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CDOs – Financial Weapons of Mass Destruction?

CDO, Collateralized Debt Obligation, became well known term after the global financial crises. The subprime mortgage bubble was created by an enormous amount CDOs. They became financial weapons of mass destruction. But what are collateralized debt obligations really?

CDOs are securities that are made up of bundles of asset-backed bonds, or to put it in simpler terms, portfolios of bonds or credit default swaps. The first CDO was issued in 1987 and until 2002, they were mostly made up of corporate and emerging markets bonds. By keeping the debt in the CDOs diversified, the risk was smaller at the same time as the return was typically better than for normal bonds.

But in 2003 some people started become greedy and things started to go in the wrong direction. Mortgage-backed securities started to increase in the CDOs. According to some estimations, already in 2004 more than half of the of the collateral in CDOs was made up of mortgage-backed securities. In other words, the diversification was decreasing. And the subprime mortgage bubble was just getting worse.

With the diversification getting smaller, the CDOs should really have become riskier. But the creators of CDOs had a way of getting around this problem. CDOs were sliced and diced into tranches. These tranches determine how the cash flow of interest and principal payments are divided. The riskiest tranche paid the highest yield but would also be the first to lose out if any of the assets in the CDO defaulted. In essence, the lower the yield, the more secure the tranche was supposed to be.

In other words, CDOs could be tailored to suit both people who wanted to speculate, high risk but also high return, as well as those who preferred low risk and low return. Not only that but also to suit everyone in between these two extremes.

With the increasing dependence on mortgage-based securities in CDOs, things started to get risky. Unfortunately, most people realized this once it was too late. Despite that risk was concentrated rather than diversified, CDOs and related financial instruments still got the highest rating by the rating agencies.

Things got more complicated by the creation of CDO squared, CDOs made up of CDOs. Unfortunately, it was just a way of hiding the fact that much of the underlying assets were made up of subprime mortgages. Far too many of them were so-called NINJA loans, to people with no income, no job, no assets. Even worse was that many of them had been allowed to borrow 100% of the property price. Add to that often an initial teaser rate was used to keep the monthly payments low, and you have a recipe for disaster. As long as house prices kept on rising, things looked good. But the frenzy just pushed already high house prices through the roof and once the market crashed, so did the value of the CDOs.

If it was not bad enough that CDOs with triple A-rating become either worthless or in best case, impossible to value, a lot of financial institutes had used leverage. They had borrowed money to buy what turned out to be more or less worthless CDOs and many of them could not repay their debts. Even worse, in a global world, almost every financial company was in one way or other involved, either by directly owning CDOs or by having lent money which went into CDO investments.

What Is Private Equity

Private equity funds have a poor reputation but far from everyone knows what they are actually doing. Here is a short overview of private equity funds.

First a few definitions, private equity funds are run by private equity firms. Private equity firms are simply investment companies that are funded by private sources. This includes rich individuals but also cash-rich institutional investors, such as pension funds and insurance companies. Private equity funds are typically set up as partnerships, with the investors as limited partners and professionals from the private equity firm as the general partners.

Private equity is often confused with venture capital. But venture capitalists don’t have anything to do with private equity. Venture capitalists invest in small young companies without taking control of them. They hope that the small company will become the next Microsoft or Google. Venture capitalists will most likely make many more failed investments than successes. But they hope that their gains on the successes will outweigh their losses. Private equity funds on the other hand, want to gain full control of the companies they invest in. They are not interested in small companies with growth potential. They are looking for large companies which they hope to make more efficient. In order to gain control, they often borrow a lot of money. The leverage makes private equity funds vulnerable for failures.

Sometimes you hear hedge funds and private equity funds being mentioned together. But they don’t have much in common, except for that they are often criticized by the same people. Both are often accused of being extremely short-sighted in order to try to make a quick profit, without any concern about the long-term outcome.

Private equity funds are often seen as successors to the leveraged buyouts (LBO). This because they very often fund their purchases with a lot of debt. Using debt can increase the ROI but also the risks. In order to be able to pay the interest, private equity funds typically look for companies with strong cashflow and plenty of assets. The cashflow can be used to meet the interest payments and assets can be sold to pay down the debt.

Since the aim of private equity funds is to sell the company at a profit, they often cut costs drastically. This is something that caused a lot of criticism, private equity funds are often accused of being only interested in short term results, sacking staff and cutting down on research and development.

Two other things that private equity groups have been criticized for are lack of transparency and tax. Since the companies are typically taken over completely by the private equity funds, they can make decisions behind closed doors without any accountability. Since debt is tax deductible, leveraged buyouts automatically receive a tax advantage. In the US and the UK, private equity has also been given additional tax breaks. Many are complaining that private equity has a significant tax advantage which makes it difficult to compete with them.

While private equity funds have a lot of supporters in the English speaking world, in many parts of Europe and Asia they are seen as pariah. Numerous studies of private equity takeovers have been done but many of them have been sponsored by groups that have a clear interest in making private equity either look good or bad. Let’s just say that private equity funds are controversial, trying to sort out if they make the world a better place would require a lot of time.

How Does A Hedge Fund Work

Hedge funds are often mentioned in media. Huge bets by hedge funds are often blamed for big movements in various markets. Hedge fund managers are buying some of the most expensive properties in London, outbidding Russian billionaires and oil sheiks. Hedge funds are often being criticized, especially outside the English speaking world. But how does a hedge fund work? What makes them so special?

Most people think that hedge funds are a relatively recent invention. After all, first time the term hedge fund appeared in mainstream media was when George Soros hedge fund made a fortune by speculating against the British pound in 1992. After that hedge funds have been mentioned much more often in media. But the first hedge fund was created already in 1949 by Alfred Winslow Jones. It is possible to go even further back but Jones is regarded as the inventor of the modern hedge fund.

Jones had a very simple idea, he bought shares which he expected to go up and went short on other shares which he thought would drop in value to the same amount. This, to some extent, protected him against loses. As long as he picked more winners than losers, he would end up with a profit. But this by itself would most likely not give much better results than the average return on the stock market. To increase the profit, Jones use leverage. He borrowed money, which increased the potential for both wins and losses.

Jones turned out to be very good at picking winning shares. But it was first after an article about him and his hedge fund in 1966 that hedge funds become popular. According to the article, Jones had outperformed the best mutual fund by 87% over the last ten years, despite charging a 20% fee on profits. A lot of hedge funds were created after the article, many hedge fund managers were probably attracted by the generous fees they could charge on profits.

Jones had set up his fund as a partnership in order to avoid the strict regulations imposed by SEC. This structure is still popular, the fund managers are general partners while the investors are limited partners.

Nowadays, hedge funds are much more complex creations but the basic principles are the same. They use a lot of leverage and cover the downside by a hedge. Despite that the number of hedge funds has exploded, the generous remuneration for the managers is still around. This has made many successful hedge fund managers super rich.

Jones invested in shares but nowadays hedge funds invest in anything that they believe will make them a profit. While it is possible to put hedge funds into categories, many of them operate in more than one category making such classifications more or less meaningless. It is also possible to divide hedge funds into two broad groups, funds that are trying to generate a steady return regardless of how the markets are going and funds that are trying to get a higher return but also accepting a higher risk of losses. The first group is trying to generate a return that is higher than the return on bonds. The second groups is trying to generate a return that is higher than the return on shares but this can also produce losses.

Hedge funds are often registered in places like the Cayman Islands, giving them not only tax privileges but also allowing them to operate with very little regulations. While many hedge funds are registered in places which impose few restrictions, they are generally operated from the US or the UK. In London, Mayfair rather than the City, has become a centre for hedge funds. In the US, most of them are based in south-west Connecticut, rather than Wall Street.

Many hedge funds have done very well in good times but a lot of hedge funds disappeared during the bear market in the 1970s and after the global financial crisis in 2008. The collapse of the Long-Term Capital Management (LTCM) hedge fund in 1998 proved that hedge funds are not foolproof, despite that they are supposed to be run be some of the most intelligent people in the business.

Is Inflation A Problem

If you want to get wealthy, you need to pay attention to the inflation. Otherwise, you could end up poorer in real terms despite that you are getting richer in nominal terms. Most people know that inflation is the increase in the general level of prices for goods and services. You hear a lot about inflation and CPI in media. But is inflation a problem?

First of all, let’s define inflation. We simply define inflation as the increase in the general level of goods and services which is measured as a percentage, generally over the last 12 months. The CPI, Consumer Price Index, is often used as the rate of inflation. If the inflation is below zero it is called deflation. If the inflation gets very high it is called hyperinflation. There is no strict definition of hyperinflation, but we are talking about inflation of at least 50% in a year, often much higher.

Persistent inflation is a modern phenomenon, before the twentieth century the price level did not change much for centuries. During war prices went up but after the war, the prices returned to the pre-war level. When looking at the general price level in Western Europe from the Middle Ages up to the 20th century, the period from the beginning of the 15th century to the middle of the 16th century stands out. It is known as the great price revolution. It is the only time of consistent inflation for a long period of time. But despite that the price increase looks dramatic compared with earlier and later periods, it was just slightly above one percent per year. This increase is in price level has been explained by the inflow of gold and silver from the New World. But some researchers think that other factors also contributed to the increase in prices.

Nowadays, a little bit of inflation is generally considered as a good thing. At least as long as the rate of inflation is predictable. The reasons given why a little bit of inflation is good are not very convincing but almost every economists agree on that a little bit of inflation is a price well worth paying to avoid deflation. Deflation decreases the economic activity. After all, why buy something today, a couple of month later on it will be cheaper. Actually, in times of deflation saving is good, the value of the money goes up. Debtors will be in trouble, their debt grows in value, in real terms, so they will have to cut down on expenses. All this means that the economy slows down and things just get worse. It has turned out to be very difficult to get the economy going again so governments want to avoid deflation.

High inflation, especially if it was unpredicted, generally redistributes wealth. For some people it is very difficult to protect themselves from inflation. People on fixed income, such as pensioners, fall into this category. For debtors on the other hand, high inflation is often beneficial, the real value of their debt decreases. If loan has been used to buy assets, such as real estate, it gets even better since inflation typically increases asset prices.

At the moment, the official rate of inflation in most western countries is low so inflation seems not to be a problem. But it is good to be aware that official inflation figures are not always reflecting the true increase in living expenses. Some people think that governments change the way of calculating the inflation so that it looks low and stable. The US is a good example of this, here two creative ways are being used to keep the official rate inflation down. One is the substitute effect. If something gets too expensive, the consumer is supposed to buy less of it and substitute it with something cheaper. For example, if beef becomes too expensive, customers are supposed to eat something cheaper, such as chicken. The other way that helps the official inflation to remain low is quality improvement. Since the quality of some goods is improving, price increases are not counted as inflation, it is supposed to be due to the increased quality. Actually, this was just two examples, the calculation of the official CPI figure in the US has been changed a lot over the years. Almost every change has lowered the CPI figure. According to shadowstats.com, the current CPI, which is around two percent, is about three percent lower than what it would be if the formula from 1990 was used. If the CPI is calculated using the formula from 1980, the difference would be even bigger.

So why are the governments understating the real inflation? Well, some people point out that for the governments with a lot of debt, high inflation will decrease the real value of the debt. Low official CPI also helps the government to keep its expenses down, a lot of expenses are pegged to the CPI.

As an investor, is inflation a problem? It depends on how high the inflation is and if it is predictable. Hyperinflation will make money almost worthless but it will also wipe out debt. Deflation on the other hand, will make money more valuable and debtors will suffer. Deflation is unlikely, central banks and governments want to avoid deflation at all costs. They are prepared to accept higher inflation in order to avoid deflation. If you believe governments will keep on printing money and that the inflation will run out of control, gold is the classic solution. Real estate, cash-positive, and quality shares, which pay dividend, are also regarded as good investments in times of high inflation. On the other hand, bonds, bank accounts and cash will be poor choices. Note that while debtors will gain from high inflation, too much debt may cause serious trouble since interest rates are likely to go up as well. Your investments should generate a positive cash flow.