I came across this passage in my readings the other day:

“CBOs are diversified investment pools of junk bonds that issue their own securities with the underlying junk bonds as collateral. Several tranches of securities with different seniorities are usually created, each with risk and return characteristics that differ from those of the underlying junk bonds themselves.

What attracted underwriters as well as investors to junk bond CBOs was that the rating agencies, in a very accommodating decision, gave the senior tranche, usually about 75 percent of the total issue, an investment-grade rating. This means that an issuer could assemble a portfolio of junk bonds yielding 14 percent and sell to investors a senior tranche of securities backed by those bonds at a yield of, say, 10 percent, with proceeds equal to perhaps 75 percent of the cost of the portfolio. The issuer could then sell riskier junior tranches by offering much higher yields to investors.

The existence of CBOs was predicated on the receipt of this investment-grade credit rating on the senior tranche. Greedy institutional buyers of the senior tranche earned a handful of basis points above the yield available on other investment grade securities. As usual these yield pigs sacrificed credit quality for additional current return. The rating agencies performed studies showing that the investment-grade rating was warranted. Predictably these studies used a historical default-rate analysis and neglected to consider the implications of either a prolonged economic downturn or a credit crunch that might virtually eliminate refinancings. Under such circumstances, a great many junk bonds would default; even the senior tranche of a CBO could experience significant capital losses. In other words, a pile of junk is still junk no matter how you stack it.”

Did I transpose a B when I meant D in the CBO? No. This is actually a passage from “Margin of Safety” by Seth Klarman.  It was published in 1991 and has been an investment “classic” ever since.  This is about the junk bond market in the late 1980’s.  The frightening thing is how eerily similar it is to the current credit crisis.  Complicit ratings agencies, “tranches” of ever more complicated derivatives, poor modeling based on faulty historical premises.  Does any of this sound familiar?  Replace the “B” with a “D” and “junk bond” with “sub-prime mortgage” and you could re-publish this in any periodical today as the cause of our current credit crisis.

A quote I love is frequently attributed to Mark Twain (although I haven’t been able to track it down), “History doesn’t repeat itself, but it sure does rhyme.”  I don’t know weather to be comforted by the fact that we have been through this before and survived, or disgusted by the fact that we haven’t learned from our mistakes.  In fact, far from learning from our mistakes, we seem to have willingly embraced the tools (repacking tranches and faulty modeling) that cause so much stress last time around.

Learning from history can be quite useful, particularly when it “rhymes”.  It is interesting to note, that after the junk bond collapse in 1990, the S&P 500 bottomed out in October.  In the subsequent six months – through May of 1991, the index returned 30%.  Let’s hope we see something that rhymes with that…