Investment banks are like arms manufacturers. They keep coming up with what Warren Buffett calls “financial weapons of mass destruction”.
Like the intercontinental ballistic missiles of the Cold War era, today’s debt bombs are known by their acronyms and are fiendishly complex. They also need to be handled with extreme care.
Take the exotically named “synthetic CFO” being launched in Europe by Credit Suisse. It may sound like a finance director built out of plastic and fibre. But it’s actually a complicated and highly leveraged debt security backed by a pool of hedge funds. These funds are managed by Paris-based Olympia Capital Management. But the new vehicle borrows three times the underlying value of Olympia’s funds.
If all goes according to plan, after five years this “collateralised fund obligation”, to give its full name, will be wound up and money will be returned to investors.
There’s a pecking order for this distribution. Holders of the senior and riskier mezzanine debt portions will get their cash first. What’s left will go to investors in the very risky “equity tranche”, who are putting up 25% of the capital.
Credit Suisse says that, based on historic performance of the pool of funds, these equity investors would earn annual returns of 30.6%, with no more risk than investing in the stock market. That sounds too good to be true.
A footnote in the marketing documents partly agrees, “Past performance is not indicative of the future performance.” Just because Olympia has not had any down years over the past decade and a half doesn’t mean it will prosper forever.
Indeed, there are a number of reasons why hedge fund returns may become more volatile. One is the increasing amount of debt piled onto investment vehicles like this. And the Credit Suisse product is structured in a way that will force it to sell assets when it loses money.
The need to sell into a declining market is what touched off the 1998 Long-Term Capital Management crisis. Indebted hedge fund investment vehicles, such as Credit Suisse’s, are primed to explode when markets crash. Their promises of high returns and little risk are dangerous to investors.