Deepening debt crisis hits close to home

But insurance has its limits. For example, no one ever insures against the worst possible storm that they can imagine. It's simply too expensive to take out coverage for such a low-frequency event. So homeowners pay premiums based on the worst storm of the last 100 years or 50 or 20. And they hope that history is a reliable guide to the future and that they won't get hit with a 100-year storm when they've insured for a 20-year storm. Or clubbed by two 100-year storms a few years apart. Or by a storm that's worse than any on record.

Same with the high-risk slices of debt pools. The more debt in these slices, the less that can be sold -- with higher ratings and lower yields -- in the BBB, A and AA tranches. Bear Stearns estimates that a typical $500 million CDO would have about $40 million in its riskiest equity tranche.

The entire structure of tranches with higher credit ratings depends on that insurance, representing 10% or less of the whole pool.

2 very bad things

So think about what happens when, instead of the 20-year storm you've insured for, a 100-year storm hits. The insurance gets overwhelmed, and the rest of the CDO is suddenly much riskier. This is exactly what has happened in the market for pools of debt built on subprime mortgages. The default rate for these mortgages -- loans to homebuyers with shaky credit histories that were often made with cursory or no examination of the borrowers' financial conditions -- has soared. The delinquency rate climbed to 13.8% in the first quarter of 2007 from 11.5% in the first quarter of 2006, according to the Mortgage Brokers Association. Foreclosures hit 147,701 in April 2007, up 62% from April 2006.

That's more than enough to stress the equity-tranche-insurance level of these debt pools. A 3% to 5% decline in a CDO as a whole, estimates Grant's Interest Rate Observer, would be enough to destroy the insurance of the equity tranche -- remember it bears the brunt of the first losses -- and threaten the BBB slices of the CDO.

Once that insurance is breached, two very bad things happen.

First, the investors who elected to buy the equity tranche, attracted by the possibility of an equitylike return on a fixed-income investment, get killed. And unfortunately, those big losses won't be limited to Wall Street or to the sophisticated investors in hedge funds.

Hedge funds bought about 10% of equity tranches in 2006, according to Bear Stearns. But pension funds bought more -- 18%. Insurance companies bought even more -- 19%. And asset managers bought even more -- 22%. When pension funds take big losses, parent companies have to make up the loss or workers have to take smaller pensions. When insurance companies take the loss, insurance rates go up. When asset managers take the loss, well, we all cry when we open our monthly mutual-fund statements.

It's hard to get a complete list of who owns equity-tranche CDOs. But some names that come up include the California Public Employees' Retirement System ($140 million), the Teachers Retirement System of Texas ($63 million), French financial giant AXA (AXA, news, msgs) and the New Mexico State Investment Council ($223 million).

And second, after the insurance is stripped away, the prices of higher-rated slices of the debt pool start to tumble to reflect that greater risk. That's the worry facing the market right now. Merrill Lynch's (MER, news, msgs) attempt to auction off the collateral from the sinking Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund revealed that the market is well beyond the 5% price drop that Grant's Interest Rate Observer pegged as a danger point. Merrill Lynch succeeded in auctioning off some collateral at 90 or 95 cents to a dollar, but other collateral didn't sell at all, even at discounts of more than 50%.

Last year, global sales of CDOs hit $503 billion. In 2006, sales of CLOs broke $150 billion. We've just started to see a massive re-pricing of all the debt in those massive pools.

And with the insurance splices stripped away -- or on the way to being stripped away -- investors who were counting on safety because they owned a pool of this debt are likely to discover that they own a pool in which pretty much everything is falling in price.

Some windshield. Some fly.

Update to Jubak's Picks

The biggest problem with CDOs, CLOs and the rest of the alphabet soup that is so roiling the bond market right now is that it's so hard to figure out what companies hold what and which companies are at risk. Way back in March, I picked insurance giant American International Group (AIG, news, msgs) as one of my "10 stocks for a financial Armageddon" because its balance sheet was so strong that, in my opinion, it would be able to ride out any debt market storm. In the months since then, the storm has grown in size and it's worth taking another look at American International's balance sheet.

After studying the company's March quarter 10Q financial statements and adding up all the figures that could represent potentially troubled loans, mortgages and derivatives, I get a total that, at most, adds up to 12% of the company's total assets. In the company's May 31 conference call, management went out of its way to stress that its exposure to the CDO market and similar markets was at the AAA-rated end of the risk spectrum. As I wrote in my June 26 column, the safety of that rating rests on the insurance provided by lower-rated equity and BBB slices of the debt pool, so those AAA-rated slices aren't risk-free. Where does that leave me as an investor? Measuring potential risk and potential return, as always. I still think American International Group is an undervalued stock. The pickup in the airline industry should put big revenue growth on the board at the company's aircraft leasing business, for example.

The stock is certainly risky, but since I still get a target price of $86 a share for the end of 2007, I think the potential payout still outweighs the risk. As of July 27, I'm keeping my target price at $86 a share but moving the schedule out to December 2007 from my earlier October target. (Full disclosure: I own shares of American International Group in my personal portfolio.)

Meet Jim Jubak at the Money Shows

MSN Money's Jim Jubak will be among the dozens of renowned money experts, advisers and analysts sharing their wisdom in free workshops at two upcoming Money Shows -- in San Francisco, July 26-28, and in Washington, D.C., Sept. 6-8. You'll also have a chance to network with fellow market enthusiasts, exchange investment ideas, share your experiences and enjoy the fellowship of like-minded investors. Admission is free for MSN Money readers. For complete details or to register for free admission, visit the San Francisco Money Web site or the Washington, D.C., Money Show Web site. Or phone 1-800-970-4355 (be sure to mention priority code No. 007420) and tell them which show you're interested in.

Editor's note: A new Jubak's Journal is posted every Tuesday and Friday. Please note that recommendations in Jubak's Picks are for a 12- to 18-month time horizon. For suggestions to help navigate the treacherous interest rate environment, see Jim Jubak's portfolio of Dividend stocks for income investors. For picks with a truly long-term perspective, see Jubak's 50 best stocks in the world or Future Fantastic 50 Portfolio. E-mail Jim Jubak at jjmail@microsoft.com.

At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: American International Group. He did not own short positions in any stock mentioned in this column.

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