BusinessWeek reports that The Bear Stearns Companies (NYSE: BSC), which reported earnings today, is behind $10 billion worth of Collateralized Debt Obligations (CDOs) at Citigroup Inc. (NYSE: C) and Bank of America (NYSE: BAC). It all comes down to yet another new word to add to your financial vocabulary -- Klio Funding -- a brand of CDO that enabled Bear to sell to the $2 trillion money market fund industry.
What is Klio Funding and how did it cause all this damage? Klio Funding is "an entity" that sells Commercial Paper (CP) -- short-term loans -- and uses it to buy higher-yielding long term investments. Since Citigroup had agreed to refund investors' initial stakes plus interest -- through liquidity puts -- money market funds that bought Klios thought they would get higher yields at low risk.
Meanwhile, Ralph Cioffi -- who headed up three Bear hedge funds which eventually folded -- used money raised from the Klios to buy CDOs and to lock in year-long financing for his hedge funds. This is significant because hedge funds typically can only borrow money for weeks at a time due to their risk. Cioffi's CDOs were popular, raising $100 billion.
The Klio structure turned out to be a pyramid scheme according to Yale University economist Robert J. Shiller. 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.
That's exactly what happened this spring. Cioffi tried to sell more CDOs to raise money to prop up the hedge funds he managed. But just after raising $4 billion in May, his hedge funds imploded, wiping out $1.6 billion of investors' money. In November, Citigroup and Bank of America wrote down some $10 billion in CDOs thanks to their liquidity puts. The financial system faces at least $500 billion in write-downs -- creating a massive capital hole that needs to be filled.
The lesson for investors is clear. If you hear lots of new vocabulary words coming out of Wall Street, someone is making huge amounts of money in the short-term that will eventually blow up, leaving others to pay the costs. If you've invested in something with a name you don't understand, find out what it is. If it sounds too good to be true, it probably is.
We already know that James Cayne, Bear's CEO, is paying the price by not getting a bonus. The question is whether he'll be able to keep his job.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter. He owns Citigroup shares and has no financial interest in the other securities mentioned.
