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According to the Wall Street Journal, a new probe has been initiated by the Securities and Exchange Commission (SEC) which may compound the legal woes of banks. The SEC is investigating whether the complex bond dealings by banks have unlawfully concealed certain risks.  

Earlier, the SEC had begun an investigation regarding the process through which banks sold such complex securities. The latest probe is an extension of this one, with the SEC’s inquiry as to how these securities are utilized and traded. Since the securities are not traded on any exchange or open market and the prices are negotiated between buyers and sellers, there are increasing chances of misuse of such transactions.

As banks have to meet the stringent Basel 3 capital requirements, the former tend to do away with risky assets to strengthen the respective balance sheets.

Notably, the SEC is investigating whether the banks are selling complex securities such as collateralized debt obligations (CDOs) or collateralized loan obligations (CLOs) to offload unwarranted risks from balance sheets. The CDOs (related to the portfolio of mortgages and other debt categorized on the basis of credit ratings and risks) were in high demand before the economic crisis. However, the demand declined after the financial meltdown.

Now the demand for such complex securities is on the rise again, with increasing demand for CLOs, where the underlying assets are loans made to companies with lower credit ratings. As per the information available from S&P Capital IQ Leveraged Commentary & Data, last year, CLOs worth nearly $83 billion were issued; this year, the figure is has already exceeded $20 billion.

The demand for high-yielding investment products is growing, owing to a stil- low-interest rate environment. As these complex securities offer higher yield than fixed income securities, the demand for the same is on rise. Hence, the SEC is probing such complex dealings.

Further, the SEC extended its probe to whether the banks including Barclays PLC (BCS - Analyst Report), Citigroup Inc. (C - Analyst Report), Deutsche Bank AG (DB - Analyst Report), UBS AG (UBS - Analyst Report), The Goldman Sachs Group, Inc. (GS - Analyst Report), Morgan Stanley (MS - Analyst Report) and Royal Bank of Scotland Group PLC (RBS - Snapshot Report) have mis-priced certain bond deals.

Notably, these probes do not necessarily mean that the banks involved would be eventually sued or indicted. We believe that such investigations will deter banks from misusing such complex securities.

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