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Harry Koza's Weekly Column

There's an old joke about a writer and an editor being marooned on a desert island. The have exhausted most of their supplies and are down to one single glass of orange juice. After a couple of days under the blazing sun, they are weak and dehydrated. The writer can stand it no longer, and picks up the glass of orange juice. Before he can put it to his lips, however, the editor grabs it. The writer watches in disbelief as the editor unzips and pees into the OJ, and then hands the glass back. "There," says the editor, "It just needed a little tweak."

Anyway, this week's column, which I admit was a mite longer than my word limit, had all the good lines cut out, so here is the unbowdlerized and unexpurgated version. I've replaced and highlighted the bits (The best jokes, too) that were cut from the printed version. Oh, and I take no responsibility for the lame headline, either. HK

PS - I had some trouble with the formatting from the Globe's web site - for some reason, if you try to read this in a window that is not maximum size, it cuts off the last line. Just put it on full screen and it reads fine.

Crack-house bonds are creative, but CPDOs are demonic

Harry Koza

07:28 EST Friday, Dec 01, 2006

I'm talking to a bond trader of my acquaintance.

"Dude," he says, "I don't know how you do it every week, write a column about freaking bonds! I mean, what's left to say? It's not as if you're writing about politics, where there is some new outrageous stupidity to pontificate on every single day." He snorts derisively. "Canada, it's the Doublemint country - it's two, two, two nations in one."

 "Good line, can I have it? Actually, the writing part is pretty easy ? I just sit down at my computer and do a brain-dump. It's coming up with the new topic every week that's often a struggle when my Thursday deadline looms and the bond market is on cruise-a-matic and I can't think of anything to write about that isn't mind-numbingly boring. I usually manage to come up with something, though ? having that deadline gun to my head does tend to clarify my mind."

"Some of The Globe's readers might say that what you write about every week is already mind-numbingly boring."

 "True, but only those who don't appreciate the arcane mysteries of the bond market. To the initiated, the bond market is a wondrous and complex system."

"Yeah, right. There're only, like, a couple hundred bond geeks. Okay, let's be charitable and say 500 ? there were 450 people at the Bondtraders' Novemberfest this year ? so you've got at least that many potential readers. What are you gonna regale us with this week?"

 "I read the other day that there were 115,568 mortgage foreclosures in the U.S. in October and over a million so far this year, which works out to be one out of every 1,001 households. That's up 42 per cent year over year.

"Yow! That's like one person that you went to high school with had his mortgage foreclosed."

"Well, maybe your high school. Cobalt High only had 165 students in it. Mind you, the worst place for foreclosures in the US is Greeley, Colorado, which has the highest foreclosure rate among the biggest 200 metropolitan areas, at one for every 175 households, so your high school heuristic still holds."

"Greeley, huh? I guess it's named after Horace Greeley - "Go West, young man.""

"Except in this case, it's more like, "Go broke, young man."

"Bummer, dude."

"Scary monsters, indeed. Yet the market was heartened this week by the fact that U.S. existing-home sales were slightly higher than expected in October."

"Sure, because sellers are more motivated to drop their prices. And existing-home sales are still down, what, 11.5 per cent this year? And new-home sales are down a ton, too, despite builders giving away free swimming pools and granite countertops in an effort to clear their inventory."

 "Yeah. Anyway, I've done the housing bubble to death in my column already, so I don't really want to go there again Here's another factoid that gave me pause when I read it: The total outstanding amount of financial derivatives in the global market is now $480-trillion (U.S.). That's almost half a quadrillion ? 30 times the size of the U.S. economy and still growing like Topsy. No wonder kids today all want to be derivatives traders instead of doctors or engineers."

 "Hey, it's a living. Speaking of derivatives, did you see that story about the crack-house bonds? Far out, eh?"

"Well, you know what I always say."

"Oh-oh. Is this another one of Harry's Laws of Capital Markets?"

"I guess it's more of an SMI, a Semiotic Market Indicator."

 "Ah, a sign from Cernunnos."

"Who's he, some kind of Celtic god, right?"

"Got it in one. Cernunnos, known to the Druids as Hu Gadarn, god of the underworld and astral planes ? which aptly describes the derivatives market, for sure. He was also consort of the Great Goddess, and was often depicted holding a bag of money. A set of antlers and a big bag of money ? what Goddess could resist him? I figure he's perfect for God of the Market. Anyway ? dare I say it ? what's your sign?"

"Well, one of the best indicators of a market bubble is the rapid proliferation of strange new investment instruments. This week, besides the crack-house bonds, I heard of a couple other doozies ? reverse convertible structured notes, and CPDOs.

"CPDO? Sounds like a ?droid from Star Wars."

"That stands for Constant Proportion Debt Obligation. Only a few billion of them have been issued so far, but you've got to figure the Street will be all over this faster than a tornado on a trailer park. ABN Amro invented them.

"It's basically a leveraged bet on the credit quality of a bunch of U.S. and European investment-grade companies. It generates income by selling credit default protection on the two main indexes of credit default swaps (which offer a kind of insurance against non-payment of corporate debt), the iTraxx Europe and the Dow Jones CDX.

"The idea is that they sell enough credit default protection to generate more income and market value gains than they need to pay the initial coupons, providing a cushion against losses. Then they roll over the exposure with each six-monthly change in the index series, so that deteriorating credits are removed on a regular basis. They gear it up at about 15 to one, so for every dollar invested in the CPDO, the investor has $15 of exposure to those indexes, and the principal acts as a first-loss piece.

"The theory is that the structure will earn enough to cover all future coupon payments before the deal hits maturity, and it can then be ?cashed out' into a low-risk bond. Where it gets silly is that if there are losses and the net asset value starts to drop, they jack up the leverage even higher to try and earn more, faster."

 "That's like going to Vegas and doubling your bet every time you lose at roulette."

 "Yeah, well, it's like they say: If you want to make a small fortune trading derivatives ....."

"..... Start with a large one. I gotta go. Someone's lifting my offer on 33s. Call me later and I'll tell you about crack-house bonds and you can tell me about

reverse convertibles."

Harry Koza,

Sr. Market Analyst,

Thomson Financial,

36 Green Meadow Crescent,

Richmond Hill, Ontario,

L4E 3W7

905-773-0328

harry.koza@thomson.com

hkoza@aci.on.ca



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