Collateralized Debt Obligations

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Collateralized Debt Obligations: The Ticking Time Bomb In Your Portfolio

by Alexander Green, Chairman, Investment U; Investment Director, The Oxford Club
Friday, June 29, 2007: Issue #688

If you own any collateralized debt obligations, you may have a ticking time bomb in your brokerage account. If so, you need to get rid of it immediately. Today.

Let me explain why…

The financial press loves it when the mighty stumble. And so it has had a field day lately covering Bear Stearns’ $3.2 billion bail out of one of its ailing hedge funds. The fund made a specialty of investing – with leverage, of course – in subprime mortgages.

Although Bear Stearns is a leader in both underwriting and trading esoteric securities backed by mortgages, the firm apparently failed to talk to my tennis partner Jim, who owns a mortgage company in Orlando.

“You wouldn’t believe the crap we’re writing now,” he told me last year. “I’ve never seen anything like it in my life. If you want a mortgage today, you don’t need income, you don’t need assets, you don’t need a credit record, you don’t even need a down payment. All you need is two things: a house and a pulse.”

Risky Collateralized Debt Obligations Make Toxic Investments

Over the past few years, subprime mortgages became not just loans to people with less than stellar credit. They became loans to people who were such poor credit risks they had no business buying a house in the first place.

“Thank God we’re selling these mortgages off as soon as we write them,” Jim added.

So who buys these crummy mortgages? The folks on Wall Street. But not for themselves, of course. They find unique and innovative ways to package and resell them to Mom and Pop.

More specifically, Wall Street takes pools of mortgages and turns them into securities known as collateralized debt obligations, or CDOs. (Years ago, we used to call them CMOs – collateralized mortgage obligations.) There were $316.4 billion in mortgage-related CDOs issued last year, according to the Financial Markets Association. More than $1 trillion have been issued, in total.

Some of these securities are safe and carry low yields. But many of them are toxic. They carry attractive yields. But they are not attractive investments. Most of them are risky, poorly understood, thinly traded and prone to going bump in the night.

If your broker has sold you a high-yielding CDO, sell it at market today. There’s a good chance the price of these securities is going to get a whole lot worse before it gets better.

I’m not just whistling Dixie here

More Bailouts to Follow

Bear Stearns did not bail out its hedge fund investors out of the goodness of its heart. The firm has made its fortune putting other people’s capital at risk, not its own.

However, redemptions at the fund were coming in faster than Bear could safely unwind its positions. If lenders had seized the fund’s assets and dumped billions of dollars in mortgage-related securities into the market at fire-sale prices, it would have caused a meltdown in the subprime securities market and would have exposed Bear to substantial losses.

Sticking it to investors and lenders would have ruined the firm’s reputation. And a Wall Street firm with a bad reputation doesn’t last long. Just ask the folks who used to work for Drexel Burnham.

Faced with no real alternative, Bear decided last week to pony up a million dollars 3,200 times. This was the biggest hedge fund bail out since 1998 when more than a dozen lenders (orchestrated by Fed Chairman Greenspan) provided $3.6 billion to save Long-Term Capital Management.

With more than $1.2 trillion washing around in hedge funds today – most of it leveraged – my guess is we’re going to see more of these bailouts in the near future. Or, worse, liquidations that cause chaos in this market because the funds aren’t there for a bailout.

Take my advice. If you have a high-yielding mortgage security in your brokerage account, don’t ask questions and don’t wait for a rebound. Get rid of that ticking time bomb today.

Good investing,

Alex

Editor’s Note: The Hulbert Financial Digest recently ranked Alex the 3rd best stock picker in the country, based on his 5-year total return. Here’s what he’s recommending now.

Today’s Investment U Crib Sheet

The prices of bonds backed by mortgages to people with poor or limited credit have been reduced by more than 50 cents on the dollar, according to Reuters. The hit is a direct result of the highest home-loan default rates in a decade. Bloomberg reports that nearly 65% of the bonds in indexes that track subprime mortgage debt don’t even meet the ratings criteria in place when they were sold.

On Tuesday, the SEC opened 12 investigations into CDOs linked to subprime mortgages.

For more on risk management, here are four ways to build your wealth.