Subprime's smoking gun?

This will be the year most remembered for the subprime meltdown and resulting credit crunch, though up until now it's been a story short on specific culprits. But check out the lawsuit filed yesterday by Barclays against Bear Stearns. The complaint alleges that Bear Stearns, along with Ralph Cioffi, top manager at one of Bear's hedge funds, and Matthew Tanin, the group's chief operating officer, had "long known" that the fund and its underlying assets were worth far less than their stated values in the early months of this year. The fund eventually collapsed, which Barclays said in its complaint was "one of the most high-profile and shocking hedge fund failures in the last decade." The suit, which includes claims of fraud, conspiracy and breach of fiduciary duty, cites a February e-mail to Barclays in which Tannin allegedly said the fund is "having our best month ever"' and that our "hedges are working beautifully." Now remember, these are only allegations – a Bear Stearns spokeswoman says the suit is an effort by Barclay’s “to avoid taking responsibility for its actions.” Fine. But there’s other smoke coming out of Bear Stearns - Cioffi left the firm last week as U.S. prosecutors examine whether and why he withdrew money from that hedge fund while simultaneously raising cash for it.

Okay, this gets very complicated, but it’s worth plowing through. BusinessWeek has posted a piece suggesting that Cioffi’s hedge funds relied on a pyramid structure in which collateralized debt obligations, or CDOs, became the building blocks. CDOs are at the heart of the subprime mess – in essence, they’re packages of debt (mortgage loans, auto loans, whatever) that can be bought and sold by investors in the financial markets. The pyramid was set up when new investors arrived, bidding up prices and boosting returns for those who got in earlier. The big gains attracted more investors, and the cycle continued—as long as the players didn’t try to take out their money all at once.

Cioffi and his group specialized in a certain kind of CDO that was aimed at the world of money-market accounts. They were called "Klio Funding," entities that sold low-yielding short-term debt and bought 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.

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The complexity of the Klios and their ilk only encouraged lax lending practices by putting too much distance between the borrowers and the ultimate holders of their debt. Since the Klios offered a refund policy, money-market managers didn't have to worry about whether home buyers would pay back their loans. Their investments were protected even if the owners eventually defaulted on their mortgages. Indeed, as the bubble inflated, there was little incentive for the array of middlemen collecting fees—mortgage brokers, real estate appraisers, bankers, money managers, and others—to do the proper checks. The lack of oversight likely contributed to the rampant fraud on some underlying loans, says S. Kenneth Leech, chief investment officer of bond-investing firm Western Asset Management.

You might already know what happened today: Bear Stearns reported its first-ever loss as a result of the bubble bursting and now having to writedown all those mortgage holdings. Lots of questions, of course, starting with whether Cioffi crossed legal lines through the use of Klios. Then there's Citi's involvement. "One can understand how the investors in Cioffi's hedge funds were burned when those hedge funds collapsed," writes Felix Salmon at Portfolio.com. "But the fact that Citi willingly signed on to Cioffi's schemes - schemes which were ultimately structured for the benefit of Cioffi, not Citi - looks positively amateurish."