As you are aware, the TSX and Dow Jones fell approximately 6% and 4% last week respectively. No one knows if this was a one-week correction or the beginning of a much larger and sustained drop in the markets.  What most people agree with is that the drop in stock prices was not seasonal in nature; there was heavy trading volumes on all exchanges last week meaning that everyone was getting out at the same time. Unlike the stock market drop earlier this year (the so-called Shanghai flu), there appears to a lot more fuel being thrown on  correction fire; the days of cheap credit are over, people are not taking as large a risk as they did last year (banks leading the financing for leveraged buy-outs are having a hard time finding other banks to participate in the financing meaning that they are assuming the entire risk of the loan) and people are running for the hills away from sub-prime mortgages (both Wells Fargo and GE have announced they will be exiting these types of loans). The big question is- now what?

First, in the words of Douglas Adams, DON’T PANIC. The markets have survived worse. The worse move that could occur is to follow the crowd and sell when the market is low. Hang tight and let’s see where the markets hang for the rest of the summer. The heavy volume may be in large part to institutions taking profits.

Second, in most corrections, the market tends to over-react and needlessly punish certain industries or stocks. For example, most real estate and real-estate related financing institutions trading in the U.S. took a beating last week- exhibit A being Brookfield Asset Management (”BAM”) (who manage commercial buildings across the global) which was trading at close to $43.00 in early July and is now trading at under $38.00 (all figures Canadian). However, its competitor, Brookfield Properties Corp., reported on Friday that its Q2 profit rose 163%. If BAM is in line with its competitor (and it reports this Friday), the market may have over-corrected on BAM and made its price attractive.

Third, you can’t hide in international equities. The London FTSE 100 and the Tokyo Nikkei 225 lost 5.62% and 4.81% respectively last week. This correction appears to be inter-linked regardless of geography.

As always, it is important to look at context- corporate earnings are slowing but from a 5 year record-breaking run so “slow” is a relative term. The other factor (which most people don’t write about) is that most non-senior level traders have not seen a slow-down or recession during their professional careers; most are in their late 20’s and were still in school during 9/11; thus, there is a natural human tendency to over-react if you have not seen the situation before.

As for me, my strategy is to sit on cash and see how interest rates will play out. If they continue to increase, the valuation of interest-sensitive stocks, such as banks and REITS, may become attractive and cash will be either used to pay down my variable mortgage more aggressively or try to consolidate stock holdings in banks.  If interest rates decrease or remain the same (which is more likely to happen in the U.S.), it may still be an opportune time to go shopping. Businesses are becoming more conservative which may mean that they will concentrate less on taking riskier ventures like lending to private equity buy-outs (are you listening TD?) and more on core steady cash flow plays.

Anyone care to share their strategies during a market correction?

One of my personal finance hobbies is to read the financial profiles columns in financial publications. We have all read them before. Someone writes into the columnist asking for help on their personal finances and an expert helps chart a plan to reach their financial goals. The one feature I have found interesting in some of these profiles is that the persons being profiled are house-rich but otherwise barely getting by in other aspects of their financial life (modest savings, little in retirement contribution relative to their age, large debt loads). They have devoted substantially all of their assets to their home/their loan to value on their mortgage is very high (90% plus)/their home has greatly appreciated in price but they have few other assets outside their home; I do not count people with real estate investments in this category (nor in this post). This seems to be more prevalent with people in booming real estate locations like Vancouver or parts of Northern California.

I am often puzzled by being house-rich and otherwise asset poor. Principal residences are not liquid assets; even in the best case scenario, it would take 3-6 weeks to sell a home and, unlike other investments, you have to find other shelter; it is not like a stock, where you can sell it and simply sit on the cash; you have to replace your home and, generally speaking, most people with young families do not down-size homes. If you don’t downsize, you tend to be a worse-off position selling your home.

I understand the mentality behind being house-rich and nothing else. It is shelter after all and one should be comfortable in their own place. Houses are also tangible assets- you can touch, taste (!) and feel a home whereas some people consider stock as “not real” assets. Thus, there is a comfort factor in owning a home.

Having said that, good investing requires mitigating against risk. For example, the conventional stock investing rule is to hold bonds which generally work in an opposite cycle as stock (as one goes up, the other goes down). Where is the risk mitigation if you are house rich? I would hypothesize that investing in vehicles which pay out cash (dividend yielding stocks, income trusts, bonds, high interest accounts) would be a prudent down-side risk for those who are house-rich. Instead of buying the $2500 stainless steel fridge, put the money away. Houses are cash flow negative assets (remember I am only addressing principal residences); thus, you need cash flow positive assets to balance this off.

I suspect some will surmise that the logical solution to being house-rich and nothing else is to leverage their home and use the proceeds to invest in stocks, mutual funds etc. I would generally say that this solution does not address the issue of mitigating risk. If a person is house-rich and nothing else, are they in this situation because they have avoided stock investing? Or are they in this situation because they have bought a house they could not afford? If so, do you now take this inexperienced stock investor and/or highly mortgaged individual and ask them to invest substantial amounts of money in the market hoping that they can return more than the interest rate charged on the leveraged money? All finance is contextual and I have argued before that leveraging is only appropriate in certain situations. I would also add that in every profile I have read with people in this situation, all of the experts zero in on debt repayment/reduction and cost-control as solutions and not assuming more risk via leveraging. Leveraging does little to address risk control in this situation.

I would like to hear your thoughts on this issue.

This post is part of the continuing series on income trusts written between three personal financial blogs: Financial Jungle, Million Dollar Journey and this blog. Financial Jungle and Million Dollar Journey have each written on different types of income trusts (REITS, Business Trusts, Oil and Gas and Pipelines) while I have blogged on general financial ratios one should look at for all trusts. This post deals with the taxation of income trusts on a personal level. As an opening note, I am NOT an accountant so please do not take this as advice but merely for informational purposes. Always, always, consult an accountant about your taxes (and not only at tax time either).

An income trust investor should be aware of four different types of tax consequences in owning this type of investment. Distributions can be classified as either: (i) ordinary income/interest; (ii) dividend (rarely declared but, in theory, possible); (iii) return of capital; (iv) capital gains on the sale of an income trust. Every income trust is required to provide information on how the previous year’s distributions are classified for tax purposes; given that capital gains is paid by the investor on the sale of the income trust and not by the trust, the trust obviously does not provide capital gains information. The foregoing tax information is provided to each investor on a T3 in Canada and I understand an IRS Form 1099-DIV in the United States. If you are investigating purchasing an income trust, please check the income trust’s website; most sites will provide this information (if it is not listed in a separate page; download the annual report).

Assuming you are not buying an income trust to sell, distributions which are predominantly classified as ordinary income/interest are taxed 100% on the dollar. Thus, for people in high income tax brackets or on the verge of graduating into a higher tax bracket, income trusts should ideally be held in registered retirement accounts or other tax deferral accounts (i.e. RSP, IRAs/401K). Otherwise, the addition of income from the trust could increase your taxable income or move you into higher tax bracket. For investors in lower incomes, this is not a great a consideration.

Return on capital (”ROC”) is a distribution based on cash resulting from depreciation, tax savings or the sale of equipment and assets. ROC is typically distributed to unit-holders in capital intensive income trusts such as REITS where assets are being sold or depreciated often. The primary tax effect of ROC is to reduce the adjusted cost base of the income trust (adjusted cost base, in plain English, is the price you paid for the income trust; for example if you bought 1 units for $10.00, your adjusted cost base is $10.00 and you are taxed on the gain above and beyond $10.00 on the sale of the unit).

As I understand it, ROC is not taxed when distributed to you; its primary effect to you is that it increases your capital gains on the sale of the unit since it reduces your adjusted cost base. Using the example in the previous paragraph, if your cumulative ROC during the life you held an income trust is $1.00 and you sell your unit at $12.00; your capital gains is $12.00 - ($10.00-$1.00) = $3.00.

Given that all gains made within a registered retirement account is tax-free, the tax effect of ROC to you in this situation is none at the time of sale. If the income trust is held outside a retirement account, and taxes are not deferred, on the sale of a trust with high cumulative ROC, your capital gains tax will be higher than the difference between the price of sale and the price you paid for the trust. If the gain is quite large (i.e. either you bought low and sold high or there was a lot of ROC over the life of your holding), it may be advantageous to off-set the greater than usual capital gains with any capital losses. You should consult your accountant about this matter. Income trusts with substantial ROC distributions held outside of a registered retirement account is tax efficient if you intend to hold a trust for a long period of time given that these distributions are tax-free at the time of “payment” and are taxable only at sale OR your taxable income is derived substantially from investment income (I suspect this is why Derek Foster recommends REIT’s in his book-I understand that his income is solely from investment income so ROC distribution is being paid to him tax free and, because I suspect he is not selling his REIT’s any time soon, the tax consequences will not be felt for many years down the road).

I hope this was a good 10,000 foot over-view on the tax issues surrounding income trusts. As I have stated before, do not take this as the gospel on this issue- it is merely a primer; all taxes issues should be made in consultation with your accountant.

As an epilogue to this post, Money Gardener had asked in my previous post on income trusts if a payout ratio over 100% is necessarily a bad thing and how some trusts can have a payout ratio of over 100%. My quick and dirty response is that payout ratios over 100% mean that the trust is in a negative cash flow position after every distribution and it is maintaining the payout by either borrowing money (increasing leverage for non-revenue generating activities is bad debt and bad management) or issuing new shares (creating dilution and earnings per share concerns).

Please note that this post was pre-written on Sunday and the Dow Jones Industrial Average may have changed quite dramatically since I started traveling.

Last week the Dow Jones hit 14,000 points before Friday’s correction sent it back below 14,000. Regardless, the larger point is that it only took approximately 3 months for the Dow to gain 1,000 points which is impressive and quite scary at the same time. At market peaks, there is simply nothing to buy at bargain prices. My cash holdings in my registered retirement plan is now slightly over 12%- the highest it has ever been and I am sitting on cash outside my retirement plan. Given that there appears to be an increasing correlation between the Dow and other markets (see my previous post on this topic), it is also getting harder to find bargains internationally as well.

What is troubling to me is that the Dow and TSX is being pushed up by merger mania in a rising interest rate environment. Money is getting more expensive but people keep borrowing. This means the margin of error keeps getting smaller for deals made on borrowed money (for both borrower and lender) and rising interest rates tend to moderate corporate earnings. Am I missing something here? Has risk tolerance for financial institutions gone by the wayside?

I wanted to end this post with a quote made by Bill Miller, a noted and successful mutual fund manager for Legg Mason, to Fortune Magazine recently about the state of the market and risk tolerance. I believe this captures good investing principles and the state of the market sufficiently:

“...You also know that rising stock prices mean lower future rates of return and falling stock prices mean higher rates of return. So I was much happier in the summer of ‘02 when you buy everything on sale than I was in the Spring of 2000 when a lot of things were super-expensive.”

My view is that the evidence is overwhelming that most people are too risk averse. And that therefore they should be taking a lot more risk than they feel like is right.

The problem is that real risk and perceived risk are two different things. And that’s where people get into trouble, because they perceive risk to be high when prices are low, and they perceive risk to be low when prices are high. That’s the psychological problem that most people have.”

Please note that I am on extensive business travel this week and this week’s postings have all been pre-written.

I am pleased to report that I sold my used car this weekend. I attribute this in no way, shape or form to my selling ability but to the fact my car (a Mazda hatch-back) is one of the leading selling sub-compacts in North America. Having never sold a used car before, this has been quite a learning experience for me and the ultimate do it yourself process. I wanted to share some of the costs of selling the car and the do’s and don’ts of selling a used car that I learned the hard way.

Costs: In the interests of reaching the largest audience possible in the selling my used car, I advertised in AutoTrader’s used car catalogue, paying for their middle of the road classified option (there’s three options: a small text only ad, an ad with a picture and more words (the one I bought) and a large ad with room for a lot of copy). It cost me $72.08 for one month’s worth of classifieds. I also had a buy a used car information package from the Province of Ontario which is required to transfer a used car here (cost $21.00). All figures include tax.

DO makes sure that your car is ready for sale. I had the car taken in for its quarterly maintenance beforehand (having a dealer’s stamp on your maintenance book seems to be a plus) and had the car washed beforehand. In the Province of Ontario, you have to buy a “Used Car Information Package” which lists how many owners the car has had and, more importantly, whether the car has a lien registered against it. It also includes a bill of sale which is the document transferring ownership along with signing off on the vehicle portion of your registration. The document is really to protect the buyer. Order this about 10 days before you advertise the car for sale so that you can clear up any issues before sale (I believe the package is good for 36 days after date of issuance). Please clear any liens before you sell the car since you will not be allowed to transfer a used vehicle without the car being free and clear of all liens. Make sure you understand the process of selling a used car (registering it with the Minister of Transportation, license plates, insurance etc.) better than the buyer. They will expect you to guide you through the process.

DON’T forget to clean the engine block as well. This was my one big blunder. Someone opened up the hood and saw a dusty and dirty engine block and said “hmmm….”. I have been told there is a debate whether to get your engine shampooed or not- some people believe that an engine shampoo may damage the electrical system if not done properly (please note I am not a “car guy” so I can’t debate the relative merits about an engine shampoo at length). At the very least, make sure you take a dirty rag and wipe down the engine block.

DO try to find some hook to sell your car. There are numerous used cars of the same make and year as mine for sale. I priced my snow tires into the price in order to make it more attractive and put this in the ad (my car has sports tires which does not grip well in snow so snow tires are highly recommended). The first thing the buyer said to me when I delivered the car was “did you bring the snow tires?” If you do not have snow tires, perhaps try a full tank of gas included in the price (which could be literally a $100 bonus if the used car is large) or payment of the seller’s new license plates; the cost is relatively small but it makes your used car stand out somewhat. Its the small things that count they say.
DON’T forget to tell the potential sellers what part of the city you live in and what color your car is. I missed these two facts in my ad and I had to explain this to every single person who called or emailed. AutoTrader has a huge advertising area. I ended up speaking to people who lived an hour’s drive away from me who were reluctant to travel far to see a used car. Color also appears to be the 2nd most important factor in the purchasing decision after mileage. Given that the pictures are black and white, it is best to describe the car’s color as well.

DO set aside some time on nights and weekends to sell the car. People called me all hours of the day inquiring about the car (top 3 questions asked: (i) have you been the only owner of the car? (ii) has it been in an accident? (iii) tell me about the maintenance history?) and wanted to sell it at strange times (the buyer of my used car saw it at 9:30 at night). Once you have someone interested, please make sure they give you a deposit so they are not using you as leverage for another deal.

I hope the buyer of my car gets as much enjoyment out of the car as I do.

I watch a lot of HGTV as both an architecture fan and as someone looking for ideas for my condo. I tend to concentrate most of my viewing in the renovation design shows. We have all seen these- a designer hosts a show that takes a room/house/yard and redesigns/renovates it doing a before and after theme. What I have noticed is that there is a certain pattern to the development of these shows over the life of a show. The designer is typically unknown outside of its local community in the first year of the show and the projects they tackle are more scalable for most viewers: a kitchen reno with a $5,000 budget, redoing the rec room for $10,000 etc. etc. The designer attains fame being on t.v. and, as the years progress, the clients become more upscale and projects and renovations become quite sophisticated. Suddenly, the designer is moving retaining walls, rewiring the entire house and adding $250,000 additions. I remember watching Bob Villa towards the end of his tenure in “This Old House”; he was regularly spending $500,000 plus on renovating homes across the country. After a while, these shows become less an educational experience than renovation voyeurism; most of us could not contemplate or have the means to spend over $500,000 on a renovation. I watch more in awe than for ideas at that point.

I don’t blame the shows. All professionals want to tackle different challenges to keep themselves fresh. But, HGTV would do me a huge favor if they re-ran more of the older shows or showed more first-time reno shows. The shows where the designer were still working on modest spaces on modest budgets. I would certainly get more out of the old shows than watching a designer working with massive budgets.

The one other helpful suggestion would be to have these shows give better time-lines. How long did the project take? How many trades were on the project? From an educational perspective, there is no context to many of these renovations. Anyone can finish on time if you utilized 10 trades-people at a project and forced them to work all night. It would helpful for the shows to address the people power required and actual budget required to finish a project.

No post on Friday- its been a long week. Have a great weekend. I’ll be on some extensive business traveling next week; I’ll pre-post some posts for next week.

TD officially announced yesterday that it is taking a major stake in the BCE takeover by agreeing to loan $3.3 billion of the $34.3 billion of borrowed money required to take BCE private and, controversially, providing $500 million in equity bridge financing. Equity bridge financing is, in plain English, the practice of taking stock back in return for a loan and then selling the stock for a gain. This is considered risky for banks because, in a worse case scenario, the bank is stuck with a stock it cannot unload. Many banks do not like equity bridge financing because in finance”debt takes before equity” which means that loans get paid out before the shareholders do in a worse case scenario (on the policy that there is a finite return on a loan- the interest and fees charged- while the upside of equity is theoretically limitless; given the risk and reward, equity gets the downside risk as well as the upside potential). The safer return for a bank is always to loan money than to take equity positions- in a loan, you have security in the event things go bad. There is no such protection for taking equity.

What is the downside of this deal? TD has announced that it intends to syndicate the loan; in other words, it will find other banks to take portions of the $3.3 billion loan. What if no one wants to take a significant portion of it and TD is stuck with a large loan on its books? This is considered bad credit management (too many eggs in one basket). I don’t think this will happen but anything goes in private equity. The larger concern is the equity bridge financing requires TD to find buyers of the stock. What if there are no buyers at the price TD sets and its stuck with the stock? Remember that BCE is trading at a relatively high valuation compared to the last few years and foreign ownership restrictions limits the pool of potential buyers.

My larger concern deals with history and business direction- TD has a bad history in the tele-communications sector and its lending a large amount of money to one borrower at the end of a credit and private equity boom. The timing doesn’t seem right. More importantly, it seems to be moving away from its knitting of being a leading retail bank to a institutional, M&A driven institution. A comparison I can make is that Wells Fargo (well known for strong retail operations) decides to become J.P. Morgan Chase (who have staked a claim as a leading M&A player). Very few businesses make the transition well (mostly due to practical considerations like the talent pool is catered towards one type of banking). Remember Eaton’s trying to become an upscale retailer? Time Warner a leading edge internet company? GM trying to make affordable sub-compacts? Its a tough transition to make. Will TD become so focused on becoming a major M&A player that it forgets what powered them these last 5 years?

The upside- fees, fees and fees. Leading a banking syndicate, especially where the loan is in the billions, is a very lucrative business for banks.  The lead bank collects fees that other banks do not (arrangement fees, finder’s fees, syndication fees). If TD lines up a buyer for the stock, it could also make considerable upside on the sale of BCE shares (which, everyone forgets, was a cash machine despite its sluggish stock price) in addition to interest and fees earned. If successful, TD also makes its name on the M&A side (a weak division compared to its rivals) which is the most profitable of all banking sectors. Of course, the stock is also up in price- traders like activity (but I am a long term buy and hold investor so I am always weary when too many momentum traders hold blue-chip stock; there is tendency by short-term investors to push conservative companies to risky ventures for short term returns).

This one makes me nervous as a TD shareholder.  I score it an “A” for sheer audacity but a “C” for risk tolerance but I don’t buy shares in a bank for audacity.

(I have hit a 2 week busy period and have not had time to respond to your comments. Thanks for your patience).

GE announced their Q2 results last week and they were impressive; earnings and revenue were both up 12% and the company has enough free cash to increase their share buy-back plan to $14 billion- usually a sign of a healthy company. While GE shareholders (including myself) are happy with the results, all investors should keep an eye on GE. Why? It has been commented by several experts that GE is the proxy or bell-weather stock of the western world (and increasingly the world at large given half of its revenue is made outside the United States). Why?

GE divides its business into 6 segments: finance, infrastructure, healthcare, industrials, money (banking and credit cards as opposed to finance which lends money for customers buy its airplane engines) and NBC Universal. There does not appear to be any major business sector which GE does not operate (GE has energy concerns under the infrastructure line). Thus, its financial results summarize how the economy is performing as a whole.

GE also reported that its infrastructure business segment had a 23% profit growth last quarter which lead all other business sectors. As I have blogged several times, this sector is quickly become the newest industry to be an investor in and GE’s focus on this sector appears to validate the business case for being in this sector (GE has been named in Fortune Magazine as one of the most admired companies in the world several times over so they do know what they are doing). And, of course, GE is doing what people are talking about- being in environmental friendly industries and leaving the subprime mortgages industry.

But here’s the catch- GE’s stock price has lagged the S&P industrial composite. Thus, it appears, in the short term anyways, it is better to follow GE’s business as an indication of investing trends than to buy the stock itself (as usual, please conduct your own due diligence before you invest). Buffet has a large holding in GE which may indicate his confidence in the long-term prospects of the company.

GE’s share price reflects the general stock rule of the “conglomerate discount”- extremely large companies trade at a discount given they are interpreted as too complicated to understand. I have never understand the conglomerate discount rule fully- which has also been applied to companies such as BCE in the past; it seems, in part, to be an admission by the stock analyst community that it has limitations on how it analyzes stock (remember analysts rate companies, they don’t run them and there are many aspects of a business you do not see without operating them) although I also understand that conglomerates also tend to be a jack of all trades and master of none (see the criticism of Citigroup).

Even if you are not interested in GE, it is a good stock to watch since its performance is a fore-shadowing of how your other holdings may perform and general business trends in general.

I recently posted on the increasing competitiveness of high-interest rate savings accounts this summer. As reported elsewhere, HSBC has entered into the fray with a 5% account but with one caveat- it only relates to new account holders. Existing account-holders continue to receive the lower stated rates (3.5% at HSBC). Yes, loyalty clearly does not pay. As Louis, a friend of mine, commented recently on another blog: “when did we as consumers allow our suppliers to dictate how we do business with them?” Have we become sucker consumers?

One of the marketing lessons that every entrepreneur/owner-manager learns is that it takes 4-5 times more money to find a new client than to keep an existing one. Thus, it is counter-institutive business sense for HSBC to offer a promotion that implicitly makes existing customers feel like they are second class citizens (as a side-note, the fact that interest rates keep increasing in high interest savings accounts means that money is increasingly becoming more expensive to borrow).

Wouldn’t the smarter promotion be to offer higher interest rates to existing account holders who hold a minimum balance if they increased their monthly contributions for a period of time? For example, an account holder with over $2,500 balance and who increased their monthly contributions by more than 15% for 6 consecutive months would have their interest rate retroactively increased by 1% for that period of time. For the record, I have switched accounts from ING to PC Financial.

My larger point, however, is what can we do to prevent ourselves from being suckers for bad service or being taken for granted? To paraphrase an interview I once saw with the author of the Naked Investor (a book about the excess and abuses of the investment industry): the financial industry preys on inertia. We should never take bad service lying down. I noticed in other blogs that many commentators have informed ING that they would be moving their money to the competition.

This is a great first step but we have to inform the right people. A client of mine who consults big businesses on improving customer experiences once commented that the role of a customer service representative was not to help us but to weed out “troublesome clients” such that they never got past their $12/hour representative. If you want to inform a company that it is losing your business, avoid telling the customer service representative (who, frankly, isn’t paid enough to care) and write a letter to the people who matter- senior executives, the board of directors and other decision makers (in publicly traded companies, these are listed on most websites). They’ll get the message that existing customers count if they get enough letters.

Before you buy, I would not only research the product but who is selling it. There are many sites such as this one which now lists the customer service experience of various retailers. The internet has been instrumental in leveling the playing field between the consumer and businesses. We just have to remember to use it and not let inertia set in.

Let me know if you have any other tips to share to avoid being made a sucker by a business.

This is a once in a blue-moon Saturday posting spurred by a comment on Thursday’s posting about CIBC. I wanted to expand on my comment and muse on the larger implications for all investors. In response to the speculation about its alleged large exposure to the sub-prime mortgages, CIBC has indicated that the “majority of its securities held are AAA-rated, the highest rating category.” But the question becomes, can this rating be trusted (to be clear, I am not stating CIBC is lying. It is not and all we have are unproven allegations. Credit ratings are given by institutions other than the purchaser of the security like CIBC)?

This is the issue in a extremely simplified and generalized manner and it may explain why we should care as investors even if we don’t hold a sub-prime mortgage. Sub-prime mortgages, junk bonds and other cash-flow vehicles are bundled into collateralized debt obligations (CDO’s) which the major credit agencies rate with AAA being the highest grade (in theory, a AAA security is not likely to default on its payment obligations).  But here is the biggest catch- how much can the credit ratings themselves be trusted?

This article suggests that the credit rating agencies are part of the problem. If the article is true, it appears that the credit rating agencies were helping the CDO issuers get higher credit ratings. Since the article was written in June, the rating agencies appear to be policing themselves (with the threat of SEC investigation) and have downgraded many CDO’s. To answer a question posed by Invest Skeptically, it is difficult to conduct due diligence on the underlying cash flow in a CDO because, as I understand it, how you determine cash flow default rates is determined by a financial model created by various credit rating agencies. The agencies, in turn, are paid to rate the CDO’s- this raises a huge conflict of interest issue; if the credit agency is not giving a good credit rating, it won’t get any business so the “model” will tend to yield positive results to maximize business.

Banks, hedge funds and investment vehicles buy CDO’s in the billions.  These purchasers then use the CDO’s as collateral to borrow money (financial institution to financial institution loans are a large segment of banking; remember banks sometimes get good deals when they have little available capital so they have to borrow funds from other banks).  As the collateral itself begins to be worth less and less (in simple terms, the CDO’s are not worth as much as originally thought as the mortgages default), the lenders to these financial institutions will ask for other collateral to take the place of the lost value of the CDO (called a collateral or cash call).  In everyday terms, imagine the value of your home becoming less than the mortgage; the bank will ask you to put up more collateral to secure their position.  This is what is happening now to institutions that hold bad CDO’s.

We, the investor get hurt, during these collateral calls. Few of us actually own CDO’s but we invest in banks and financial institutions that do. If they become subject to collateral calls, they are diverting funds which they could use to pay us greater dividends, buy back shares or acquire competitors and using money instead to fund bad investments in CDO’s (or, in a nightmare scenario, they dump all the CDO’s on the market and create a panic). Bears Stearns’ collateral call cost them $1.6 billion (or over 10% of shareholders’ equity). Shareholders of Bear Stearns are most likely less than pleased by the share price this last month.

How do you avoid this mess? Quite frankly, most financial institutions will hold one form of CDO’s or another. The key is the magnitude of its exposure. If you invest in a financial institution, read the press releases and financial statements for their exposure to CDO’s- a lot of people are asking for full disclosure on this matter (BNS and TD have publicly stated they have no exposure). To state the obvious, avoid investing in these institutions- financial institutions are supposed to be “safe” stocks and they, ideally, should not be investing in such risky products and, to carry this thought further, institutions that invest in CDO’s most likely have a gun-slinger mentality and will put money in the next fad and jeopardize your investment. Thus, it may be time to look at the security of the institution long term.