In what may be a scary revelation for many investors, it appears that Wall Street is back to its old tricks again in repackaging old mortgage debt into new investment vehicles. For those who have forgotten the events of the last few years, the now-infamous CDOs, or "collateralized debt obligations," were a combination of both solid and risky mortgages squashed together into one instrument. Deemed the safest of all investments thanks to their AAA rating, they were ushered into the marketplace where unsuspecting investors bought them in droves.
Of course, we all know how it played out. After a few years, the bottom fell out of the real-estate market, and the investments -- which relied on portfolios of properties that were expected to continually increase in value -- crumbled too. In the process, they also took down Lehman Bros., dozens of mortgage lenders and the nation's economy.
Though the practice seems akin to a horror-film franchise that just won't die, some experts argue that it's the only way to clear the system of the hundreds of billions of dollars in mortgages that are preventing banks from lending to a current generation of wannabe homeowners.
However, until Wall Street can get a fix on how much those CDOs really are worth, they'll just sit there, festering. The investments are currently sitting because there's a wide divergence between the prices sellers are seeking and the prices buyers are willing to pay, said Ronald W. Filante, associate professor of finance at Pace University.
"This is all about price discovery," Filante said. "Part of the problem is that no one knows what the value of these things is, and the only way to find out is to give them back onto the market where people can buy them and sell them."
Filante notes that it's entirely possible that the market can and has been wrong. But, with no trading going on, the price discovery process doesn't happen, he said, and then no one knows. "I think there's some possibility that reconstructing these pools might in fact get more trading to occur," he said.
Filante concedes that the practice could put average investors at risk again should real-estate prices take a further tumble.
That risk is something that Stijn Van Nieuwerburgh would like to see taken out of the system. The New York University finance professor wants safeguards put in place that would require average investors to opt into funds that invest into these newly repackaged investments. "Potentially they could be given a choice," he said, but the risks should be explained very clearly.
Still, Nieuwerburgh remains skeptical due to the nature of the investments. "They are so complex that even professional investors barely understand them," he said. Further, he warned, even rating agencies, which were faulted for not picking up on the risks involved with CDOs and then blessed them with their highest and therefore safest rating, are prone to misread these securities again.
Nieuwerburgh fears that once the newly repackaged securities are given AAA status, pension funds, those that manage Americans' retirement money, will be among those in line to buy them.
"They don't have the intellectual capacity to perform the due diligence on these very complex securities," he said, adding, average investors shouldn't be investing in these securities, either directly or indirectly, such as through a 401(k) plan.
Introduction to Economic Indicators
Measure the performance of the economy.View Course »