House of Cards (3 page)

F
OR ANYONE WILLING
to listen to Sedacca in early March, the price of the credit default swaps for both Bear Stearns and Lehman Brothers was broadcasting a potentially catastrophic liquidity problem similar to that faced by Thornburg, Peloton, and Carlyle: Both Bear and Lehman had, respectively, approximately $6 billion and $15 billion of unsalable Alt-A mortgages on their balance sheets. Others, such as John Sprow, a bond fund manager at Smith Breeden Associates in Boulder, Colorado, had noticed that the Bear Stearns swaps “were off in a world of their own,”
and by January were twice the cost of similar protection that could be bought against the debt of Morgan Stanley, and four times that of insuring the debt of Deutsche Bank.

“Enter Lehman and Bear Stearns,” Sedacca continued in his March column. “Lehman reportedly has two times [its] capital in CMBS”— commercial mortgage-backed securities—“and nearly five times [its] capital in ‘hard-to-price' securities. Hard-to-price in my book equates to hard to sell…. Bear Stearns is actually in worse shape. It has irritated so many clients that its business model is broken. What would happen if you told it to sell its ‘hard-to-price bonds'? The company couldn't. No one has the balance sheet to absorb it. So you can see the vicious cycle developing.”

Sedacca explained how the cost of insuring the obligations of Lehman and Bear Stearns—the credit default swaps—had increased dramatically in a month. Insurance for the Bear Stearns obligations cost more than those for Lehman, meaning the market thought the risk of default for Bear was higher. The insurance premium for the Bear debt, which had been $50,000 per $10 million of debt for the first half of 2007 and then crept up slowly, had spiked up to $350,000 per $10 million of debt by March 5. “In my book, they are insolvent,” he concluded. “I feel bad for all my friends that work there, but I did the Drexel Burnham stint and I saw my stock go to zero. Yes, it can happen. Quickly.” Sedacca seemed unconvinced by Bear's announcement the day before, on March 4, that it would release its first-quarter 2008 financial results on March 20, which would show the firm had “available liquidity” of $17.3 billion and had made a profit for the quarter of $115 million, a turnaround of sorts from the first quarterly loss in its history, $857 million. (In the previous year's first quarter, the firm had earned $554 million.) Nothing
seemed
amiss at Bear. But some inside the firm were very scared indeed.

T
HE
C
ONFIDENCE
G
AME

hile Sedacca proselytized from a Florida strip mall, Tommy Marano, Bear Stearns's top mortgage trader, then forty-five years old, had a feeling of impending doom. Marano was at the center of the engine that had powered the firm's success during the previous
twenty-five years, generating upward of $2 billion of the firm's $9 billion in revenue in recent years. He was sitting on the sixth-floor trading room at Bear Stearns's sleek new $1.5 billion corporate headquarters at 383 Madison Avenue, in Manhattan, in the left ventricle of metaphorical Wall Street, which had long before moved to various Manhattan locations—mostly in midtown—away from the real Wall Street.

Not wanting to telegraph his concern about Bear Stearns into the market but anxious to determine whether his concern was well founded, at eleven in the morning on March 6 Marano placed a phone call to Roddy Boyd, then a writer at
Fortune
. Marano had been a source of Boyd's for years, when the journalist was covering Wall Street at the
New York Post,
and had freely offered commentary about his competitors and the markets generally. Boyd had been a trader for eight years before switching careers to journalism, and the two men spoke the same language. “I know the mortgage product dead cold,” Boyd said. Their relationship was a well-defined
pas de deux
. “It was unusually well defined,” he explained. “We knew exactly what we were saying. I could have a very long conversation in two minutes. I protected him always. I never BS'd with him. I never got him in hot water. The corollary was he never BS'd with me, and he would give me good stuff.”

This time, Marano called Boyd to talk about Bear Stearns, and specifically about his concern that the firms he had traded with for years were suddenly asking him whether Bear had enough cash on hand to execute his trades. “He called me at 11:00
A.M.
that day and we talked about one or two things,” Boyd continued. “It was weird. He knew it was weird. We did small talk in under ten seconds. I said to him, ‘What's up?' He said, ‘What are you hearing about Bear?' I said, ‘You know what I'm hearing and you know what I'm seeing.' He said, ‘I know what you're hearing and you're seeing. It's just baffling.' Now here I'm playing him a little because I'm hearing things and I'm seeing some things, but he's not saying much more than I am, so I let him walk and talk. He said to me, ‘Roddy, our guys, our senior guys here, are hearing a really strange thing from custies.' That's customers. He said, ‘We were not prepared to hear stuff like this. This is baffling. People are quite literally questioning our solvency, questioning our ability to go on. The shorts are having a lot of fun with us today.’”

Since Wall Street is a confidence game as much as anything, for counterparties on routine trades to start asking pointed questions about things as fundamental as cash and liquidity is not likely to be good for business. “What he meant,” Boyd continued, “is that the shorts are putting out rumors about Bear Stearns, and eventually their bigger customers
are saying, ‘If I sell this big block of securities or derivatives to you, can you clear it or is this coming back at me in three days in distress?’” These kinds of questions are serious for traders and their firms, because if a firm you are trading with has financial problems and those financial problems cause it to need to raise cash quickly, the trader may have no choice but to sell into the market the securities just purchased at a lower price, forcing other firms holding a similar security to adjust the value of that security to the lower price. This is called “mark-to-market,” a source of great consternation on Wall Street throughout the financial crisis.

“Do you understand the reason that would be so horrific for a customer?” Boyd continued. “Because if you sell something at 95—say, half of your position—and you sell it to a guy who's in trouble economically and he has to puke it back out in five days at 81, the second half of your position, or securities like that, have to be legally marked starting around 81. That's your new value conversation. Traders who do that stuff just as a course of business are despised…. That's what customers are saying to Marano, and Marano said, ‘I cannot imagine.' This is like me questioning your mental health.

“He's thinking two things,” Boyd continued. “One, he's got to stop this whole line of inquiry right here, right now, because if you have to ask the question, oh my God. Second, he's thinking about the trajectory of rumor and supposition, and that thesis of smoke versus fire. He's thinking that people are going to have a lot more hesitancy to trade mortgage-backed securities. Volumes are already drying up. Trading flows are already slowing down sharply. It's already hard enough to get your average trade done. With a question of their ability to act as a counterparty on the table, that's unimaginable. I mean, this is Bear Stearns. This is a company that was regularly making $6.00, $7.50, $8.00 a share in profits, and then these guys are making $25 million to $30 million [annually in salary and bonuses]. Now they're being questioned from the standpoint of fundamental liquidity. He said that he believed that these short sellers had been speculating in the credit default swap market and telling counterparties at other firms that they had concerns about Bear Stearns's liquidity and solvency, and that was driving the cost of spreads wider. What that was doing was making their overnight funding more expensive. That was cutting into their profit margin, and in turn was also starting a sort of a cottage industry of rumors about Bear Stearns.”

Although the two men spoke for about fifteen minutes, the import of the call was clear immediately. “‘There's no need to explain anything between us,' he said. I said, ‘Are you sure you're seeing this?' He said, ‘Look at [the credit default] swaps.' So I looked them up and then I see
the hockey sticks”—a sharp spike up in their cost, as Sedacca wrote. “He said, ‘It's unbelievable. It's all bullshit.' At that point—he's very much a corporate guy—but he had left me [with a clear message]. I'm not stupid. Hedge funds and prime brokerage accounts are unusually skittish about questions of financial health, financial solvency, and he said, ‘I'm hearing there's questions about our financial health.' At that point, Marano is telling me he knew he was done, because once that question of credibility goes out there, and serious people say it to you enough, you're done. It's all that there is to it. It's all that there is to it. Where do you go to get your reputation back?”

Concern was spreading beyond the granite walls of 383 Madison Avenue, too. On Bear Stearns's Yahoo message board, someone using the name “rutlando” wrote of these fears on the afternoon of March 6: “Funding costs surging. Way overleveraged—33 to 1. There was no shrinkage in the balance sheet between the last two quarters…. Bear has $320 billion in debt. BSC is insolvent!!!” By 2008, the Yahoo message boards related to individual publicly traded companies had become a popular venue for anonymous venting. Their wisdom is best taken with a healthy dose of skepticism, as biases or the depth of research upon which conclusions are reached is rarely disclosed. Still, the running commentary does provide a real-time oral history of sorts. “The mighty Bear Stearns is finished,” wrote “bwhal40er” after the market closed on March 6. “The SEC will be relieved.” That night on
Mad Money,
his manic CNBC show about investing, the hedge fund manager Jim Cramer said of Bear Stearns: “The brokers have been killing us. At $69 [a share], I'm not giving up. I think it's a good franchise, but it's going to be a rocky ride.”

F
OR YEARS
B
EAR
Stearns had been among the leading underwriters of mortgage-backed securities, even going so far as buying firms that originated mortgages to the less-than-creditworthy so that it would have a ready source of mortgages to package up and sell in bulk to the market. Bear also was a big holder of the Alt-A mortgages (theoretically of better credit quality than subprime mortgages) that UBS's February 14 decision had made less valuable for everyone. Bear Stearns had also been a lender to Carlyle's hedge fund, Peleton, and Thornburg. Bear's net exposure was minimal, although that may have been of little consequence. Then there were the rumors in the marketplace that Marano and Boyd had been discussing. “It really didn't impact us,” explained one Bear Stearns executive. “But people probably assume that between the lending we had to them and the fact that we owned other assets similar to what they owned and what the impact must be on their mark-to-market value, we were
going to have another wave of issues, which may have been true. I don't know. [With] those three firms all going bust in a short period of time, the next week started to trigger the customer flight.”