Bear Stearns Shakes the CDO Honey Pot

New York, 5 August 2005

All of Wall Street may come to rue the day Bear Stearns sold $16 million in collateralized debt obligations to Hudson United Bank.

The sale prompted a complaint to New York Attorney General Eliot Spitzer from Hudson United, which believes Bear Stearns gave it bad prices on the sophisticated bonds. Now Spitzer's office is contemplating taking a broader look at the market for these fast-growing derivative investments.

Bear Stearns disclosed in a regulatory filing last month that Spitzer's office sent it a subpoena seeking information about the transaction. The firm didn't provide any details or identify the customer that bought the CDOs.

A June 23 memorandum from Bear Stearns' legal department, which was obtained by TheStreet.com, indicates Spitzer's office is looking into the marketing of three CDOs sold to Hudson United and the valuations provided to the bank on those transactions. The deals in question involve a series of high-yielding bonds backed by revenue streams from a potpourri of commercial, residential and mobile-home mortgages.

Hudson United complained to Spitzer after trying to sell the CDOs and allegedly finding they were worth much less than Bear Stearns claimed, people familiar with the investigation say.

Hudson United and Bear Stearns both declined to comment on the investigation. A spokesman for Spitzer also had no comment.

The inquiry by Spitzer's office is in its infancy and, for the moment, limited to just Bear Stearns. But if history is any guide, once Spitzer's staff begins probing a Wall Street practice it doesn't like, an investigation rarely remains a small and isolated event.

If Spitzer needed any further prodding, Bear Stearns also disclosed last month that the Securities and Exchange Commission's Miami office is much further long in a separate investigation involving a similar dispute over the pricing of $64 million in CDOs. In the SEC investigation, which began more than a year ago, regulators have notified Bear Stearns they are contemplating filing civil charges against the firm.

The buyer of the CDOs at issue in the SEC inquiry is Westernbank Puerto Rico, a division of W Holding, Bloomberg reported.

The estimated $700 billion CDO market could be a fertile one for Spitzer. It's developed almost overnight with little outside oversight. Five years ago, the dollar value of outstanding CDOs was just $120 million.

Since then, the structured finance product has found a ready stream of buyers in banks, hedge funds and other institutional investors all seeking higher-yielding securities to sink their money into.

The great thing about CDOs is that just about anything that produces revenue can be stuffed into the underlying portfolio that backs these securities. A typical CDO represents claims on cash flow from a combination of junk bonds, bank loans, accounts receivable, mortgage-backed securities -- even other CDOs.

In effect, a CDO is a structured finance smorgasbord that allows investors to sample a wide array of assets, some better than others. But cynics say the CDO structure provides a perfect vehicle for banks and other companies to dump their poor-performing loans and bonds on unsuspecting investors.

Critics fear the explosive growth in CDOs could spell trouble for Wall Street, since many of the institutional investors buying them are not fully aware of what they're biting into.

To compound matters, independent pricing information about these specialized bonds is hard to come by. With a limited secondary market for trading CDOs, buyers often must rely on the Wall Street firms that underwrite them for an idea on what they're worth.

And that can have big ramifications for hedge funds and banks that must periodically value their investments for any paper gains or losses. The lack of independent pricing information appears to be the issue in the Hudson United situation.

Another problem is that managers of the portfolios underlying the securities can sometimes make substitutions in the bonds or loans that serve as the collateral for the CDO, people say. This ability to make changes in the make-up of the portfolio can lend itself to potential abuse and provides another opportunity for CDO issuers to unload poor-performing assets on their investors.

"There are huge transparency issues,'' says Janet Tavakoli, a structured finance and derivatives consultant and the author of a book on CDOs. "In some cases, investors have been taken in by hype. Some investors don't know what they are getting into."

Tavakoli says buyers typically only care about how much yield a CDO will throw off. Rarely do they inquire about how the underlying assets will be valued, or whether there's a secondary market for trading them.

Increasingly, CDO buyers are crying foul about the quality of the information they are getting from Wall Street.

In June, Bank of America settled a lawsuit filed by Italy's Banca Popolare di Intra, stemming from the sale of $80 million in CDOs. The Italian bank claimed that BofA had misrepresented the risk associated with the securities. Earlier in the year, Barclays reached an out-of-court settlement with Germany's HSH Nordbank over a similar issue.

Last month, Royal Bank of Scotland sued Weil Gotshal & Manges, a big New York law firm, over its structuring and documentation for a six-year-old CDO. The lawsuit, filed in London, stems from Weil Gotshal's role as the legal adviser on the Sabre Funding No. 1 CDO for Natwest, a division of RBS.

"The buyer is at the mercy of the underwriter to know what the valuations are,'' says Gary Kendall, president of CDO2, a London company that sells a software that helps investors independently price CDOs. "It's an industrywide problem.''

To understand why CDO pricing and valuation can be such an opaque process, consider the composition of one of the CDOs that Spitzer's office has requested information on from Bear Stearns: the Trainer Wortham First Republic CBO II. This 2002 CDO is a hodgepodge of mortgage-backed securities, that are in turn backed by mortgages on single-family homes, mobile homes, commercial properties and home equity loans.

Underwritten solely by Bear Stearns, the CDO raised about $335 million for First Republic and its investment advisory firm Trainer Wortham, which manages the underlying portfolio.

The Trainer Worthman CDO really was five securities, or tranches, rolled into one. Each piece of the CDO was reviewed by Moody's Investors Service and received varying degrees of investment grade ratings. This May, Moody's downgraded three tranches of the CDO with a combined value of $41 million. One tranche valued at $7.6 million was lowered to junk bond status.

The other two CDOs that Spitzer requested information on are Aspen Funding I and Madison Avenue Manufactured Housing Contract Trust 20002. The Madison Avenue deal involved mortgages on mobile homes that were originally issued by GreenPoint Financial and later sold to Bear Stearns' EMC Mortgage subsidiary.

Both the Aspen Funding and Madison Avenue deals were rated by either Moody's and S&P back in 2002. The rating agencies have since downgraded all or portions of both CDOs.