Bond expert Edward Devlin of PIMCO explained how ABCP works in Changing on the Fly: Canadian Credit Markets. Warning: reading and trying to understand how it works will hurt your brain! Only an expert could understand it. I doubt even 0.1% of average investors could, or 1% of investors not specialized in fixed income, even when it is explained clearly as in this example. Did regulators or ratings agencies like DBRS even understand what was going on?
PIMCO certainly knew what was going on and took advantage, though it seems not in a direct way, merely through exploiting the indirect effects; "Needless to say, PIMCO has not invested in the ABCP of any Canadian conduits, but we have found a way to capitalize on their market impact."
Favorite quote from this article, written in May 2007, a few months before ABCP blew up: " ... tick, tick, tick ..."
Moral of the story: don't invest in something you don't understand. That's why people like Warren Buffett say the average investor should stick to index funds, despite the fact that he, an expert, doesn't operate that way.
Reality check: if you think you understand something, ask yourself if you really do. The ultimate test of perfect understanding: could you explain to someone how to create the product in question?
Thursday, 27 August 2009
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