There’s an excellent article titled “How professionals dump their toxic waste on you” by Paul Tustain that is worth reading. He starts with much of the current situation in subprime loans that we’ve talked about before… but then goes on to some additional interesting topics… below are some highlights.

Many investment funds (pension funds, bond funds, etc.) are holding CDS (credit default swap) portfolios as income generating bond-equivalent securities. The catch is that many of the CDSs are not actually insuring against default, but the other side of a speculative position that a risky borrower would default. The example cited was Delphi Corp’s recent fall from grace — when their debt was defaulted on, an astounding 10 times the amount of the debt was executed in the form of CDSs on their debt.

So these pension funds, hungry for bond-like returns, basically took the other side of a bet that Delphi would collapse. Not exactly investment grade, but thanks to financial alchemy, a pool of these CDSs were highly rated, and most likely offered to the buyers with leverage.

Digging back a bit in the chain of consequences, these pension funds were eager for bond funds and bond-like returns because of… [drum roll please…] government regulations. “Governments began trying to enforce investment prudence. One of the things they did was require retirement funds to make a better attempt to match their long-term liabilities to their assets. Equities had suddenly and spectacularly failed to do this. So legislation was introduced which forced funds to buy investment grade bonds.”

Thus was born a large demand for fixed-rate paper. This demand is also the source of funding for most of the private equity buyouts we’ve seen recently. If you’re an investment firm and you can sell pensions tons of bonds (at their request), you pretty much find a way to put that money to use — whether it’s via buyouts or selling them premium generating CDS or CDO portfolios.

If things are as bad ads Mr. Tustain presents them, this would be a significant risk to the markets and to pension and bond funds. If we see pension funds burned yet again, we would likely see standards for credit re-evaluated and that bid for the buyout funds disappear or change significantly. Oh yeah, and the end recipients of the pension funds would be screwed too.

Who are these mysterious pension and bond fund holders? They’re a lot closer than you might think… A quick check of the very conservatively managed bond funds available in my spouse’s 401k include some surprising results. The “total market bond fund” is 34% mortgage backed securities, and 9% commercial mortgage backed securities. The “long term corporate bond fund” includes 6% of commercial mortgage backed securities. Commercial real estate probably isn’t a risk yet, but it’s still exposure to CDSs, even if through counter-party risks.

Action to take: review any bond funds you own for exposure to mortgage securities.? Even if you don’t sell the bonds, you should be aware of what composes your fund.

Hopefully the fund managers are not as complacent as the ones Tustain describes, but on average across many fund managers, my hopes are not incredibly high.