House of Cards (62 page)

To minimize the ongoing failure of Cioffi's team to get the approvals in advance for related party transactions, Bear Stearns decided to place a moratorium on BSAM's ability to do transactions with the Bear Stearns broker-dealer and hired the law firm WilmerHale to determine whether any client had been hurt in the process (apparently not) and whether the firm needed to report voluntarily the violations to the SEC (apparently no need for that, either). “Because no clients have been harmed,” one senior BSAM executive said, “we fixed the procedures. We changed it. We shored it up. And [Cioffi] thought it would be fine.”

By September 7, the moratorium was in place. Alex Reynolds, yet another person hired by Cioffi to deal with getting the consents in a timely fashion, wrote Pusateri that the BSAM administrator had given the approval for a deal with Bear Stearns but then the head of Bear Stearns compliance “squashed it … until further notice, no trading with Bear again.” The moratorium on trading with Bear raised questions in the minds of Cioffi and Matthew Tannin about the liquidity of the High-Grade Fund, which had $1.527 billion of investors' money, including around $25 million from Bear Stearns itself and several million dollars from Cioffi and Tannin. Bear Stearns was one of the fund's largest trading partners, and now that no additional trading was possible, the liquidity of the securities in the fund was theoretically diminished. The other consequence of the moratorium was an end to the eye the Bear traders had been keeping on what Cioffi was doing, since he was a counterparty on their trades. “The trading desk that from time to time would go in to Warren, or me, or somebody else,” Friedman said, “and say, ‘Listen, are you aware of what Ralph just bought? You might want to look into this.' Spector had an informal understanding that the mortgage guys would keep an eye on Ralph. But now it was hands off. All the people who up until then would go in to Warren on a regular basis and say, ‘Look, Ralph is too highly leveraged. Ralph is doing this. Ralph's strategy doesn't make sense,' largely got backhanded and told to go away—but not entirely, Warren's not stupid—and were told, ‘Hands off. You have nothing to look at. He's not a customer. Leave him alone.' We slammed the wall down.” But even as late as November 2006, Cioffi was having trouble getting the message that trading with Bear Stearns was over. “I don't like to argue
with you but I was told that we are definitely not allowed any repos with Bear (PTL or not),” Pusateri e-mailed him on November 9.

T
HE “INVESTMENT PHILOSOPHY”
of the High-Grade Fund, stated clearly every month on investor return summaries, was to “generate total annual returns through ‘cash and carry' transactions and capital markets arbitrage. The Fund generally invests in high quality floating rate structured finance securities. Typically, 90% of the Fund's gross assets are invested in AAA or AA structured finance assets.” In 2004, the High-Grade Fund had a return (net of fees and other expenses) of 16.88 percent. In 2005, the net return was 9.46 percent. At the end of January 2006, after posting a net gain for the month of 0.86 percent, the fund had 30 percent of its collateral in “asset-backed securities,” which many investors assumed were either high-quality credit card receivables or auto loan receivables, and 15.2 percent in subprime residential mortgage-backed securities. At that time, Cioffi also raised the idea of a new “leveraged” fund “to better accommodate our investors who may be looking for higher return potential while staying within the [f]und's investment parameters.” He encouraged interested investors to call to “reserve capacity.” The idea for the new Leveraged Fund was to make investments similar to those of the High-Grade Fund, only using more borrowed money to buy them. In a March 2006 call with potential investors, Cioffi and Tannin suggested that the 9.5 percent return achieved in the High-Grade Fund for 2005 would have been more like 15 percent to 22 percent in the new Leveraged Fund, depending on the amount of debt piled on the assets. At one point, during an April 2006 call with a potential investor, Tannin was asked what the “perfect storm” would be for the Leveraged Fund. He responded, “The important point is that a perfect storm will not cause a liquidation of assets.”

Tannin also shared his views about what he and Cioffi expected the economic environment in 2007 to look like. He spoke of a slowing economy, interest rate “easing” by the Fed, and a widening of interest rate spreads. He said, “We are set up for wider spreads because we are short subprime and we are properly hedged.” He explained that people were worried about the 2006 vintage of subprime loans because of “looser underwriting standards” as a result of “no-doc loans,” “high loan-to-value ratios,” and a “large dispersion” of FICO scores. He said the High-Grade Fund “had avoided that vintage,” that it was “net short” mortgages issued in 2006, and that the “data does not support a nationwide real-estate bubble,” only “isolated pockets” of trouble. He said if 2007 was like 2006, the High-Grade Fund would return 10 percent to 11 percent and the new Enhanced Leveraged Fund would return at least 14 percent.

At the end of July 2006, the High-Grade Fund reported a net return of 0.83 percent and showed investors that 50.5 percent of the fund was invested in “asset-backed securities” (ABS) and 6 percent in subprime. “Despite the significant downturn in the housing market and deterioration in sub prime credit fundamentals overall structured credit spreads remained tight and the credit performance of the Fund assets remains strong,” Cioffi wrote investors. “And [we] have not seen any significant market price weakness in any of our particular asset sectors.” There had been a fair amount of confusion among the fund's investors about what types of securities were actually “asset-backed securities.” This subject came up on both the January 2007 and March 2007 investor conference calls. For instance, in January 2007, one investor asked Cioffi what specifically the assets were in the “ABS CDO” column on the monthly investor reports—except that the actual reports only said “ABS” on them, not “ABS CDO,” an important distinction that confused many of the fund's investors, to the point where in a meeting with one of them Tannin wrote “ABS CDO” above the column where “ABS” had been printed. The investor and Cioffi had a lengthy and sometimes confusing discussion, but there was little doubt from Cioffi's answer that there were subprime mortgages in the “ABS CDO” column. “I want to be very clear about the way in which subprime risk is embedded within the structures that we own,” he said. “We're not believers in the world-is-coming-to-an-end housing bubble scenario.” (According to the September 2007 congressional testimony of Kyle Bass, the managing partner of hedge fund Hay-man Capital—who made a fortune betting against mortgages and some say kicked off the run on Bear Stearns in March 2008 with a request to Goldman Sachs for a novation—the “ABS CDO” category was created sometime in the late 1990s and originally comprised numerous assets ranging from “aircraft receivables to mortgages” but that “by late 2003 ABS CDOs were comprised almost entirely of subprime mortgages.”)

By August 2006, “the [High-Grade] fund's performance had begun to decline,” according to the June 2008 indictment of Cioffi and Tannin. “In part as a response to this performance decline, and as a consequence of threatened investor withdrawals of money from the High Grade Fund,” the two men completed the launch—with the support of Warren Spector—of the second fund, known as the Enhanced Leverage Fund, which invested primarily in CDOs and “employed substantially more leverage” than the High-Grade Fund while promising higher returns but only “limited additional risk, in part because it would invest in an even higher proportion of the least risky securities. The increased profits would result from increased leverage.” On August 1, the High-Grade Fund was split
into two funds and 36.74 percent of the money in the High-Grade Fund, or around $560 million, was transferred into the Enhanced Leverage Fund. The
Financial Times
lauded the new fund since Cioffi “had a stellar reputation and Bear [was] a giant in the mortgage business…. The thinking was that if anyone could clean up on rising turmoil in the mortgage market, sparked by an increase in defaults by high-risk borrowers, it would be Bear Stearns and Mr. Cioffi.”

On September 17, Tannin was still concerned that the moratorium on trading with Bear Stearns could hurt the High-Grade Fund's liquidity, and he also worried about how the new Enhanced Leverage Fund would finance its positions. The next day, he wrote Cioffi, Pusateri, and Ray McGarrigal, another senior executive at the funds, with his thoughts on “what we have to do with our repo” situation. “I think we are under a clear mandate to eliminate repo with Bear as quickly as possible,” he wrote. “Changing prime brokers”—away from Bear Stearns—“is a possibility but one that is not immediate and one that comes with difficulties.” Tannin's best idea was to have a “certain amount” of unencumbered assets that could be financed away from Bear Stearns. He asked his partners for their thoughts, too.

On September 19, McGarrigal replied to Tannin that not being able to trade with Bear Stearns any longer could hurt the funds' investors. “Bear is #1 in [mortgage-backed securities] and in the top 5 of CDO issuers,” he wrote. Not being able to trade with the firm was “all bad for our investors. I think we should work hard to put in place all necessary compliance procedures to allow [us] to continue operating as we have to date.” But that never happened, and BSAM's moratorium on Cioffi trading with Bear Stearns remained in effect.

A
S IF ALL
of these machinations at Cioffi's hedge funds weren't confusing enough, he and his colleagues decided to complicate the situation further by creating a new entity—first called Rampart, and then Ever-quest Financial when the company filed an IPO document—to hold hundreds of millions of dollars of less liquid CDOs from the two hedge funds. By selling the illiquid securities to this new entity, Cioffi's hedge funds would be able to raise cash in a creative way from the market. The for-profit Rampart would manage the portfolio for a fee. And the hedge fund's investors would also benefit from their ownership stake in Rampart when it went public in an IPO to be underwritten by Bear Stearns. Cioffi's partner in Rampart was Stone Tower, a $7.7 billion hedge fund focusing on structured credit securities.

Rampart bought the CDOs from Cioffi's two hedge funds for $548.8
million: 16 million shares of Rampart stock, valued at $25 each, and $148.8 million in cash. But even McGarrigal and Tannin had serious questions about the efficacy of the Rampart deal and raised them with Cioffi. In a September 5 e-mail to Cioffi and Tannin, McGarrigal worried that the securities being sold to Rampart “are arguably the best things we've owned” and had “given our investors a tremendous bang for the buck.” He also worried that the hedge funds were giving up a portion of their management fee on those securities to Stone Tower and that the assets would be managed differently than they had been to date.

In his response, Tannin said, “I too have concerns” about Rampart. “We are putting a lot of very big eggs in one basket, including our ‘signature egg.’” Tannin also worried about Rampart's “liquidity and permanent capital. Do we know if there are any special disclosure rules we'd have to make were we to want to sell shares? I am worried that any selling by us would raise questions in the minds of other shareholders and create the potential for price volatility. I know from Newcastle”—another publicly traded real estate investment company—“that investors want to know that management has their money in the deal. This seems at odds with our hope that [Rampart] will provide greater liquidity to the hedge fund. Our hedge fund would be completely exposed to public market volatility. If we were to have a problem in just one position that affected a distribution, we face unknown price action.”

In an e-mail the next day, Cioffi responded to his colleagues that they raised good questions, “and God knows I've questioned this transaction a dozen times in the past 3—6 months.” But he saw more benefits than concerns. Among them were “increased liquidity to our [hedge funds] from the injection of $200M of cash and reduction in CDO equity positions.” Then, he wrote, there was “significant upside from the IPO in the form of liquidity and mark to market gain.” Cioffi wrote that the bankers at Bear Stearns believed the funds' stake in Rampart would immediately be worth 20 percent to 30 percent more than Cioffi had paid for it, which he figured could add four to five percentage points to the funds' returns during the next year—a significant bump. He also was sure there was “significant upside to our [hedge fund] in the form of risk free [asset management] fees” paid to the hedge funds as Rampart grew; he pegged it at $5 million a year “if the IPO raises $400M.” Finally, in a jargon-filled piece of banker gobbledygook, he wrote that the Rampart deal would allow the hedge funds to create a $140 million less-risky CDO-squared from a number of riskier CDOs that were harder to finance in the repo market. “We are a structured credit fund and we marketed ourselves as a fund that would engage in capital markets arbitrage, here is one of the
better arbitrages I've seen in a long time so Matt I think our investors will appreciate the transaction and will trust our judgment.”