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F FINANCIAL CRISIS INQUIRY COMMISSION REPORTINANCIAL CRISIS INQUIRY COMMISSION REPORT
The short-term nature of repo money also makes it inherently risky and unreli-
able: funding that is offered at certain terms today could be gone tomorrow. Cioffi’s
funds, for example, took the risk that its repo lenders would decide not to extend, or
“roll,” the repo lines on any given day. Yet more and more, repo lenders were loaning
money to funds like Cioffi’s, rolling the debt nightly, and not worrying very much
about the real quality of the collateral.
The firms loaning money to Cioffi’s hedge funds were often also selling them
mortgage-related securities, and the hedge funds pledged those same securities to se-
cure the loans. If the market value of the collateral fell, the repo lenders could and
would demand more collateral from the hedge fund to back the repo loan. This dy-
namic would play a pivotal role in the fate of many hedge funds in —most spec-
tacularly in the case of Cioffi’s funds. “The repo market, I mean it functioned fine up
until one day it just didn’t function,” Cioffi told the FCIC. Up to that point, his hedge
funds could buy billions of dollars of CDOs on borrowed money because of the mar-
ket’s bullishness about mortgage assets, he said. “It became . . . a more and more ac-
ceptable asset class, [with] more traders, more repo lenders, more investors
obviously. [It had a] much broader footprint domestically as well as internationally.
So the market just really exploded.”
BSAM touted its CDO holdings to investors, telling them that CDOs were a mar-
ket opportunity because they were complex and therefore undervalued in the general
marketplace. In , this was a promising market with seemingly manageable risks.
Cioffi and his team not only bought CDOs, they also created and managed other
CDOs. Cioffi would purchase mortgage-backed securities, CDOs, and other securi-
ties for his hedge funds. When he had reached his firm’s internal investment limits,
he would repackage those securities and sell CDO securities to other customers.
With the proceeds, Cioffi would pay off his repo lenders, and at the same time he
would acquire the equity tranche of a new CDO.
Because Cioffi managed these newly created CDOs that selected collateral from
his own hedge funds, he was positioned on both sides of the transaction. The struc-
ture created a conflict of interest between Cioffi’s obligation to his hedge fund in-
vestors and his obligation to his CDO investors; this was not unique on Wall Street,
and BSAM disclosed the structure, and the conflict of interest, to potential in-
vestors. For example, a critical question was at what price the CDO should purchase
assets from the hedge fund: if the CDO paid above-market prices for a security, that
would advantage the hedge fund investors and disadvantage the CDO investors.
BSAM’s flagship CDOs—dubbed Klio I, II, and III—were created in rapid succes-
sion over and , with Citigroup as their underwriter. All three deals were
mainly composed of mortgage- and asset-backed securities that BSAM already
owned, and BSAM retained the equity position in all three; all three were primarily
funded with asset-backed commercial paper. Typical for the industry at the time,
the expected return for the CDO manager, who was managing assets and holding the
equity tranche, was between and annually, assuming no defaults on the un-
derlying collateral. Thanks to the combination of mortgage-backed securities,
