House of Cards (63 page)

McGarrigal responded to Cioffi's message by saying that as long as Cioffi was able to cut a fair deal with Stone Tower, he would support the Rampart deal. Cioffi responded, “I'll insist on it,” and then wrote, “I'm fighting hard to keep our entrepreneurial spirit and drive against the backdrop of the BSAM bureaucracy and regulations. I'm not arguing against all of that, I know it's required and it's smart but I want it both ways—conform but not compromise on what got us here.”

With the plan to launch Rampart coming together rapidly, Cioffi responded to Tannin's September 17 e-mail about liquidity concerns. “As far as liquidity, we have the repo on the Rampart equity and if my numbers are correct after [R]ampart we will have over $200 [million] of liquidity,” he wrote. “So unless we go into a full unwind [in] the short term, liquidity is not an issue. What we need to figure out is how to get the majority of our LPs into the enhanced [leverage] fund. That will take some time but once we do that we have an easy liquidity source and that's Barclays,” which had just agreed to provide a $400 million line of credit to the new Enhanced Leverage Fund. At least one plaintiff, suing BSAM, Cioffi, and Tannin, believed Cioffi's September 2006 e-mail to Tannin was evidence that they knew then that “the High-Grade Fund's longer-term outlook was so dismal that it could be alleviated only by transferring the majority of the High-Grade Fund's investors into the new Enhanced Leveraged Fund.”

I
RONICALLY, BACK IN
the spring of 2006, when Tannin and Cioffi were busy enticing Barclays to provide its $400 million loan to the Enhanced Leverage Fund, the two hedge fund managers did everything possible to convey to Barclays the safety of the structure and the investments. “We are more than happy to discuss with you credit and portfolio limits for the underlying portfolios as well,” Tannin wrote Barclays on April 6. “This way if there is measurable credit deterioration we can factor this in and reduce the leverage. I don't want to sound like a broken record but the value of this transaction lies in the transparency of credit information on high underlying credit quality assets. We have a lot of it and you can have it as often as you want. We'll even chew it up for you and give you customized reports. Look at the stability of the ratings in these portfolios.” On May 1, as the negotiations with Barclays were progressing, Tannin e-mailed his contacts at the bank to reassure them that the Enhanced Leverage Fund would not be investing in risky assets, in keeping with the investment guidelines that had been agreed upon. He described the “AA/
AAA assets” the fund would invest in as having “very very low volatility” and wrote that the new “enhanced” structure would “continue to operate [as did the High-Grade Fund] in the best parts of the capital structure,” “concentrate the ultimate exposure in the highest rated floating rate kinds of assets,” and “generate a prudent return for our investors which allows our portfolio managers and structuring team to concentrate on the areas in the market where there is the greatest liquidity and greatest value.”

By the end of September 2006, Cioffi was ready to consummate the Rampart deal, which he designed to accomplish three tasks: to sell the funds' “high-yielding, less-liquid positions,” to create a company that could be taken public and that would trade at a premium to the private market value of the securities, and to provide “a permanent capital vehicle that will have ongoing access to the capital markets.” Sixty percent of the management fees from Rampart would flow to Cioffi's funds. For a variety of reasons, including that Bear Stearns would be investing $25 million in Rampart and that Cioffi was selling assets to Rampart, the independent directors of the funds needed to approve the deal after hearing a presentation from a third party about the “reasonableness of the fair market value process.” The problem for Cioffi, as of September 29, was that the funds did not then have two independent board members, a sin of omission that was all of a piece with Cioffi's cavalier approach to the legal niceties of running a hedge fund. Once informed, Cioffi found “Gilmore and Gilbert”—their only identification in a Cioffi September 29, 2006, e-mail—and urged a colleague to “get them [named] official board members by Tuesday,” October 3, when the independent directors were to approve the deal. In a typical last-minute rush, the directors were certified and Cioffi's deal to create Rampart was approved. But there seemed to be little doubt that Cioffi and Tannin were already aware by the end of September 2006 that the market was drying up for the complicated mortgage-related securities they had invested in.

Not only was that quickly becoming a major problem for the performance of the funds themselves—fewer buyers than sellers inevitably meant lower valuations on the securities, which meant lower returns for the funds' investors—but the truth was that Cioffi and Tannin had advertised the funds to investors as a safe investment. “The High Grade Fund's objective was to provide a modest, safe and steady source of returns to its investors,” Cioffi and Tannin claimed, adding investors “could expect annual returns of approximately 10 to 12 percent.” The fund was not designed to hit “home runs”; rather, the idea was that it would be “only slightly riskier than a money market fund.” And this idea was reinforced in the performance statements that were sent to investors every month.

Month after month, Cioffi repeated for his investors his investment thesis. “It's a broken-record paragraph,” explained one of the investors in the funds, “that basically says, ‘The fund is 90 percent invested in AA and AAA structured finance assets and the goal is to generate spread through cash and carry transactions. We're expecting an economic slow-down. We think mortgage delinquencies are going to rise. We think there will be a reduced appetite for [residential mortgage-backed securities]. We are particularly concerned about the 2006 vintage. We are dialing down the leverage in the fund.’”

In an August-September 2006 commentary, Cioffi reported that the two funds' results for those months were positive—up 0.69 percent and 0.62 percent for the High-Grade Fund and the Enhanced Leverage Fund in August, respectively, and 0.99 percent and 0.96 percent in September—and that the outlook was for continued weakness in the housing sector. “As we've discussed in prior letters and calls, this is something we've been following very carefully,” Cioffi wrote. “Real estate has been driving the economy for the last few years and as the sector slows it will have a drag effect on the economy.” He wrote that the funds' “surveillance system monitors” would alert them “in advance” of any increase in “delinquency rates” and was “an early warning system” allowing them to “hedge those risks.” He reiterated his belief that “our risk is further mitigated in that the portfolio we own is primarily at the AAA, AA and A level. Our belief is that the riskiest mortgages are those that originated in 2006 and we have been very selective and only small buyers of that vintage.” Cioffi also announced to the investors the Rampart “repackaging vehicle” and his “intention to immediately begin the SEC registration process” for Rampart “with an offering timetable of 6—9 months.”

When this investor received his December 2006 statements, there was an outlook comment for 2007. “It said,” the investor recalled, “‘As we told you at the beginning of the year [2006], the market for residential mortgage-backed securities was going to be deteriorating. Mortgage delinquencies were going to rise. We've reduced our exposure from 55% down to 22%.' If you had eighteen months of these things in your hand, you would say to yourself, ‘This is my guy. He's calling for it. He's preparing for it, and he's either not going to get hurt by it or he's going to make a lot of money when the opportunity presents itself.' It's right there in print.” The December statement for the High-Grade Fund not only showed a return for the month of 1.22 percent, and for the year of 10.67 percent, but also showed investors that 67 percent of that fund's collateral was in asset-backed securities, with only 6.2 percent in subprime mortgages. The idea of trouble in the housing market was reinforced by a
December 2006
New York Times
article about an auction held in Naples, Florida, to sell quickly a number of homes. The auction results, the paper reported, “suggested that the houses at the auction had lost about 25 percent of their value since 2005.” David Leonhardt, the reporter, concluded the article with the prescient observation, “Over the last few decades, the world's financial system has endured a crisis roughly once every three or four years. There was the stock market crash of 1987, the Asian and Mexican meltdowns in the 1990s, the dot-com implosion of 2000 and, most recently, the aftermath of Sept. 11, 2001. We may now be living on both borrowed money and borrowed time.”

By January 2007, the statement said the High-Grade Fund had a return of 1.09 percent for the month and had 77 percent of its collateral in asset-backed securities. For February 2007, Cioffi reported to investors that the fund's net return was 1.38 percent and the collateral in asset-backed securities was an astounding 81 percent of the total, with subprime being 6.1 percent.

In his monthly commentary, Cioffi acknowledged February had been a rough month—for others. “February was a volatile month in the structured credit markets,” he wrote, “particularly in any credit associated with subprime mortgages. Over the course of February there were a number of failures in subprime originators as well as historically high levels of early delinquencies in subprime securitizations originated in 2006. The mass media carried many stories about potential disasters in the subprime market. The result of this was a rapid and severe widening in the subprime credit derivatives index which in turn led to a broad based widening of mortgage-backed assets up and down the capital structure.” The High-Grade Fund, though, was “well positioned for this spread widening” because of hedges “put in place over the second half of 2006.”

T
HE PROBLEM WAS
that none of it was true. Cioffi had not been avoiding residential mortgage-backed securities, as he had suggested to his investors on their monthly statements. Actually, he had done precisely the opposite and had started to load up on these toxic securities at exactly the wrong moment. Since he no longer was allowed to trade with Bear Stearns, the firm had no idea what he had been doing. “I don't think not being able to buy from us or borrow from us hurt them,” Paul Friedman said. “There were plenty of people willing to kill each other for Ralph's business. Careers were made from selling to Ralph and lending him the money to buy stuff. They had $14 billion of repo on when the balloon went up and had plenty of additional capacity. What hurt them was that once they stopped being counterparties of ours, no one on the dealer side
of Bear paid attention to them. Previously, the credit department evaluated them frequently and the mortgage-trading desk would wander in to see me from time to time if they thought Ralph was doing something odd. Once we stopped dealing with them, no one knew what they were up to.”

“T
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ARKET
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