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:
- 5 Wisconsin school boards took $35 million of their own money and borrowed another $165 million from Depfa.
- They used the $200 million to buy a tranche of a synthetic CDO created by Royal Bank of Canada.
- 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.
- 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.