House of Cards (6 page)

A
T ABOUT THE
moment when CNBC was reporting on the Bear Stearns rumors, Geithner and Ben Bernanke, chairman of the Federal Reserve Board of Governors, were hosting a long-scheduled luncheon in the win-dowless Washington Room on the thirteenth floor of the New York Federal
Reserve Bank, at 33 Liberty Street in lower Manhattan, for the CEOs or senior executives of nearly every important Wall Street firm. It was an august gathering of Wall Street's most powerful men. In attendance were Lloyd Blankfein, CEO of Goldman Sachs, Richard Fuld, CEO of Lehman Brothers, Jamie Dimon, CEO of JPMorgan Chase, and Robert Rubin, the former Goldman CEO and U.S. Treasury secretary who was then chairman of the executive committee at Citigroup. Also in attendance were, among others, Steve Schwarzman, CEO of the Blackstone Group, Kenneth Griffin, CEO of Citadel Investment Group, and Stanley Druckenmiller, CEO of Duquesne Capital Management. Alan Schwartz, Bear Stearns's CEO, was not there. Nor was he invited. He remained in Palm Beach, at the Breakers, hosting the firm's annual media conference.

One would think such a meeting would be the perfect opportunity to share frank concerns about the credit crisis then engulfing the financial markets. Some of that did occur. But there were “no surprises,” according to one participant, even though there was a spirited discussion of the increasingly worrying events, including the causes of the crisis, what else could possibly go wrong, and who or what was to blame. But a room full of alpha males apparently was not the setting in which to bare one's soul. “These guys don't complain,” said one of the attendees. “They would never in that context express weakness or concern about themselves. You can imagine you're sitting around the table with a bunch of predators and you'd never do that. But I would say people were very, very nervous about the world. So there was a lot of talk about what the system was vulnerable to.” No notes are kept of such meetings, and the general rule is never to speak about what happens there or who said what to whom.

A few hours later the indefatigable Gasparino reported on his conversation with Sam Molinaro, the longtime chief financial officer of Bear Stearns who had recently been promoted to be the firm's chief operating officer. Molinaro was at a total loss to explain what was going on. “The rumors about Bear's inability to make margin calls and its illiquidity are completely false,” Gasparino said Molinaro told him. “Why is this happening? I don't know how to characterize it. If I knew why it was happening, I would do something to address it. I've spent all day trying to track down the source of these rumors, but they are false. There is no liquidity crisis. No margin calls. It's all nonsense.”

Once again, the denial of liquidity problems by a Bear Stearns senior executive did nothing to quell the concerns, especially since competitors knew full well that cash was draining out of the firm, as it had to make good on its hedge fund clients' legitimate request to get back their freecash
balances. The cost of Bear's credit default swaps moved up again. And the option volume that Pisani alluded to was in fact skyrocketing. Starting March 11 there were 79,000 March $25 put contracts traded, 20,000 April $20 puts traded, 3,700 April $22.50 puts, and 8,000 April $25 puts. Not surprisingly, very few call options—the right to buy Bear stock—traded at these prices.

Steven Smith, a columnist for
TheStreet.com
, focused on the fact that on Tuesday, with Bear Stearns stock trading at around $65 per share, more than 55,000 put contracts betting that the stock would fall to $30 a share by March 20 were bought and sold. “So that left only ten days for some event to occur that would cause these puts to go into the money and have some value,” Smith wrote. “So it appears that as rumors began swirling early in the week that Bear was having liquidity problems and might possibly be bordering on insolvent, someone took that to heart and bought the puts as disaster insurance.”

Whether Molinaro knew it or not—and he certainly should have known—Bear Stearns's trading partners across Wall Street, the firm's counterparties on trades and overnight funding, began to seriously question the wisdom of continuing to trade with Bear or to accept its collateral as security for overnight funds. At 5:06 on the afternoon of March 11, Stuart Smith, a trader at Hayman Capital, a Dallas, Texas, hedge fund, sent an e-mail to Goldman Sachs's credit derivatives desk in New York asking Goldman to “please novate”—or take over Hayman's position on—a February 2007 $5 million derivatives trade between Hayman's Subprime Credit Strategies Fund and Bear Stearns. In other words, Hayman wanted out and asked Goldman to take its place on the trade with Bear Stearns as the counterparty. About forty minutes later, the Goldman desk wrote back, “GS does not consent to this trade.”

The message this left with Hayman Capital was a profound one. No less than the mighty Goldman Sachs had told one of its hedge fund clients that it would no longer act as a stand-in for it on trades with Bear Stearns. During the previous weeks, Goldman had been willing to provide this service—at a price—as its clients became increasingly nervous about Bear's ability to honor its obligations. Late in the afternoon of March 11, Goldman apparently no longer believed the risks equaled the reward. And the firm told that to at least two of its hedge fund clients. “I was astounded when I got the [Goldman] e-mail,” Kyle Bass, of Hayman Capital, told Boyd at
Fortune
. Bass, a former Bear Stearns salesman, checked with a friend at Goldman to see if the e-mail had been sent out in error. “It wasn't,” Bass said. “Goldman told Wall Street that they were
done with Bear, that there was too much risk. That was the end for them.” As the manager or co-manager of hedge funds in Dallas with $4 billion that had bet—correctly—that residential mortgage-backed securities would lose value, he had testified before Congress in September 2007 about the growing credit crisis: “It is becoming increasingly clear as each month passes, subprime credit has become the mad cow disease of structured finance. Nobody knows who consumed the infected product.” Bass was a heavyweight in the market and made a killing when the mortgage market crashed. “When that got out, that's when the unbridled selling started,”
Fortune
's Boyd explained.

Maybe so, but Goldman's decision at that moment not to take over Hayman's position was only half the story. While certainly Goldman's decision not to immediately novate Hayman's trade sent a message that Hayman interpreted as concern—and, given the rest of the swirling rumors and bets being made against Bear Stearns, it is not hard to understand why he did—inside Goldman, Hayman's request was unusual enough and the rumors about Bear Stearns's liquidity position were credible enough that Goldman decided to “escalate” the decision, bringing it to the attention of Gary Cohn, the co-president of the firm, and his partner, David Viniar, the Goldman CFO. Cohn's concern was actually the opposite of Hayman's reaction, since he was worried that if Goldman took over the Hayman trade with Bear Stearns, the market would get the message that a large hedge fund did not want to wait around and see if Bear Stearns made good on the money it owed Hayman on this particular trade. “The reason we didn't take novations is because we had conversations with the senior leadership of Bear Stearns and said, ‘If we start taking novations, people pull their business, they pull their collateral, you're out of business,’” Cohn said. Indeed, Goldman's view was that the best way to keep these firms in business was to force clients to do business with them and force them to keep trading. For that reason, Cohn said, he had considered not novating the Hayman trade.

The argument may seem counterintuitive, but not to Cohn. “Look, I need these guys to survive,” he said of his competitors. “I just said to someone, ‘We all live in the same neighborhood. Right now, I'm the only guy that's got a nice house. My gutters are attached. My windows aren't broken. My shutters are on. But the house to the right and the house to the left, broken windows, shutters. So it doesn't matter how nice my house is. It's worth less than if those houses are nice. So I need to help them, and it's better for my industry to make sure their houses at least look good from the outside.' The last week of Bear Stearns's existence, we
were working on it to try and help them and buy assets from their balance sheet. We were there to be helpful. We weren't looking to take advantage. We were looking to be helpful.”

Cohn asked Schwartz that night if Bear wanted Goldman to take over the Hayman trade. In other words, Goldman would assume the risk that Bear Stearns would pay the money owed. “Now, no one ever wants to tell you to novate a trade,” Cohn said, “because basically, when you novate a trade, the person that asks for the novation, when it's a credit novation, has basically said, ‘I don't want to do business with you anymore.' So if we don't novate the trade, the client's only other alternative is to go back to you and trade with you.” In this case, Schwartz told Cohn that Bear was actually looking to settle the trade and said it was fine to novate the trade.

The next morning, just after nine, Goldman sent Smith at Hayman a new e-mail: “GS would like to consent to the trade” with “details to follow.” And then Goldman sent Smith one more e-mail a few hours later. “GS consents to the novation. Please see trade details below.” Just like that, Goldman had taken Hayman's place in the trade with Bear.

But that seemed like a lifetime of waiting to Hayman, which had wanted immediate service and did not get it. “All he knew was we couldn't do it instantaneously,” Cohn said of Hayman. “All he knew is he picked up the phone to his sales guy, and his sales guy, every time he talks to him, says, ‘Anything I can do for you today? How can I help you?' He calls up and says, ‘Here's how you help me today. I want you to novate this trade.' The sales guy goes, ‘Okay, let me see if I can get that done.' Hangs up the phone. The sales guy goes running. ‘Hey, I need to novate this trade.' Everyone's like, ‘Whoa, hold on a minute. It's a Bear Stearns novation. Let's elevate.' And eventually it ends up in my office. It takes us twelve or fourteen hours to make a decision and have the conversations whether we want to do that or not. Meanwhile, Hayman Capital is going—every hour that goes by—he's going, ‘Oh, my God. Am I not going to get paid? Am I not getting paid? If they won't novate this, things must be worse than I even think. I want out quicker.' It's just an avalanche of brain waves that go off that allow people to panic.”

Cohn said Goldman was doing “nothing different than everyone else out there” but that whatever he did in that particular circumstance became “a double-edged sword.” “I've got my client franchise over here that I'm trying to protect and do what they want,” he explained. “I've got my equity shareholder base over here that I've got a fiduciary responsibility to protect at all costs. We are trying to do what's best for both sides of
this equation all the time. Clearly, novating everything instantaneously was best for my client base, because they were going to love me. Right? They could call instantaneously and know they could get rid of 100 percent of their credit risk. My shareholders over here would have said, ‘You're fucking crazy. Why are you guys taking credit risk without making money?' See, when I take credit risk from a normal client, they're paying me a bid/offer spread. When you're novating, you're stepping into someone else's shoes. You get paid no money to do that. So that's why you usually do it when it just nets you down and offsets, because you've made your money on the other side of the trade. So my shareholders on this side and my employees would be going, ‘Why are we taking all this credit risk?' So you balance the client needs versus the firm's needs and the shareholders' needs. And that's never, never a simple equation.”

(Soon after Boyd's
Fortune
article appeared on March 28 with the news of Goldman's e-mail to Bass, a Goldman Sachs spokesman disputed the implication that Goldman had stopped acting as counterparty for Bear Stearns and therefore had helped fuel the firm's liquidity problems. “We received a request to novate the trade [from Bass] late in the day on Tuesday, March 11, escalated it for a decision consistent with our normal procedures when an increase in credit exposure is requested, and agreed to the novation the next morning,” Goldman said. The firm further criticized Boyd for telling only half the story—that Goldman had refused the trade—and not that Goldman had accepted it the next morning, albeit at a higher cost of execution.)

The rumor quickly spread in the hedge fund community that Goldman Sachs was finished with Bear Stearns. The damage to Bear in the marketplace was substantial. “That was just one of many e-mails,” said Paul Friedman. “There were internal memos at Goldman. There were internal memos at Credit Suisse. There were internal memos at JPMorgan. Various flavors of how to deal or not to deal with give-ups generally, assignments generally, or Bear generally. Everybody was trying to figure out, in fairness, what to do with the assignments that they were getting…. By Tuesday afternoon, they were starting to increase. In fairness, the credit default swaps assignment process is extremely manual. It's extremely cumbersome. Firms didn't really have a handle on what their risk was to us, let alone what to do with new assignments of trades coming in over the transom. For a firm to put the brakes on dealing with us—if I were the credit guys, was it done for the right reason? I don't know, but it doesn't surprise me. We were putting out fires every day, all day every day, for firms that wouldn't take assignments, or wouldn't take our name in
the foreign exchange markets, or wherever, either localized within departments or at the corporate level. I'd have done the same thing.”