The Mortgage Risk in Public Pension Funds

The Economist reports:

Bankers bundle what is often speculative-grade securities into a CDO, dividing it into pieces with credit ratings as high as AAA. The riskiest parts have no rating, and are known as the equity tranches because they are first in line for any losses. Investors in the equity portion expect to generate returns of more than 10 percent.

Fees for managers can range from 45 basis points to 75 basis points of the amount of the CDO, GoldenTree's Wriedt said. For a $500 million CDO, a manager earning a fee of 50 basis points, or half a percentage point, would pocket $2.5 million a year until maturity.

Besides Cohen, the other top five issuers of CDOs last year in the U.S. were Trust Company of the West in Los Angeles, New York-based Goldman Sachs Group Inc., Duke Funding Management LLC in Greenwich, Connecticut, and Aladdin Capital Management LLC of Stamford, Connecticut, according to Merrill Lynch & Co. in New York.

Better than GE

CDOs with loans and AAA ratings yield 23 basis points over benchmark rates, according to JPMorgan. That's 10 basis points more than top-rated regular corporate bonds sold by Fairfield, Connecticut-based General Electric Co., Merrill Lynch data show.

The Dallas Police and Fire Pension Fund invested in its first CDO about two years ago to boost returns, according to Richard Tettament, administrator of the $3.2 billion fund.

``We were beefing up our risk and we were hoping for a greater return,'' Tettament said in an interview from his Dallas office. ``We have an unfunded liability to pay off.''

Tettament said he isn't sure what type of collateral backs the CDO, though he thinks returns exceeded 20 percent last year.

Your wallet is supposed to bail the "public sector" out here.