Bear Stearns CDO liquidation sparks contagion fears

By Walden Siew and Al Yoon

NEW YORK (Reuters) - Even as Bear Stearns held out hope of keeping two hedge funds from collapsing, worries over their forced liquidation are reverberating through U.S. financial markets, raising concern about broader contagion.

So far the risks seem contained, but the fallout may be felt everywhere from leveraged buyouts, investment bank earnings and sales of collateralized debt obligations. Those securities have pushed sales of corporate and housing-related debt to record highs in the past year.

Merrill Lynch & Co. (MER.N: Quote, Profile, Research) on Wednesday sold only $100 million of $850 million of highly rated collateral assets it auctioned after seizing them back from the Bear Stearns funds, said a person familiar with the auction.

Three other banks -- Goldman Sachs Group Inc. (GS.N: Quote, Profile, Research), JPMorgan Chase & Co. (JPM.N: Quote, Profile, Research) and Bank of America Corp. (BAC.N: Quote, Profile, Research) -- have closed out their positions with the funds.

High-grade CDOs trade infrequently because of their perceived safety relative to lower-rated securities that provide higher yield for investors. It might be difficult to sell such a large quantity, dealers and investors said. The concern is that a generalized markdown of CDO positions could be inevitable and spark a greater wave of selling.

"The problem is that marking down the assets to where the market will bid them may in fact be the right thing to do, but no one wants to take the loss," said Jason Brady, who helps manage $4 billion in bonds at Thornburg Investment Management in Santa Fe, New Mexico.

Details about Merrill's auction and efforts by Bear Stearns to offer $2 billion of CDOs were not immediately clear as possible buyers determine how to value the complex CDOs.

Some fund managers speculated the failure to sell the assets as intended indicated the dealers were largely disappointed with what they saw.