The townspeople just can’t win.
Consider Wall Street’s latest financial Frankenstein of a bad idea, collateralized fund obligations. Perhaps a better monster metaphor would be zombies, because these securities are the sort of terrible concoction that rise out of the Wall Street swamp and don’t seem to die. Collateralized fund obligations, or CFOs, were first given life in the early 2000s, but the market for them has mostly been dormant since the financial crisis. It has come back only recently.
What Is a Collateralized Fund Obligation?
Here’s how they work: CFOs are in the same structured-finance family as collateralized debt obligations, which blew up in the financial crisis and made everything so much worse, and collateralized loan obligations, which are potentially fueling a bubble in the corporate credit market.
(Related: CLOs Are Hot. Plan Accordingly.)
CDOs and CLOs, though, are built on loans — in the former case usually consumer loans like mortgages or credit cards, and in the latter loans to companies.
CFOs, on the other hand, are backed by stakes in funds, often private equity or hedge funds. That’s the collateral. Through Wall Street magic, some would say voodoo, those fund stakes are securitized into bonds that then get rated by riskiness, with some receiving A ratings on down. The returns of the funds pay the interest that is due to the buyers of the CFO’s bonds, just like mortgages or loans would on CDOs or CLOs.
Recent CFO Issues
In August, Sightway Capital, which was formed by executives from the Two Sigma hedge fund, raised $216 million for a CFO, SWC Funding, that is backed by stakes in 32 private equity funds. That was the second big CFO deal in three months. In June, a unit of Temasek Holdings, the Singapore sovereign wealth fund, sold a $562 million CFO Astrea IV, also backed by private equity investments, to local individual investors, marketing it as a good retirement holding. A local editorial said the the “overwhelming response” for the CFO showed that retail investors have a “growing appreciation for sophisticated investments” and “know a good deal when they see it.”
Wall Street sophistication, though, rarely makes for better investments when markets turn. And that’s most likely the case with CFOs. In a report on CFOs last year, analysts at ratings firm Fitch noted that while the value of the funds backing CFOs fell 25% during the financial crisis, the prices of many CFOs tumbled 75%. At times of crisis, investors’ appreciation for sophistication dries up pretty fast.
The biggest problem is that CFOs appear to transform equity investments into bonds, which are assumed to have much less risk than stocks. Structure and ordering of bonds can remove some of the extra risk and volatility that goes along with equities, but it can’t eliminate it. What it does is concentrate the risk somewhere until it breaks down the door of the closet bankers thought they had locked. That’s what happened with subprime loans during financial crisis. Worse, regulators don’t appear to be watching.