created a CDO called Abacus 2007-AC1 for hedge-fund firm Paulson & Co., which wanted to magnify a bet against the U.S. housing market.

The deal delivered a profit to the hedge-fund firm and founder John Paulson. But in 2010, Goldman paid $550 million to settle accusations by the Securities and Exchange Commission that other investors in the deal were misled. Goldman didn’t admit any wrongdoing but said it had made mistakes in its marketing of the deal.

Investors are barreling into a related type of security tied to corporate debt, called collateralized loan obligations, or CLOs. So far this year, more than $35 billion of CLOs have been sold in the U.S., while European issuance is equal to more than $2 billion, according to Royal Bank of Scotland Group PLC. RBS.LN -1.61%

The synthetic CDOs being built by J.P. Morgan and Morgan Stanley differ from their predecessors in some ways. For example, one middle slice has been harder to sell than other pieces because it doesn’t yield enough, some investors complain. Since the crisis, credit-rating firms have made it tougher for deals to get top-notch letter grades.

In another difference, buyers of the least-risky slices would get more protection against potential losses than buyers of similar slices did before and during the crisis, said people familiar with the discussions.

Hedge funds are considered the likeliest buyers for riskier parts of the deals, which are the first slices to absorb losses.