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

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

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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.