Deepening debt crisis hits close to home

By Jim Jubak

If I hear one more money manager who loaded up on subprime mortgages or buyout loans say "don't worry," I'm going to tear the rest of my hair out.

Don't worry about rising numbers of subprime mortgages going into default, they say, it's not going to hurt the portfolios of pension funds, college endowments, mutual funds, insurance companies, etc.

Don't worry that the bonds issued by companies buried under a mountain of buyout debt will go into default.

We -- the individuals who will take the hit if a pension fund can't meet its obligations or if a mutual fund's returns go south -- shouldn't worry, the professionals imply, since, well, since they're professionals and know what they're doing. The professionals have carefully built portfolios to spread out the risk so that even if one or two loans or mortgages go bad, the portfolio as a whole won't take a noticeable hit.

To which I say, "If only." In truth, either these professionals don't know what they're talking about -- which I believe is true in a number of cases -- or they're deliberately trying to sell happy endings in the hope that they can get out with their skins intact.

Harsh? I'll let you judge for yourself after I've explained how these "low-risk" portfolios actually behave.

Murky pools

The pools of debt investments that are at the center of this story -- things that go by names such as collateralized debt obligations (CDOs) and collateralized loan obligations (CLOs) -- are pools of mortgages, corporate bonds, corporate loans and other sorts of debt.

Because the buyer of a CDO gets a pool, rather than a single mortgage, bond or loan, CDOs are less risky in a same way that a portfolio of 20 stocks is less risky than a portfolio with just one stock. If one mortgage or bond or loan goes bad, the total damage to the portfolio as a whole is very small. It's this very real portfolio effect that lets someone like David Baland, president of the board of regents at the School for the Blind and Visually Impaired in New Mexico, tell The Wall Street Journal, "Some loans may go bad, but when it boils down to us, if there were one or two defaults among the pool of loans, it would be like a fly hitting a windshield."

But CDOs and CLOs aren't simply pools of mortgages, bonds or loans. Wall Street has "improved" on that concept by slicing up these pools into different pieces, called tranches, that each offer the potential buyer of that tranche a different mix of risk and return. (For more on the slice and dice of CDO and CLO manufacturing, see my video with this column.)

By carving up these pools of loans, Wall Street has also been able to manufacture a sizable supply of investment-grade debt just as the supply of raw investment-grade debt was getting smaller and smaller. Even blue-chip companies such as IBM (IBM, news, msgs) are borrowing money to beef up their dividend payouts, and other companies are taking on tons of debt to pay for acquisitions to fund their own purchase by a buyout fund. So there just isn't enough highly rated, low-risk debt to feed the appetites of investors who want safe fixed-income assets with long maturities that pay more than Treasury notes do. This kind of debt is in huge demand as pension funds and insurers try to build long-lived portfolios to match the increasing life span of workers and retirees.

Slicing and dicing pools of debt is one solution -- a huge solution -- to that problem, since it lets Wall Street manufacture high-quality debt out of the mixed credit quality in a pool. This is done by segregating the riskiest debt in a pool into a separate tranche -- often called the equity tranche because this debt is so risky that it can behave like a stock and go up and down with corporate earnings -- and then dividing the rest of the pool into other tranches of gradually increasing credit quality. (Why would anyone buy the riskiest tranches? Because the riskier the tranche, the more interest it pays . . . and the more the price of the tranche will appreciate if the default rate is lower than projected.)

Rising from the below-investment-grade equity tranches are slices of the debt pool rated at the BBB level (on the Standard & Poor's scale), which is just into investment-grade territory. And then above them are the even less-risky and higher-quality slices of A and AA debt.

No insurance for the 100-year storm

The higher-risk tranches act as a kind of insurance policy, then, for the BBB, A and AA tranches. If anything goes wrong in the debt market -- if more mortgage holders default on their mortgages or more post-buyout companies can't make their interest payments -- the damage will be concentrated in the sub-investment-grade tranches. The investors who took the risk -- in hope of getting a higher reward -- will lose their bets, but the higher-credit-quality tranches will sail on, undisturbed.

Continued: Insurance has its limits

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