March 13, 2007

In for a penny, in for a pound

CDOs May Bring Subprime-Like Bust for LBOs, Junk Debt

A CDO is clever financial agglomeration of bonds, derivatives, and loans. A lot of subprime loans in the housing market are winding up in them. It's fortunate that housing always goes up in value and subprime borrowers are great at making payments on time. Right?

And who is heavily investing in CDOs?

The Dallas Police and Fire Pension Fund invested in its first CDO about two years ago to boost returns, according to Richard Tettament, administrator of the $3.2 billion fund.

``We were beefing up our risk and we were hoping for a greater return,'' Tettament said in an interview from his Dallas office. ``We have an unfunded liability to pay off.''

Tettament said he isn't sure what type of collateral backs the CDO, though he thinks returns exceeded 20 percent last year.

Emphasis mine. Geez.

The Economist magazine's blog has further discussion. Unfortunately, they fail to mention the principle-agent problem. The taxpayers and pension fund managers are not necessarily sharing the same viewpoint. A pension fund manager whose fund does extremely well for ten years before sinking like a stone has made out like a bandit, while the taxpayers get it in the shorts.

Props to Megan McArdle, guest blogging at Instapundit, for the link.

Posted by jeffreyb at 11:14 PM | Comments (0)