the debacle of two Bear Stearns hedge funds - CDO

--At the center of it all was the new breed of CDO pioneered by Cioffi and his team to tap into the $2 trillion universe of money-market accounts in which individuals and corporations stash their spare cash. Cioffi's CDOs, initially branded "Klio Funding," were entities that sold commercial paper and other short-term debt to buy higher-yielding, longer-term securities. The Klios were a win-win proposition for money-market funds. They paid a higher interest rate than the usual short-term debt. And investors didn't need to worry about the risky assets the Klios owned because Citigroup had agreed to refund their initial stake plus interest, through what's known as a "liquidity put," if the market soured. Cioffi engineered three such deals in 2004 and 2005, raising $10 billion in all. --What did Citigroup get for guaranteeing the Klios? For one thing, fees. The Klios were also a ready buyer of Citi's own stash of mortgage-backed securities and other debt. Citi probably never imagined it would have to make good on those guarantees because the underlying assets had the highest credit ratings. --Cioffi used the money from each deal to purchase billions in mortgage-backed securities and pieces of other CDOs for his three Klios. He bought many of the assets directly from the two Bear hedge funds he managed. The move also supplied the hedge funds with cash. --In hindsight, CDOs and SIVs served as a foundation for a pyramid-like structure that Yale University economist Robert J. Shiller says occasionally arises from bull markets. As new investors arrive to the party, they bid up prices, boosting returns for those who got in earlier. The big gains attract more investors, and the cycle continues—as long as the players don't try to take out their money en masse. --The mortgage-market system played out much the same way. The new type of CDO lured a different tier of investors: money-market funds. The flood of fresh money made it even cheaper and easier for buyers to get mortgages. That, in turn, drove up home prices, holding off defaults and foreclosures. The process enriched the people who bought earlier in the boom and triggered more speculation. --Now investigators are trying to determine whether Cioffi and his team crossed legal lines. The Klios provided the Bear hedge funds with a ready, in-house trading partner. Their financial reports, which were reviewed by BusinessWeek, show many months in which the Cioffi-managed Klios traded only with the Cioffi-managed Bear funds. For example, in April, 2006, one Klio CDO bought $114 million worth of securities from one of the Bear funds. Such trades, says Steven B. Caruso, an attorney who represents several Bear hedge fund investors, may be "indicative of an incestuous, self-serving relationship that appears to have been designed to establish a false marketplace." --Amid the market turmoil earlier this spring, Cioffi hoped the Klios would work their magic once again. In April, as losses at the funds began mounting, Cioffi set up another CDO, High Grade Structured Credit CDO 2007-1, which issued short-term paper and offered investors a money-back guarantee from Bank of America. Cioffi had raised nearly $4 billion by late May, making it the biggest CDO of the year, according to Thomson Financial (TOC). --By autumn the practice of using CDOs to raise cash was dead. Money-market funds had stopped buying the short-term debt, and the credit markets were frozen. That forced Citigroup and Bank of America to make good on their guarantees to investors in Cioffi's CDOs, triggering big losses at the two banks. --The global markets are dealing with the consequences: The tab from the mortgage mess could run up to $500 billion, and central bankers are struggling to stave off recession. As investigators sort through the wreckage, the records of Bear Stearns' doomed hedge funds are turning out to be some of the most revealing in an era of financial folly.