Meet the Collateralized Fund Obligation

J. Paul Forrester, a partner at law firm Mayer Brown and one of the go-to lawyers in CFO deals, wrote in a note to clients that one of the biggest attractions of CFOs is that they allow an opportunity for “regulatory capital relief.” I

nsurance funds, he wrote, can exchange their stakes in private equity funds for CFOs and maintain similar exposure without having to hold as much capital against the investment because regulators treat CFOs as bonds, not the private equity-linked investments that they are.

That doesn’t mean that the CFOs being sold now are a bad investment. The $216 million in bonds sold by the SWC Funding are backed by more than $500 million in assets and received only a single-A rating. Forrester says rating agencies demand that CFOs have enough collateral and interest to make them safe. Nor are CFOs likely to cause a financial crisis. They are rarely bought by banks, and the market for them is still way too small to cause any systemic problem.

But once the mad scientists of sophisticated investments get into the lab, things can get out of hand in a hurry. Just as a quick mental exercise, I came up with a hypothetical CFO backed by stakes in S&P 500 index funds. My pitch would be that investors could buy into a bond that offers nearly twice the expected return of the S&P 500 and as much as 10 times. (The collateral is super easy to source. Just log onto Vanguard.)

Here’s how the math would work: Imagine I sold $800,000 of bonds tied to a $1 million vehicle I’ll call Sophisticated LLC, which is just an S&P 500 fund. The marketing materials would assume that stocks generally rise 8% a year, supported by recent historical data (though likely incorrect, especially at this point in the cycle, but we’ll gloss over that). That means I will have $80,000 in returns a year. I offer a 4.5% yield on half of the bonds, which will sell out quickly because they look a lot like typical corporate bonds — they are tied to the S&P 500 after all — yet they pay on average 0.4 percentage points more than highly rated corporate bonds (which they are not, but who’s looking).

That sucks up $18,000 of my $80,000 return, which is what $400,000 in bonds with a 4.5% yield would pay out. That leaves me with $62,000. I pay 6% on the next $300,000 in bonds. They are only a little bit riskier than first group and still pay a pretty beefy yield for bond-land these days. That leaves me with $44,000 and $100,000 worth of bonds to pay out. Those bonds can get a 16% yield, double my expected return of the S&P 500. The remaining income goes to the $200,000 that I didn’t sell bonds against because I needed to have some extra collateral to protect my CFO. This is the equity piece and gets a 14% annual return when the S&P goes up my expected 8%, but a 24% annual return when the market goes up 10%, as it is on track to do this year, or a 79% return when the market goes up 21%, as it did in 2017.

What’s not to love? Well, just about everything. If the S&P 500 goes up only 5%, part of the fund’s collateral would get wiped out, likely causing a rating downgrade. A 10% drop the year after that would essentially crash Sophisticated LLC. My equity investors would suffer a 75% loss, and prices on the bonds would most likely plunge as well.

That’s just off the top of my head, and it’s not an implausible example. I don’t spend my days trying to come up with esoteric investments. The point is there are people who do, and then they peddle their creations to the unsuspecting townspeople. It’s usually only a matter of time before the torches and pitchforks have to come out.

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Stephen Gandel is a Bloomberg Opinion columnist covering banking and equity markets. He was previously a deputy digital editor for Fortune and an economics blogger at Time. He has also covered finance and the housing market.