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Bear Stearns Shakes the CDO Honey Pot

"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 (BAC) 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 (BCS) 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 (FRC) and its investment advisory firm Trainer Wortham, which manages the underlying portfolio.

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