Mortgage-Bond Pioneer Dislikes What he sees

More than two decades ago, Lewis Ranieri, the authors of 1989 best-selling book "Liar's Poker" which celebrated his billion-dollar trades in these bonds, helped create a vast new business: selling bonds backed by millions of Americans' home-loan payment.



The innovation: combing regular mortgages into giant pools of loans that could be divided up and resold as bonds to pension funds and other institutional investors. These bonds come with a variety of credit ratings and are repackaged in endless permutations to meet investors' varying appetites for risk.



Until the past few years, the business was dominated by Fannie Mae and Freddie Mac, the two government-sponsored providers of funding for home loans. But they have lost their dominance amid accounting scandals.



During the boom, investment Banks promoted new instruments that made it easy for more investors to dabble in mortgages. One of them is the collateralized debt obligation, or CDO. Money managers set up CDOs, which raise money by selling notes and shares to investors. The proceeds are used to buy a wide variety of mortgage securities. The target market: insurers, pension funds and other investors that lack the time or expertise to choose individual mortgage securities. Instead, they can buy into a CDO, just as a stock-market investor get immediate diversification by buying a mutual fund.



CDOs, which are particularly popular with Asian and European institutional investors, have become huge buyers of the riskier slices of mortgage securities, the high-yielding portions that suffer some of the first losses if mortgage defaults are higher than initially expected.



One Concern, Mr. Ranieri says, is that it isn't clear exactly which investors hold lots of the riskiest slices and whether they understand those risks. Investors in CDOs don't get as much information about the collateral backing their investments-thousands of homes scattered across America-as do traditional, specialist buyers of individual mortgage securities, he says.



Adding to the complexity: CDOs also often invest in other CDOs, putting another layer of opaqueness between investors and their collateral.

CDCs aren't bad, per se, but can bring mortgage exposure to "a much less sophisticated community," Mr. Ranieri says.