Bear Stearns Shakes the CDO Honey Pot

The buyer of the CDOs at issue in the SEC inquiry is Westernbank Puerto Rico, a division of W Holding(WHI Quote), 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.