OK, remember Felix Salmon’s explanation of synthetic CDOs from my previous post? Good, because you’re going to need it.

Earlier this month, Planet Money and The New York Times collaborated on a story about how five Wisconsin school districts may have blown $200 million – $165 million of which was borrowed – on an investment that no one involved, including the investment banker selling the deal, seems to have understood. The details aren’t entirely clear from the main Times article, but by looking up a couple of other Planet Money posts, I’m pretty sure it went something like this:

1. 5 Wisconsin school boards took $35 million of their own money and borrowed another $165 million from Depfa.
2. They used the $200 million to buy a tranche of a synthetic CDO created by Royal Bank of Canada.
3. Royal Bank of Canada took that money, and presumably money from other people as well, and created that synthetic CDO by selling insurance (using credit default swaps) on $20 billion worth of corporate bonds. The synthetic CDO was like an ordinary CDO in that it had cash flows coming in – premium payments on the credit default swaps. The up-front money (including the schools’ $200 million) was needed as collateral. It’s not clear how senior the schools’ tranche was, but the Times says that most if not all of the $200 million in collateral will be lost, so it was probably pretty junior.
4. If there were no defaults, the schools would have netted $1.8 million per year – a 5.1% return.

We’ve all made bad investment decisions. I don’t want to pick on the Wisconsin schools for choosing a bad investment, but for something else: having the wrong investment goal.

Continue reading “Synthetics and School Boards” →