Risk is back on Wall Street!

In the wake of the crisis, new financial regulations were passed to help avoid another disaster. This might suggest Americans have learned their lessons. Or have we?

The finance industry is starting to feel better about business again, having recovered from huge losses made to troubled borrowers. Most of America’s largest banks passed their annual stress test after unloading their riskiest assets and cleaning up their balance sheets. And investors have certainly taken notice. So far this year, shares of financial companies listed on the Standard & Poor’s 500 index have risen 16%, higher than the overall index’s rise of 9%. Bank of America (BAC) stock, in particular, has rallied 59.3%, becoming S&P’s second-biggest gainer next to Sears (SHLD).

But similar risks that infamously defined the years leading up to the financial crisis appear to be slowly creeping back. The Federal Reserve’s cheap money policy may have spurred investments, which in turn would ideally help the economy grow. But at what cost?

Here are four signs that risk is back on Wall Street:

Risky borrowers get loan offers

For some lenders, troubled borrowers no longer seem as troubled.

Capital One (COF) and GM Financial are luring back riskier borrowers that financial institutions turned away only a few years ago, The New York Times recently reported. In December, credit card lenders issued 1.1 million new cards to borrowers with damaged credit, a 12.3% increase over the previous year.

There are a few ways to look at the rise. For one, as the Times points out, it’s questionable if it’s even good for the broader economy. Are consumers even ready to take on more debt? Unemployment is high. Millions are still chained to mortgages worth more than their homes. This clearly raises ethical issues.

Meanwhile, it also reflects banks responding to a new profile of borrowers. They’ve begun to realize they can’t always turn down people with credit blemishes, given that the financial crisis has pushed even the most creditworthy borrowers into foreclosure. Of course, lending standards for mortgages remain tight, but the consultancy Deloitte has suggested that it would be a mistake for lenders to dismiss “first-time defaulters,” who otherwise would be in good credit standing if it weren’t for the recession. In a report released last summer, Deloitte recommended: “Targeting this segment of first-time defaulters could become a unique revenue opportunity for institutions.”

Deloitte might see it as “unique,” but it’s likely that banks just see it as necessary. After all, they’re looking to make up billions of dollars in fees lost by new financial regulations. So it’s really no surprise that credit cards, which charge relatively high interest rates and late fees, could be one answer.

AIG gets back in the game

It was only a few years ago that American International Group (AIG) nearly went bankrupt as a result of outsized bets on the U.S. housing and real-estate market. Today, the insurer is planning to return to U.S. property investing, The Wall Street Journal reported this week.

In 2008, the federal government rescued AIG through a $182.3 billion bailout, but the company has since repaid Uncle Sam. Its stock has risen nearly 32% so far this year. Now on firmer financial footing, it seems as though AIG is easing its way back into risk.

The insurer is investing in the U.S. apartment market – joining the plethora of foreign and U.S. investors that have recently been snapping up multi-family properties as the price of rentals rise. AIG’s bet might not be as grandiose as its pre-financial crisis days, given, as the Journal notes, its portfolio once included a Vermont ski village, office towers in Shanghai and a Tokyo shopping mall.

But smaller investments could lead to bigger ones. And the fact that AIG has resumed property investing is nevertheless symbolic. The insurer, which is still 70% owned by the U.S. government, is still fresh in the memories of those tumultuous months of the financial crisis and the recession that followed.

Big bets with bank cash

Propriety trading has become a dirty word in the years following the 2007-2008 financial crisis. Former Federal Reserve Chairman Paul Volcker is known for trying to put a stop to it, arguing that firms making big trades with their own capital played a key role in the crisis.

But as Washington wrangles over implementation of the Volcker rule, JP Morgan Chase (JPM) trader Bruno Iksil, nicknamed the “London whale,” has been fueling debate over whether banks are taking excessive risks with its own funds. The trader has amassed big positions in credit default swaps, effectively betting that the creditworthiness of a group of companies will improve and not deteriorate. Hedge-fund managers and dealers say the trades are big enough to move indexes and resemble proprietary bets.

The Volcker rule is part of the Dodd-Frank Act, which sets limits on risk-taking by banks with government backing and was passed after the collapse of the subprime mortgage market triggered the worst financial crisis since the Great Depression.

There’s no suggestion so far that JP Morgan or the trader acted improperly. Nevertheless, it’s pretty clear the appetite for risk reminiscent of years prior to the crisis is ever present.

Sub-prime mortgage bonds are back

Those toxic home loans that essentially blew up the U.S. housing market are apparently back in vogue. As
The Wall Street Journal
reported, prices of some distressed bonds backed by subprime loans issued before the crisis to borrowers with spotty credit histories have seen double-digit percentage gains this year.

During the financial crisis, investors essentially avoided such bonds. Their resurgence signals that investors’ appetite for risk is returning.

In a way, investors may see it as a safer bet today since prices reflect worst-case economic scenarios. What’s more, such bonds, because they’re riskier, yield relatively high returns of 7% to 9%. And at today’s low-interest rates, it might come as a decent alternative.

Then again, the housing market is still a mess. And Europe’s ongoing debt crisis has continued to rattle investors. Another crisis could certainly turn these bonds sour, but that’s apparently the risk investors are willing to take.