In case you didn't know, there is something called a CDO (Collateralized Debt Obligation) and if your retirement system, investment firm, or even you own them, you better start worrying.
First, a CDO is an "investment-grade security backed by a pool of bonds, loans and other assets."(investopedia.com) In this case, the CDO is one way for the issuer to relieve themselves of the debt by selling off the assets in the form of small manageable segments. Should there be a default on the original note, the loss to the individual segment holders will be negligible. So what's the big deal?
The big deal is that the original owner, in order to lessen the load/burden of carrying a note(s) that has the potential of failure, sell off the note or a pool of notes to someone who is not looking at the potential for loss but the confidence that the obligation will be met and the return will be more than what they paid for.
The issuers are able to sell the pool that has been broken down into manageable units. As mentioned, that way they can sell to multiple parties and the load is diminished that a loss on the original note will not be felt as much as someone who is carrying the entire note. The allure of a return, by the new owner, is backed by the fact that the original issuer is selling the note at the current value and not at its Net Future Value (without discounted cash flow). The NFV then becomes the selling point and people buy.
What they are buying is "an investment in the future" but isn't that what U.S. Savings bonds are? However, they also believe that if they buy a little piece of a big pie their loss is almost not important, it is a risk that they are willing to take. A risk? but a who's expense?
So who is buying the CDOs?
Unfortunately, many people are buying. The mystique of a little bit has them looking at buying a lot. Let's see who's buying; Bllomberg reports "The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions", while the Teachers Retirement System of Texas purchased just "$62.8 million" of the CDOs, and the New Mexico State Investment Council, which funds education and government services for children, has purchased $222.5 million and recently acquired another $300 million. That is a lot of money dumped into the riskiest of investments, and that's a lot of people that will be out something they were expecting to get, something they believed their retirement program was going to give them, especially after contributing all these years.
So what happens if they default?
A lot. Aside from organizations being out millions the confidence of those organizations to make sound investment decisions in the future will be questioned every step of the way, by not just the people that were hoping to use the returns for their golden years, but you can bet your bottom dollar the government will be knocking on someone's door. But it does not stop there.
The word will get out and across the board two things will happen...
One, under increased scrutiny financial lending institutions will restrict any form of subprime lending (thus creating the risky investments) and re-do the lending structure for prime lending. This will then shift the borrower status. Those that were considered Prime, but on the fringe, are now definitely considered Sub-Prime.
Two: consumer confidence in the value of any financial organization will be considerably low. This is especially so, in those that made the decisions to buy those risky (and unrated) CDOs. Additionally, the consumer confidence of the lending institution will be lower as well. This is because they will be perceived as the root of all this evil. They are the ones who created the bad/risky debt then pawned it off on someone else.
While the investing confidence of an individual will not be lost, in fact it will be strengthened as the individual will start to realize that if they can control their own financial future then they can blame no one but themselves. Therefore, this will then launch a new era of the "consumer-investor" They will not only invest on their own but do the homework to get the better deal.
A BETTER FUTURE?
Will this happen again? You bet it will. If there is a risk, someone will take it. As Deloitte & Touche Internal Auditor Eric Hespenheid and Rick Funsten recently said in a Deloitte Insights Podcast that Risk is the foundation of the entrepreneurial spirit. Knowing this does not excuse the actions of those that make bad decisions. I am not saying that if an investment goes south it was a bad one. This means that if there is too much of an inherent risk and steps aren't taken to minimize the risk then you get what you got coming.
Go into any deal with the knowledge that one day it will end, whether through default or the note is paid in full, it will end. Preparing for both will minimize the risk should something bad happening. Lastly, understanding that in this day and age stakeholders rule. They will drive what happens to their interests. However, there is no greater stake than cold hard cash, especially the cash that they plan to live off in retirement and if it is not there when they need it, they will not be happy campers.
So dear reader, why wait until something bad happens? Do something now, be aware of the consequences of what could happen to your money. Get informed NOW and not when it is too late. It is your money and you do have a right to do something about it.
KNOW WHAT INVESTMENTS YOUR FUTURE IS IN!!!
Reference:
Investopedia.com
Bloomberg.com
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