This is really fucking pitiful. By David Evans June 1 (Bloomberg) -- Bear Stearns Cos., the fifth-largest U.S. securities firm, is hawking the riskiest portions of collateralized debt obligations to public pension funds. At a sales presentation of the bank's CDOs to 50 public pension fund managers in a Las Vegas hotel ballroom, Jean Fleischhacker, Bear Stearns senior managing director, tells fund managers they can get a 20 percent annual return from the bottom level of a CDO. ``It has a very high cash yield to it,'' Fleischhacker says at the March convention. ``I think a lot of people are confused about what this product is and how it works.'' Worldwide sales of CDOs -- which are packages of securities backed by bonds, mortgages and other loans -- have soared since 2003, reaching $503 billion last year, a fivefold increase in three years. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses. The investments could be wiped out. Fleischhacker, 45, says she doesn't associate toxic waste with the equity tranches she's selling. Pension funds in the U.S. have bought these CDO portions in efforts to boost returns. Many pension funds, facing growing numbers of retirees, are still reeling from investments that went sour after technology stocks peaked in March 2000. Fund managers buy equity tranches, which are also called ``first loss'' portions, even though those investments are never given a credit rating by Fitch Group Inc., Moody's Investors Service or Standard & Poor's. `I Have Trouble' The California Public Employees' Retirement System, the nation's largest public pension fund, has invested $140 million in such unrated CDO portions, according to data Calpers provided in response to a public records request. Citigroup Inc., the largest U.S. bank, sold the tranches to Calpers. ``I have trouble understanding public pension funds' delving into equity tranches, unless they know something the market doesn't know,'' says Edward Altman, director of the Fixed Income and Credit Markets program at New York University's Salomon Center for the Study of Financial Institutions. ``That's obviously a very risky play,'' he says. ``If there's a meltdown, which I expect, it will hit those tranches first.'' Calpers spokesman Clark McKinley declined to comment. Because CDO contents are secretive, fund managers can't easily track the value of the components that go into these bundles. ``You need to monitor the collateral in your investment and make sure you're comfortable there will be no defaults,'' says Satyajit Das, a former Citigroup banker who has written 10 books on debt analysis. Tough to Track Most investors can't do that because it's extremely difficult to track the contents of any CDO or its current value, he says. About half of all CDOs sold in the U.S. in 2006 were loaded with subprime mortgage debt, according to Moody's and Morgan Stanley. Since CDO managers can change the contents of a CDO after it's sold, investors may not know how much subprime risk they face, Das says. As the $503 billion-a-year CDO market thrives, CDO marketers like Bear Stearns and Citigroup find buyers for the portions known as toxic waste, the equity tranches. A typical $500 million CDO requires a $40 million unrated equity tranche, says Fleischhacker, who addressed the 12th annual Public Funds Summit, a meeting of pension fund managers, at the Loews Lake Las Vegas Resort on March 12. `Lipstick on a Pig' Chriss Street, treasurer of Orange County, California, the fifth-most-populous county in the U.S., says no public fund should invest in equity tranches. He says fund managers are ignoring their fiduciary responsibilities by placing even 1 percent of pension assets into the riskiest portion of a CDO. ``It's grossly inappropriate to take this level of risk,'' he says. ``Fund managers wanted the high yield, so Wall Street sold it to them. The beauty of Wall Street is they put lipstick on a pig.'' Seven percent of all the equity tranches sold in the U.S. in the past decade were purchased by pension funds, endowments and religious organizations, Fleischhacker says. Public pension funds have bought more than $500 million in CDO equity tranches in the past five years, according to data from public records requests. The New Mexico State Investment Council, which funds education and government services for children, has $222.5 million invested in equity tranches. The council decided in April to buy an additional $300 million of them. That investment would be 2 percent of the $15 billion it manages. Broker Suggested Purchases The General Retirement System of Detroit holds three equity tranches it bought for $38.8 million. The Teachers Retirement System of Texas owns $62.8 million of them. The Missouri State Employees' Retirement System owns a $25 million equity tranche. Ronald Zajac, spokesman for the Detroit pension fund, declined to comment on the fund's equity tranche investments. Kay Chippeaux, fixed-income portfolio manager of the New Mexico council, says it decided to buy equity tranches after listening to pitches from Merrill Lynch & Co., Wachovia Corp. and Bear Stearns. ``We got very interested in them just because a broker brought them to our attention,'' Chippeaux, 50, says. She says the investment is worth the risk because the fund may be able to get higher returns than it can from bonds. The council has purchased equity tranches from Bear Stearns, Citigroup, Merrill Lynch and Morgan Stanley. The council is relying on advice from bankers who are selling the CDOs, Chippeaux says. ``We manage risk through who we invest with,'' she says. ``I don't have a lot of control over individual pieces of the subprime.'' Return: 6.1 Percent As of March 31, the Texas teachers pension fund's CDO investments had returned a total of 6.1 percent since December 2005, spokeswoman Juliana Fernandez Helton says. They include the fund's $62.8 million in equity tranches, which were purchased from Credit Suisse Group, Goldman Sachs Group Inc., Citigroup and other banks. The Texas fund also bought $10.1 million in investment-grade tranches from Merrill Lynch and RBS Greenwich Capital Markets, a unit of Royal Bank of Scotland Group Plc. The Texas fund managers won't put more than 1 percent of the fund's assets into CDO investments, Helton says. They review CDO managers' capabilities and the design of an individual CDO before making a purchase, she says. Last September, the Missouri retirement system bought half of the equity tranche of the BlackRock Senior Income Series 2006 collateralized loan obligation, managed by New York-based BlackRock Inc. A CLO is a CDO that invests exclusively in loans, not bonds.