SECURITIZING GOES PUBLIC.

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Author: Hess, Lisa W.

Recently a Money Manager collared me, to talk about the remarkable investment she had bought. The security, with a three-year maturity and an A credit rating, paid the three-month London Interbank Offered Rate plus a percentage point, for a not-bad yield of 6.1%. This asset-backed bond was called Rosy Blue Carat. Huh? Then my friend told me it was collateralized by diamonds. I chortled.

Diamonds may be a girl's best friend, but they are pretty obscure in the investment realm. When Wall Street people think of precious materials with mainly decorative uses, they think of gold, for which a well-established futures market exists. Still, maybe I shouldn't have laughed at a diamond-backed bond. Giving this concept a second look, I realized that it is a pretty good idea. It has a floating rate--good when interest rates are headed up--is cheap compared with other single A-rated bonds and has rock-solid (pun intended) collateral unless the diamond market collapses, which is very unlikely.

Why not package diamonds into securities? Everything else is being securitized. Mortgages, credit cards, loans to leveraged buyout funds, airplanes, forests, even guitars. The securitization upsurge is healthy for both issuers and investors, lightening corporate borrowing costs, thereby aiding earnings and stock prices.

This is an evolutionary advance. Historically, the first stage in the development of markets is equity fundraising for companies. Next, debt markets appear, and leverage increases company valuations. Emerging markets are in the second stage today. In the developed world, we are entering a third stage: structured finance, where assets on a balance sheet are carved up into various slices, with each slice appealing to an investor with a different risk appetite. So the collateralized debt obligation (CDO), which is backed by a collection of bonds, the collateralized loan obligation backed by bank loans and the collateralized mortgage obligation are hot on Wall Street these days. There are even CDOs backed by credit derivatives--synthetic CDOs that insure against defaults--and CDOs of CDOs, called CDOs squared. At $250 billion, according to the Bond Market Association, CDO issuance in 2005 was larger than junk bond issuance.

For issuers, often securities firms or large institutions, the attraction of CDOs is that they get management fees to run the portfolios, plus they lock in permanent financing. The attraction for investors: CDOs typically pay higher yields than equivalently rated corporate bonds because their exotic nature perplexes even sophisticated institutional investors.

Paradoxically, CDOs often carry less risk. With a traditional investment-grade bond portfolio, investors assume that, while losses may occur frequently, those losses will be relatively small; in other words, defaults or credit downgrades may occasionally hurt a few of the bonds' prices. With CDOs, the economics are the reverse. Losses will occur only rarely, but when they do they will be very, very large. That's because CDOs usually are composed of an array of bonds with differing credit ratings, protected by varying levels of subordination. Defaults are absorbed by the lowest-rated slices first; by the time the investment-grade tranches experience a loss, defaults would be mammoth.

The new playground at first was open only to the big boys. CDOs cost hundreds of millions to buy. Fortunately, retail products are becoming available, which let individual investors benefit from these innovations.

Alas, not all are wonderful. Kohlberg Kravis Roberts, the celebrated buyout firm, took KKR Financial public last June. This is a glorified real estate investment trust, holding $8.8 billion of adjustable-rate mortgages and commercial loans packaged into CDOs. The copious dividend yield of 7.1% is sucker bait, though, and doesn't offset KKR's bad timing. The end of the housing boom has made it a lackluster investment. The stock went public at $24 and now trades at $22. At a price/earnings multiple of 25, that's pretty expensive for a leveraged bond fund.

A better choice is Capital Trust (31,CT), at 11 times earnings. Capital, whose chairman is the hard-charging Samuel Zell, uses the same REIT structure as KKR, but it lends to commercial real estate, which is still going strong. In this arena, traditionally dominated by banks, Capital makes loans, securitizes them in a CDO and sells them to institutional investors.

Expect two new public offerings in the next few months: Highland Financial (commercial credit); and one from Crystal River (run by Lewis Ranieri, father of the mortgage-backed security) and Brascan (commercial real estate--from Canada's brilliant Brookfield Asset Management). Worth a hard look.

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By Lisa W. Hess

Lisa W. Hess is a New York money manager. Visit her homepage at www.forbes.com/hess.