Tanta,

I rarely read things twice, bravo, just bravo!

What bothers me most is that "CDO managers can change the contents of a CDO after it's sold, investors may not know how much subprime risk they face."
What you think you are buying is not necessarily what you end up owning (unless you are the CDO manager or his brother in law.)

Thanks Tanta. Now i get it.

It is interesting that the whole series of slicing is even worth the fuss. The mezzizine tranches are already thin. Mezzazine tranches of CDOs backed on mezzazine tranches are even thiner. And somebody sliced it anyway to get CDO squared? And there are buyers of this whole convolution?

Anonymous: another reference to CDOs and credit ratings and escalating losses

Thanks, I was trying to find that one again. It would seem that all the raters have dug out their disclaimers and are frantically waving them around: "What, you used our ratings for gasp Investment Decisions?!"

"CDOs mask huge subprime losses, abetted by credit rating agencies", by Richard Tomlinson and David Evans, Bloomberg / IHT, June 1, 2007.

The rating companies apply their usual disclaimer about the reliability of their analyses to CDOs. S&P says in small print: "Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision."

Joseph Mason, a finance professor at Drexel University in Philadelphia and a former economist at the U.S. Treasury Department, said the ratings were undermined by the disclaimers.

"I laugh about Moody's and S&P disclaimers," he said. "The ratings giveth and the disclaimer takes it away. Once you're through with the disclaimers, you're left with very little new information."...

"It's important to understand that unlike in the corporate bond market, in the securitization market, the rating agencies run the show," he said. "This is not a passive process of rating corporate debt. This is a financial engineering business."

Tanta: "... How many portfolio managers does it take to tile a bathroom? Just one, if you slice real thin."

You're forgetting ... everything can be delegated.

"How Wall Street's Top Earners Live", by Matt Woolsey, Forbes, May 31, 2007.

The quirkiness doesn't stop there. Picked up in the mornings by private car from his $15 million 14-acre compound in Greenwich, Conn., and delivered to SAC headquarters in Stamford, Conn., Cohen, 50, works in an office flanked by a 14-foot tiger shark preserved in formaldehyde. In the SAC lobby is "Self" by Marc Quinn, a full-size replica of the artist's head, sculpted from Quinn's frozen blood.

You neglected to mention CDO cubeds. And I'm sure you can find CDO to the fourth power if you look hard enough. And then there's the really fun stuff - CDPOs and the like. I figure they are just a version of portfolio insurance, but that's probably me being overly skeptical, right?

Somebody mentioned to me that one of the French banks came out with a CPDO squared, but I think he was joking.

Whatever happened to the Collateralized Loan Obligation (CLO). Last fall I posted on these -- Safety Net XII (Aug 23), when Jan-Martin Feddersen confirmed that CLO sounded like a German euphemism for "toilet."

Some perspective -- CalPERS total asset pool is $234 billion. This means that the $140 million investment is less than one tenth of one percent of their overall investments. I'm not saying it's right for them to invest in boondoggles (if this proves to be), but it's not like CalPERS couldn't weather a .001 decrease in their overall fund even if the CDO fund went entirely bust.

Unless I am reading this wrong, Calpers manages more than $200 billion in funds:
Asset Allocation

$140 million is big number but is a small slice of $200 billion. That makes the risk seem not so huge to me... but am I thinking about this in the wrong way?

Insurance Guy-

I am sure that Calpers does incredible due diligence on their intial choice to invest in a particular hedge fund, their site actually goes through the process, which undoubtedly is likely one of the best in the nation.

That said, THE problem is that these asset pools are NOT regulated, there is a tremendous amount of money currently mounting a serious battle to prevent regulation. In my humble opinion, this is beyond comprehension. As many here have stated, the potential conflicts are unending and disclosure does not exist, therein lies the problem.

These asset pools are there to provide future income streams for unsophisticated investors, there is plenty of information available in regard to hedge funds in particular taking concentrated positions, chasing the same trade attempting to generate alpha, and thus magnifying risk. Per the Calpers site, the objective is to increase diversification with the use of the alternative asset classes, I would argue that today, they are much more likely to be highly correlated assets.

I would also argue that all of the due dilgence in the world does absolutely no good if you do not know or have the slightest understanding of what these hedge funds hold.

The problem today is that you are in an environment in which risk premiums are extremely small and risk itself is dramatically understated in most cases. This is a fact, knowing this, and understanding the dynamic nature of a hedge fund, and the quest to generate alpha, I question the prudence of the decision.

If you look at their site, there is quite a list of hedge funds, you can download it of of the link. My point would be this, knowing that they do not/don't have to disclose any position, you might think you are diversified by owning positions in 15 different hedge funds...

What if they are all buying the same shit?

Yal:

Make that a Zero-Coupon Perpetual

Risk Capital,

I agree. Jeremy Grantham has written about the drive to emulate the Harvard and Yale endowment funds among the institutional investor community.

What are funds to do? How do you pretend to be close to fully funded if you hold only assets that can't possibly meet your return assumptions? Alternative assets are magic, no?

The problem here is that most funds don't have the talent and aren't willing to pay for the talent that Harvard and Yale have. So you're right, regulation is necessary.

Tanta and CR, I don't thank you guys enough for what you do. It is much appreciated.

Risk Capital, I asked you a couple of days ago why you're so confident we're moving into a new phase of the credit cycle. Particullarly with respect the the LBOs. You may not have seen it. Anyway, I'd like to know what you're looking at.

credit cylce is turning-

Bloomberg.com ne...id=a5ZErZ8qQogs

404 - The News Tribune | Seattle-Tacoma News, Weather, Sports, Jobs, Homes and Cars | South Puget Sound's Destination 76797.html

Spreads remain tight, but rates are rising, the fixed income markets will force a repricing of risk. the approximate 40bps move on the 10 yr is in effect a tightening in and og itself, this in turn will influence the debt service coverage estimates on the recent lbo & pe deals, lowering the equity premiums. The current pe expansion that has taken place has been predicated on continued credit bubble-based metrics. This has ended, the deals will trickle out due to backlog, but, the turn is upon us and a repricing is underway.

Some believe that the current environment is restrictive, this is honestly nothing compared to what lies ahead.

Risk assets are about to experince a massive sea-change.

Other than the articles cited above with IB's prepping for the inevitable, default rates are at historical lows, they have nowhere to go but up. The number of firms in the S&P coverage universe rated junk are at historical highs, refinance costs are rising, and the economy is slowing. This environment is not condusive to a continuing credit binge, thus, the activity in the distressed markets that the articles cite.

The toxic waste, scratch & dents, equity-like tranches, etc will begin to surface on balance sheets as the securities are forced to be marked to market, triggered by further ratings agency action (forced).

The decrease in revenues which is inevitable within the banking and more broadly the financial sector will magnify the extent of the loan losses, and force what has been delayed- the disregard in many instances to properly reserve considering the economic backdrop.

Tough period ahead.
risk capital | 06.02.07 - 9:07 am

I humbly request an ubernerd post explaining CDO's oh great and powerful Tanta.

Thanks. I agree with your diagnosis, I'm just less confident on the timing. I have always figured the curent situation would buckle when American consumers finally exhausted themselves.

It could be though that inflation bubbles up in places like the middle east and China and FCBs start to slow their investment in USD, and rates begin to rise. A different catalyst. That could be what we're seeing.

Timing is tough.

lama-

"I met the head of Yale's endowment fund. I wouldn't want to be across the table from that guy."

I am sure that he was an extremely intelligent person.

As were the guys that led LTCM.

I think many suffer from a "God" complex and think that they have changed the wheel or continue to think that this time is different, it ain't different.

If it sounds to good to be true, it is, there ain't nothing out there that is risk-free, the term might be used (t-bills), but, there are different types of risk with everything.

The most difficult task is attempting to understand exposure with things in which you have a good understanding, take that a step further when you don't know what is under the hood.

I read a response here where the person thought we could potentially be headed for depression, this, in my opinion is removed from reality. Tough period, yes, they are part of every business cycle.

I think that Tanta's post promoted good thought, I hope it makes pension participants learn more about their pensions and ask questions, afterall, they worked for it and their interests should be addressed.

"I think many suffer from a "God" complex and think that they have changed the wheel or continue to think that this time is different, it ain't different."

Exactly- much confusion among money managers between risk and uncertainty. Lots of lucky fools in credit markets assume they have gotten rich because they can model outcomes that probably can't be modeled.

I would guess that each derivation (mbs to cdo to cdo squared) increases the uncertainty (not risk). It's simply harder to model one outcome, let alone multiple layers of outcomes.

I also assume, perhaps wrongly, that each derivation increases the likelihood of default due to systemic factors.
-Rob

mid20something, is it true that TruPS CDOs can't get executed anymore? No market?

unrelated, but aren't first-loss holders of option arm deals going to get a decent return even if the loans eventually start defaulting after 5 year recasts b/c they get their o/c release after 3 years?

dryfly-

my thoughts exactly, this kid is right out of school and was in diapers in 87, junior high during LTCM, and now, undoubtedly, knows everything.

Schahrzad-

again, you do not know what the total exposure is due to the pension funds exposure to alternative investments/asset classes and the underlying holdings, this coupled with some of the conventional fixed managers quest to have some equity-like exposure as well.

Until you have full disclosure and regulation from these managers that are held within pension funds-

you have NO idea what the FULL exposure is.

This is just one reason why employees participating in pension funds need to become involved-

"Tax officials said yesterday that they could not comment on New Jersey or any other individual governments that operate pension funds. But they echoed Mr. Cox’s general sentiment that there appeared to be a need for more monitoring of public pension plans.

“We sense that perhaps compliance is not as good as it should be in this area,” said Joseph Grant, the I.R.S.’s director of employee plans. “We are looking at what our authority allows us to do, and where we can best use that authority to have the most salutary effect on participants.”

New Jersey Says Its Pension Fund Is Being Examined by the S.E.C. - NY Times

do you think any of the pension funds are managing their exposure to these investments with other derivatives? Maybe an accreting CDS or some other form of insurance? I am not really up on this but can you short CDO equity through another type of derivative?

"Tough period" (s)

are and always will be tj.

depression(s) are extremely remote. that said, yes, you, in my opinion, in this instance, are removed from reality. no offense intended.

tj-

you might find that you are able to learn something tj, if you took the time to attempt to interpret what others are actually saying, and respect the knowledge that they possess.

I wish you well.

Let's see. Pension funds, in order to pay out their pensions, need to earn x% a year. The risk-free (U.S. treasury rate) is y% a year. Invariably, x > y. Invariably x is much greater than y. Thus pension funds need to take on risk, or need to admit that they will default on their obligations, or need to have more infusions from the taxpayers (in the case of public funds) or from companies (in the case of private funds). So people here can be shocked, shocked that pension funds are taking on risk; but that's only because they don't want to default, and they have to live with the infusions that they are given.

According to the above post by Brian, the CALPRS equity CDO traunches amount to 7 bps. At a 20% return the equity traunch would contribute yield of roughly .00015%. Its hard to see how this would be a meaningful amount. Is this a discussion of how many angels can be fit on the head of a pin?

There are significant CDO losses somewhere, and there will be more, but the IBs will go to great lengths to obfiscate that fact. There will be many buybacks of CDO loss positions over time, written off against reserves, trading gains, etc. Just another credit cycle in the financial world.

As we say in Texas, there are a few of you off of your range and many of you appear to be sycophantic dileTantas. The CDO pig/sausage analogy is inaccurate. At the end of the day the assets underlying the MBS/ABS components of CDOs are loans collateralized by U.S. real estate with real value, not worthless tripe. Successful hedge funds/pension funds/endowments don't heed rating agency ratings, they reverse engineer and surveil from CDO2 to CDO to ABS/MBS down to loan level. They have vetted assumptions about geographically specific home price appreciation, loan level foreclosure freqeuncy and loss severity. They take into consideration the structure of ths underlying ABS/MBS and their attendant triggers. The value they assign (and perhaps elect to pay or not) to the mortgage component of a CDO is the price at which the present value of the expected cashflows under their assumptions returns the required expected IRR hurdle. In effect, they assume there are going to be huge losses and pay pennies on the dollar in order to get the return they are looking for. No doubt, this is a game for profesionals - don't try it at home. But don't have a conversation about the riskiness of any asset without discussing the price of that asset. There is no risk/reward discussion possible without it. An illustrative example is beyond the scope of this post but just consider that the prices that are getting paid for the equity pieces factor in huge losses. I assure you that public funds of all ilk took losses on some equity pieces in the first and second quarters. Also rest assured that the same funds double downed as spreads blew out from panic selling. Also know that many CDOs are comprised not just of resi mortgage assets but commercial, transportation and infrastructure debt too...