Lipstick On A Credit Pig: Dan Amoss / June 4, 2007

Large pension fund managers working for those with the least to lose tend to be the biggest patsies when it comes to misguided investments -- new-era Internet speculations, revolutionary Enron-type business models, and the like. The speculation du jour is called a CDO, which stands for Collateralized Debt Obligation. It sounds sophisticated, but CDOs are just portfolios of loans like the kind a banker would hold. Wall Street divides the claims on these loan portfolios into “tranches,” or segments with different risk/reward profiles.

The patsies, expecting they’ll get 20% annual returns with no risk, have been buying the riskiest tranches -- the ones that will absorb the first wave of defaults when they inevitably occur. It doesn’t seem to matter if these tranches are backed by, say, subprime mortgages written in Detroit at the peak of the housing bubble. These big investors are naïve if they expect they’ll sidestep the time bombs ticking inside these CDOs. Bloomberg describes the phenomenon in Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund:

“Because CDO contents are secretive, fund managers can’t easily track the value of the components that go into these bundles. ‘You need to monitor the collateral in your investment and make sure you’re comfortable there will be no defaults,’ says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis.

“Most investors can’t do that because it’s extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody’s and Morgan Stanley.

“Since CDO managers can change the contents of a CDO after it’s sold, investors may not know how much subprime risk they face, Das says.

“As the $503 billion-a-year CDO market thrives, CDO marketers like Bear Stearns and Citigroup find buyers for the portions known as toxic waste, the equity tranches.

“A typical $500 million CDO requires a $40 million unrated equity tranche…”

The Treasurer of Orange County, California isn’t buying into this new-era investment. “It’s grossly inappropriate to take this level of risk,” he says. “Fund managers wanted the high yield, so Wall Street sold it to them. The beauty of Wall Street is they put lipstick on a pig.”

Putting lipstick on a pig may seem like a savvy way to generate profits for the likes of Bear Stearns, but it strikes me as dishonesty, not beauty. Angry politicians will know where to look when it comes time to look for scapegoats. — Dan Amoss

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