Best Economics Post of the Year
The Calculated Risk weblog highlights one ridiculous side effect of the rush to private equity. The same companies that are making a commission on selling high-yield bonds to pension plans are recommending that those plans buy these bonds. Ordinarily, this would be a garden-variety example of today's financial marketplace, but the bonds in question are worse than ordinary junk bonds—they carry the first-loss position before the ordinary junk.
You take a bunch of subprime loans, and make a pool with them. Then you tranche that pool up and create a security... Then you take those low-rated subordinate tranches and put them into a pool with a bunch of other stuff (commercial security tranches, corporate debt, junk bonds, heaven knows what), and then you tranche that up into a new thing called a Collateralized Debt Obligation, the "beauty" of which is that it's an actively traded, not static pool, so that while you might know what's in it the day you bought part of it, you may never know what's in it after that. Then you take the lowest possible tranche of the CDO—the "equity" portion or the very first part to take any losses, which is so high-risk it is referred to as "toxic waste," the stuff that is unrated by the rating agencies because it has no "credit support" whatsoever—and you put it in a pension plan managed by some goofball who thinks that it must be a good deal because a party who owns some of the higher rated tranches—the ones you "support" with your equity piece—tells you that if the planets align and the Messiah returns and everybody rolls a lucky seven, you'll make 20%!
I'm still not sure everyone is getting the picture here, so let's try this: the subordinate tranche of a subprime ABS/MBS is a "pig." With or without lipstick. The equity tranche of a CDO made up of subordinate tranches of a subprime ABS/MBS, mixed up with some other junk you do not understand, is a pig of a pig, distilled essence of pig, ur-pig, Total Ultimate X-Treme Mega Pig. Buying a B tranche of a subprime ABS is playing with matches. Buying the equity tranche of a CDO is playing with a blowtorch in the parking lot of the Exxon station while wearing a St. Lucia wreath on your head.
To put it another way, when someone is selling you a tranche of a security, there is a reason. It is because someone else did not want that part. Sometimes, that someone else is too risk-averse, but often that someone else has made a reasonable decision. Buying a lower-rated tranche is gambling that their risk assessment is somehow flawed. And buying an equity tranche is not only gambling that everything will go right and you will actually earn you stated return, but that the other tranches are filled with fools who are getting better security when they do not need it.
Labels: bond tranches, stupid corporate tricks, Wall Street
