An Investment That Could Turn Ugly
The latest edition of BusinessWeek tells how big firms - having spent two years devising the right formula - are now targeting individuals, and the mutual fund managers who cater to them, with the latest investment gimmick: collateralized debt obligations (CDOs). These complicated investment pools, which are generally filled with such risky assets as subprime mortgages and junk-rated corporate loans, have usually been sold to hedge funds, insurance companies, and the like. Now several firms, including fund manager Highland Capital Management and affiliates of Kohlberg Kravis Roberts and investment bank Bear Stearns, are pitching publicly traded vehicles that hold CDOs.
But a close look at the preliminary prospectuses shows that these aren't the same kind of CDOs that the pros have been feasting on for years. Add to that the very real possibility that the credit cycle will soon turn, along with the fact that some of the underlying holdings are potentially toxic, and you have the recipe for a retail nightmare.
The market for CDOs has been piping hot. Big investors are attracted to the bond-like securities because their returns beat the market (at least recently). A dozen CDO funds managed by Highland have historically paid dividends of 19.6%, according to an IPO filing with the SEC. Eighteen CDOs in which a Bear Stearns' affiliate has invested have average annual returns of 24.5%, according to a company filing. Some $550 billion worth of CDOs were sold last year, more than triple the amount in 2004.
But it's a dangerous game for small investors. CDOs are generally divided into different tiers, with the so-called equity portion sitting at the bottom of the pile. Investors in that part of the structure get higher returns, but they can be hurt badly if something goes wrong and borrowers can't make their payments. Those equity investors are the first to absorb any losses and can be wiped out because CDOs use a lot of leverage.
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But a close look at the preliminary prospectuses shows that these aren't the same kind of CDOs that the pros have been feasting on for years. Add to that the very real possibility that the credit cycle will soon turn, along with the fact that some of the underlying holdings are potentially toxic, and you have the recipe for a retail nightmare.
The market for CDOs has been piping hot. Big investors are attracted to the bond-like securities because their returns beat the market (at least recently). A dozen CDO funds managed by Highland have historically paid dividends of 19.6%, according to an IPO filing with the SEC. Eighteen CDOs in which a Bear Stearns' affiliate has invested have average annual returns of 24.5%, according to a company filing. Some $550 billion worth of CDOs were sold last year, more than triple the amount in 2004.
But it's a dangerous game for small investors. CDOs are generally divided into different tiers, with the so-called equity portion sitting at the bottom of the pile. Investors in that part of the structure get higher returns, but they can be hurt badly if something goes wrong and borrowers can't make their payments. Those equity investors are the first to absorb any losses and can be wiped out because CDOs use a lot of leverage.
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posted by Bob Moser at
7:10 PM
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