Junk Bonds, Subprime and Oliver Stone’s miss

Seth Klarman is a widely respected value fund manager, reportedly generating long term returns of ~18% p.a. for his clients. He is a man worth listening to. Mr Klarman wrote the book Margin of Safety in 1991 and in one particular chapter describes the junk bond fad of the 1980’s. Towards the end of the fad, the collaterised bond obligation (CBO) was created. Ratings agencies gave the senior tranches of these CBO's investment grade ratings by making optimistic assumptions on overall default rates.

Wall St produced a spectacular sequel to the junk bond mania with the more recent subprime fiasco:

Lending to non-creditworthy borrowers. Check.

Packaging tranches of dodgy debt to make it look better (Collaterised Debt Obligation (CDO)). Check.

Ratings agencies giving the dodgy debt tranches investment grade ratings. Check.

Everything blowing up when optimistic underlying macroeconomic assumptions prove incorrect.  Check.

Of course there are some differences. Borrowers of junk bonds were companies. Borrowers of subprime debt were individuals. But the overall parallels are extraordinary.

 

Coincidentally, I was reading Margin of Safety on a flight recently while watching Oliver Stone’s 1987 Wall St. It got me thinking that Gordon Gekko from  might well have used junk bonds to help finance his takeovers.

It’s such a pity Oliver Stone’s own sequel, Wall St II: Money Never Sleeps, was such a flop. Wall St produced an outstanding sequel. Oliver Stone should have done the same.

And beware of crap financial products.

Kristian