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March 09, 2011

Hedge funds are snapping up packaged junk bond "derivatives" like hot cakes

What could possibly go wrong?

...The instruments, created by using credit derivatives on junk bond or high-yield indices, resemble transactions linked to US mortgages that proliferated before the financial crisis...


I'm reminded of Gordon Gekko's remarks at a stockholder's meeting:

"Teldar Paper, Mr. Cromwell, Teldar Paper has 33 different vice presidents each earning over 200 thousand dollars a year. Now, I have spent the last two months analyzing what all these guys do, and I still can't figure it out. One thing I do know is that our paper company lost 110 million dollars last year, and I'll bet that half of that was spent in all the paperwork going back and forth between all these vice presidents. The new law of evolution in corporate America seems to be survival of the unfittest. Well, in my book you either do it right or you get eliminated. In the last seven deals that I've been involved with, there were 2.5 million stockholders who have made a pretax profit of 12 billion dollars. Thank you. I am not a destroyer of companies. I am a liberator of them! The point is, ladies and gentleman, that greed, for lack of a better word, is good. Greed is right, greed works. Greed clarifies, cuts through, and captures the essence of the evolutionary spirit. Greed, in all of its forms; greed for life, for money, for love, knowledge has marked the upward surge of mankind. And greed, you mark my words, will not only save Teldar Paper, but that other malfunctioning corporation called the USA. Thank you very much. "
Gekko essentially summed up the difference between productive greed and stupidity here. He wasn't afraid of investing in a busted business if he saw a way to fix it and get it back on track, AND had a healthy dollop of influence in implementing the changes to get it back on track.

When some company has bonds with a "junk" rating, that pretty much tells the world that they got big problems. Its the corporate version of borrowing from loan sharks.

Apparently people believe that investing in a bushel full of rotten fruit is somehow safer than investing in one particular fetid fruit - the theory being they can't ALL go bad on you and you'll continue to reap a phat 7% or so even if a few do go bad. The problem is if you've invested in some junk index or junk derivative you don't have any influence at all to fix the sort of problems Gekko had when he bought into the problem child directly. You're at the mercy of others; others who's agenda you aren't necessarily even aware of; at the mercy of healthier foreign competitors; etc, etc.

What happens when say the government, the rottenest fruit of all, but the only one that can print money at will and raise taxes to solve its problems, continues down the path of currency devaluation and interest rates start exceeding that previously "phat" yield on your junk portfolio? You're boned, in spades, that's what happens. Those previously seductive junk bonds and derivatives suddenly make the Titanic look like a blimp as people head for the exits. It won't be be the summer of love with sex drugs and rock and roll, that's for damned sure.

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posted by Purp at 08:12 AM

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