I'd like to continue my focus on the debt market -- because, without the incomprehensible complacency in all of its sectors, we would not be seeing the lunacy now on display in the equity market. I've already discussed how the world's central banks, by printing their own money to suppress their own currencies, have wound up owning trillions of dollars' worth of U.S. Treasurys.
The nightmare in retirement dreamsNow I'll turn my attention to those who have been gullible enough to buy the sliced-and-diced mortgages that found their way into collateralized debt obligations (CDOs) and other exotica. A synopsis of what's happening in that arena was recently penned by Bloomberg writer David Evans in a story titled "Banks Sell 'Toxic Waste' CDOs to Calpers, Texas Teachers Fund."
It begins: "Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds."
Evans explains: "Worldwide sales of CDOs -- which are packages of securities backed by bonds, mortgages and other loans -- have soared since 2003, reaching $503 billion last year, a fivefold increase in three years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out."
At a recent presentation to pension managers, a Bear Stearns shill described the bottom rung of the CDO ladder as follows: "It has a very high cash yield to it. . . . I think a lot of people are confused about what this product is and how it works.''
I'm sure that's the case, but not in the way the Bear Stearns marketer meant it.
At the presentation, she likened CDOs to financial institutions in terms of having strict oversight: "The outside agencies that oversee these structures are the rating agencies,'' she said.
However, her comment drew the following from Gloria Aviotti, managing director of global structured finance for rating service Fitch: "It's not accurate. We don't provide any oversight.'' That view was echoed by Yuri Yoshizawa, group managing director of structured finance at another rating service, Moody's Investors Service: "It's a common misperception," he said. "All we're providing is a credit assessment and comments.''
Thus, the ratings agencies are trying to have it both ways: They want to be paid to rate these structures so people will feel good about them. But they're also trying to say: If they blow up, don't blame us, as we're really not doing any work.
Bloomberg's Evans noted the motivation of the buyers: "Many pension funds, facing growing numbers of retirees, are still reeling from investments that went sour after technology stocks peaked in March 2000."
So, because the funds took too much risk or weren't competent, or both, they got themselves into a hole. Now they're attempting to dig themselves out by reaching for yield in the form of debt that's been ginned up and blessed by the ratings agencies. I would not be surprised to find out that these pension funds are the biggest subscribers to high-risk leveraged buyout (LBO) funds, as well.
Marketing serpents pitch to civil servantsNext, Evans quoted Chriss Street, treasurer of Orange County, Calif. (The county, for those who don't know, went bankrupt by over-leveraging itself during the infamous 1994 version of the carry trade.) Said Street, regarding the appropriateness of public funds investing in equity tranches, the diciest of all mortgage paper:
"It's grossly inappropriate to take this level of risk. 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. . . . Very few pension plans could meet their fiduciary duty by buying portfolios of subprime loans. They (Wall Street) spiked up the yield, but that yield means nothing when the defaults start to mount, as we know they will. The funds will take big losses."
Those losses will be enormous, and we'll see an incredible witch hunt when these pension funds are left holding the bag, even though they brought it on themselves.
As I noted at the beginning, a variation of this theme is going on in the funding of all the junk debt being created for the current LBO craze. However, knowledgeable people have told me that we're starting to see some covenant tightening and higher coupons, as deals already announced are being finalized via bond financing. At some point, even though some of those deals have been announced, they actually won't be funded (a la what happened in 1989 with United Airlines).
As to which deals meet that outcome, I don't know, but I have no doubt that LBO artists will go too far. It doesn't take much imagination to see why once the music finally stops, we will face a litany of problems like we've never seen before.
Ultimately, the debt market is going to gag. That will certainly end the equity party (though other things could end it, as well), and this LBO mania will be over.