CDOs Returning to Wall Street: Do Your Believe It?!!
CDOs - complex financial instruments that caused massive losses and were instrumental in the 2007-2008 collapse of financial markets - are being resurrected by Wall Street. Surprised? Don't be.
First of all, investors have short memories. I know of no example of bad investment ideas, chicanery, or stupidity that has not been repeated endlessly in the history of investing. No matter how horrendous the losses, after a few years people forget and put their money into the same or similar investments yet again. It's quite stunning - but true.
Second, investors continue to "reach for yield." Returns on real investments like stocks and bonds are meager. Cash pays nothing. Investors won't settle for this, so they take on risk just to squeeze out a few more percentage points of yield. Again this "reaching for yield" has proven historically to be a bad idea and, for the most part a losing proposition: after getting higher yields for a period of time, the principal value of the investment collapses because it was a highly risky security, perhaps even a total piece of garbage and therefore reverts to its true value of virtual worthlessness. Few get out before the collapse, but they felt good for a spell collecting higher yields. Madness? You tell me.
And so we now find that enough time has passed since investors lost billions in CDOs. They're ready for more, and Wall Street - which is and always will be a sales organization as we've said here in the past - steps right up to the plate to accommodate the suckers, er, I mean customers.
Ideally, you won't be one of the suckers, but just for the heck of it, let's take a look at how CDOs really work, just in case you're ever tempted.
In a zero interest rate world, you can't get higher returns on Wall Street from anything approaching a sane or rational investment. And even the suckers would think twice before investing substantial sums in some investment that's promising far more than it could ever hope to deliver - like let's say a truly junky junk bond issued by a company desperate for cash, that promises to pay 14% a year for, oh, 5 years, before they pay back principal. The company has no hope of being able to do this, but they find enough suckers and get their cash. They use some of the cash to pursue some business purpose, and some (most?) to pay their top people bonuses. After a few years, the company goes bust. The investor got maybe 40% return, then loses their principal. Great deal, huh?
Well, what CDOs do is they take a bunch of this crap and "bundle" it into a "structured" vehicle. They tell you that you won't lose your money because, instead of investing directly into the crappy company, you're investing into lots of crappy companies. So, heck, they can't all go bust, right? And, sure enough, suckers line up and purchase what are called "slices" of the CDO.
(The example used is made up. The CDOs can contain all sorts of crappy stuff, not just ultra-junky junk bonds of crappy companies. I'm just using this example to keep the illustration simple.)
The suckers buy slices. The riskier slices return more, the less risky return less. The less risky pay off first; that's why you get a lower return.
Now, how does the sucker justify this? Maybe he "trusts" the investment banker who's selling it. I suppose that's still possible, although anyone buying from an investment banker on trust these days needs to have their heads examined. Nevertheless, it's still somewhat of a free country - especially when it comes to freedom to lose your money. But because most suckers can't justify their idiocy by mere trust in the banker, the banker goes to a ratings company - Moody's, S&P, etc. - and has them "rate" the CDO. Before the 2007-2008 collapse, ratings companies rated lots of CDO "AAA" that later fell apart. It caused a great scandal. But, of course, that was oh-so-long-ago. The same ratings companies are around and it will be interesting to see if they're called on to repeat their past outrages.
I wouldn't be surprised if they do, since I'm sure the "new" CDOs will be marketed as being "different" in some way from past CDOs. Remember, Wall Street may be a sales organization, but the people who work there aren't stupid. For example, as this article points out,
First of all, investors have short memories. I know of no example of bad investment ideas, chicanery, or stupidity that has not been repeated endlessly in the history of investing. No matter how horrendous the losses, after a few years people forget and put their money into the same or similar investments yet again. It's quite stunning - but true.
Second, investors continue to "reach for yield." Returns on real investments like stocks and bonds are meager. Cash pays nothing. Investors won't settle for this, so they take on risk just to squeeze out a few more percentage points of yield. Again this "reaching for yield" has proven historically to be a bad idea and, for the most part a losing proposition: after getting higher yields for a period of time, the principal value of the investment collapses because it was a highly risky security, perhaps even a total piece of garbage and therefore reverts to its true value of virtual worthlessness. Few get out before the collapse, but they felt good for a spell collecting higher yields. Madness? You tell me.
And so we now find that enough time has passed since investors lost billions in CDOs. They're ready for more, and Wall Street - which is and always will be a sales organization as we've said here in the past - steps right up to the plate to accommodate the suckers, er, I mean customers.
Ideally, you won't be one of the suckers, but just for the heck of it, let's take a look at how CDOs really work, just in case you're ever tempted.
In a zero interest rate world, you can't get higher returns on Wall Street from anything approaching a sane or rational investment. And even the suckers would think twice before investing substantial sums in some investment that's promising far more than it could ever hope to deliver - like let's say a truly junky junk bond issued by a company desperate for cash, that promises to pay 14% a year for, oh, 5 years, before they pay back principal. The company has no hope of being able to do this, but they find enough suckers and get their cash. They use some of the cash to pursue some business purpose, and some (most?) to pay their top people bonuses. After a few years, the company goes bust. The investor got maybe 40% return, then loses their principal. Great deal, huh?
Well, what CDOs do is they take a bunch of this crap and "bundle" it into a "structured" vehicle. They tell you that you won't lose your money because, instead of investing directly into the crappy company, you're investing into lots of crappy companies. So, heck, they can't all go bust, right? And, sure enough, suckers line up and purchase what are called "slices" of the CDO.
(The example used is made up. The CDOs can contain all sorts of crappy stuff, not just ultra-junky junk bonds of crappy companies. I'm just using this example to keep the illustration simple.)
The suckers buy slices. The riskier slices return more, the less risky return less. The less risky pay off first; that's why you get a lower return.
Now, how does the sucker justify this? Maybe he "trusts" the investment banker who's selling it. I suppose that's still possible, although anyone buying from an investment banker on trust these days needs to have their heads examined. Nevertheless, it's still somewhat of a free country - especially when it comes to freedom to lose your money. But because most suckers can't justify their idiocy by mere trust in the banker, the banker goes to a ratings company - Moody's, S&P, etc. - and has them "rate" the CDO. Before the 2007-2008 collapse, ratings companies rated lots of CDO "AAA" that later fell apart. It caused a great scandal. But, of course, that was oh-so-long-ago. The same ratings companies are around and it will be interesting to see if they're called on to repeat their past outrages.
I wouldn't be surprised if they do, since I'm sure the "new" CDOs will be marketed as being "different" in some way from past CDOs. Remember, Wall Street may be a sales organization, but the people who work there aren't stupid. For example, as this article points out,
...buyers of the least-risky slices would get more protection against potential losses than buyers of similar slices did before and during the crisis, said people familiar with the discussions.So the wheel turns round and round. CDOs are back. Let's keep our eye on this. If it catches on (yet again!) we may be following the same path to disaster that marked the years before the 2007-2008 collapse.
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