With Apologies to Shakespeare

 WALL STREET SMARTS, THE BLOG, IS NOW WALL STREET SMARTS, THE BOOK.  FULLY EDITED AND REVISED WITH NEW MATERIAL ON AMAZON

I owe William Shakespeare an apology.  In his play, Hamlet, Polonius, a counselor to the King of Denmark, gives his son, Laertes, some fatherly wisdom as the young man leaves for school.  He advises him, "Neither a borrower nor a lender be."  I always attributed that line to Ben Franklin.  In any event, not many adhere to this proverb these days.  From individuals to governments, the use of credit is ubiquitous.  In April, 2013, the US national debt exceeded $16 trillion.  Total US debt, including household, corporate and government borrowings, exceeded $50.7 trillion in 2009.  According to the US Government Accountability Office, total daily trading volume in US bond markets in 2011 was $900 billion.  You read that right; $900 billion is the face value of the loans changing hands every day in America's debt markets.  US Treasury debt made up $500 billion of that $900 billion total. 

The forms of that debt are quite varied as well.  There are US treasury securities, bonds issued by states, counties and municipalities, US governmental agency debt and US corporate debt, secured and unsecured.  Foreign government and corporate bonds issued in US Dollars for purchase by US citizens (called Yankee Bonds) can also be found in US bond markets.  These are forms of direct debts owed by a borrower to the holder of the promissory note.

There are also debt securities "manufactured" by Wall Street and sold to investors.  Wall Street investment banks will buy government and corporate bonds and combine them into a security which is called a Collateralized Debt Obligation (CDO).  They pool the debt and then divide it into what are called tranches, each with a different maturity, interest rate and, in many instances, level of creditworthiness (the likelihood of repayment).  Tranche is a French word for "slice."  The investment bank marks up the price of the tranche to make its money and sells certificates for this new security to debt investors.  Each portion of the pool of debt instruments is sold to someone looking for a particular cash flow and rate of return.  These are "pass through" securities in which the borrowers' repayments on the loans in the pool are recycled to make the payments to the CDO owners.

Some CDOs are made up of pools of consumer debt.  There are CDOs consisting of pools of credit card debt, student loans or auto loans.  Of recent infamy are mortgage backed securities (MBS), also referred to as collateralized mortgage obligations (CMO).  During the US real estate bubble in the early years of this century, the mortgages taken out to finance those home purchases found their way into CMOs distributed by Wall Street around the world.  When the bubble burst and the recession hit, home values plummeted.  Home owners became either unable or unwilling to service the debt on their now much less valuable homes.  In many instances, the value of the home fell to less than the amount of mortgage debt on it.  Homeowners in this situation are commonly referred to as being either "upside down" or "underwater."  As the home owners' payments dried up, the CMOs containing those mortgages defaulted on a mammoth scale, and the debt market plunged into a credit crisis.  Although not the only reason, worthless CMOs played a role in the recession of 2007-2009.

Most financial advisers advise their clients to divide their portfolios between equity and debt.  This asset allocation is supposed to reduce the overall volatility of the investor's investment portfolio.  We will begin our study of investment opportunities and risks for individual investors in debt markets in the next blog.

Comments are always welcome.