Invest Skeptically

Recently, the media have been talking about CDOs (or Collateralized Debt Obligations) in a manner that makes me wonder if the sky isn’t falling. Fabrice Taylor wrote a piece called, The ABCs of CDOs. Can you spell RISKY? (The Globe and Mail, June 27, 2007) and warns, “there will be shocks, both in terms of asset writedowns and lower earnings or losses”. A quick Google search turns up many articles about how CDOs helped fuel the subprime mortgage bubble, and Bloomberg reports that Bill Gross thinks “Moody’s Investors Service and Standard & Poor’s were duped by the make-up and ’six-inch hooker heels’ of collateralized debt obligations”. To top it off, the SEC is concerned about proper valuation processes as two Bear Stearns hedge funds have run into trouble investing in CDOs.

It seems that the big commotion over CDOs is due to the losses that investors have had and are going to have in the near future. But investing always comes with risk so why should anyone be so surprised? Could it be that some investors didn’t do their homework? Did CDO investors not ask questions like: What is the underlying collateral? How do I value it? How do I monitor it (for credit worthiness)? Do I understand, and am I comfortable with, the structural leverage built into the CDO tranches? Do I understand the rating methodology and assumptions used by the Rating Agency? Do I understand how the CDO is priced? Do I have the capability to price it myself?

And so dear reader, what is the lesson we humble retail investors should take away from all of this? Perhaps it is that even big “sophisticated” institutional buyers of debt securities can be dazed (by greed, laziness, etc.) into missing the fundamental rule of: know what you’re buying and invest skeptically.