Capital Misallocators

"A recent rash of bank failures is wreaking havoc on a large but little-known corner of the credit markets, in a development that could mean more writedowns for banks and higher borrowing costs for companies everywhere. ... As a result, the users of synthetic CDOs are facing a wave of credit-rating dowgrades and outright losses, which are coming to light gradually as ratings firms pore over hundreds of individual synthetic-CDO deals. ... Meanwhile, hedge funds and other investors are heading for the exits amid worries about how bad the losses and downgrades will be, causing the market value of synthetic CDOs to slide. Dealers are offering about 50 cents on the dollar or less for some pieces of synthetic CDOs that used to be rated triple-A, according to one trader. ... As opposed to regular CDOs, which contain actual bonds, synthetic CDOs provide income to investors by selling insurance against defaults, typically on a pool of a hundred or so companies or individual bonds. ... Ratings firms, Standard & Poor's and Moody's have already downgraded several synthetic CDO deals containing or related to Lehman, Washington Mutual and U.S. mortgage companies Fannie Mae and Freddie Mac. ... In many cases, the banks that created the CDOs stuffed them with companies, such as Lehman and Iceland's Glitnir, that paid the highest possible return for their top-notch credit ratings. That made the CDOs more attractive, but also riskier, because they contained companies that the market perceived as more likely to get into trouble. ... CPDOs, for example, typically borrrowed about $15 for evey dollar their investors put in. ... Other specialized funds, known as 'credit derivative product companies,' borrow as much as $80 for every dollar invested, according to a recent report from Citigroup", my emphasis, Neil Shah, at the WSJ, 21 October 2008.

What's wrong with higher interest rates? Why shouldn't savers be compensated in real terms? What idiots let anything leverage 80 to 1? Banks apparently exist to facilitate gambles with their depositors' funds. The practice of putting risker credits in such "bundles", I call "reverse cherry picking". To her credit, Ann Rutledge at R&R Consulting has denounced this practice, among others, see my 9 May 2008 post, AAA-Failure.