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This Investment Could Turn Ugly


Who's the latest investor Wall Street wants to lure into the credit boom? You.

After spending two years devising the right formula, big firms are now targeting individuals, and the mutual fund managers who cater to them, with the investment du jour: collateralized debt obligations (CDOs). Those 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 private equity giant Kohlberg Kravis Roberts and investment bank Bear Stearns (bsc), are pitching publicly traded vehicles that hold CDOs. "It wouldn't surprise me if you see a dozen of these, if not more" in the next year, says Michael R. Littenberg, a partner at law firm Schulte Roth & Zabel.

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 stock market (at least recently). A dozen CDO funds managed by Highland have historically paid annual dividends of 19.6%, according to an IPO filing with the Securities & Exchange Commission. Eighteen CDOs in which Bear Stearns' affiliate Everquest Financial 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. The new vehicles buy those equity portions. "The equity piece [of the CDO], by definition, is the riskiest piece," says Gary Kendall, president of CDO2, which sells software for valuing the instruments.

TYING MANAGERS' HANDS

It gets worse. Many of the new CDO products for the retail arena are more limited than the ones institutions have been loading up on. To avoid restrictive rules governing investments for individuals, managers have tweaked the investments. KKR Financial Holdings (KFN), Everquest, and Highland have been changing the legal contracts that govern the majority of their CDOs to bar the managers from trading the underlying assets for profits, a strategy that has boosted CDO returns. The three companies warn in their filings that this restriction puts them at a potential disadvantage to most CDOs. Spokesmen for all three firms declined to comment. In a conference call with analysts, KKR officials said the changes won't be as onerous for them as for others who trade more frequently in their portfolios.

Such investments are also ripe for abuse, since there's little transparency in the underlying holdings. "We've seen several examples in the past where managers succumb to temptation and inflate prices to increase their fees," says Janet Tavakoli, a consultant to institutional investors and president of Tavakoli Structured Finance Inc. "These products are not appropriate for retail investors."

The timing of the new push isn't ideal, either. Late to the party, individual investors, who face a potentially huge headache come tax season with these types of products, have missed out on the easy gains. Now they may be lured in just as borrowers max out and the credit cycle turns down after five up years. If a credit crunch leaves borrowers unable to refinance, a wave of defaults will follow--along with a wave of losses for investors in this latest generation of CDOs.

By David Henry, with Matthew Goldstein in New York


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