House of Cards (64 page)

f Paul Friedman had no idea what Cioffi was up to in his hedge funds, it was a pretty good bet Jimmy Cayne had no idea, either— not that the CEO of a major Wall Street firm would be expected to know what was in the portfolio of a hedge fund in which the firm had a relatively tiny $20 million investment. Still, the firm's financial performance had been nothing short of dazzling. Through the nine months ended August 30, 2006, Bear Stearns had earned nearly $1.5 billion, more than the $1.46 billion the firm made for
all
of 2005.

In September, the firm decided to reorganize a number of departments—among them equity derivatives, clearing, and stock trading—and have these businesses report to Spector. The reorganization made it appear that all of equities reported to Spector for the first time, effectively giving control of 90 percent of the firm's income statement to him. The rank and file wondered how Schwartz had allowed that to happen. “Some people came up to Schwartz after that meeting,” a Bear senior managing director recalled, “and said, ‘Whoa, Warren's taking over.' He said, ‘Nothing's changing, guys. We just needed to get that in one place.’” After that announcement, the idea that Spector was Cayne's heir apparent began taking on renewed momentum. “The heir apparent and all that kind of stuff, he liked that,” one Bear executive said of Spector. “If he couldn't be CEO, he wanted the world to know that Jimmy was the figurehead and he was the profit machine. He also wanted to outperform. He wanted to have a good quarter and have the stock go up so he could be even wealthier.” The firm's stock had been on a tear, soaring to around $150 per share by November 2006, making Cayne a billionaire, a fact celebrated by
Forbes
in its annual list of the country's four hundred wealthiest people. In 2005,
Forbes
ranked him number 384, with $900 million, and a year later, he was number 354, with $1.1 billion. The bulk of Cayne's growing wealth was tied to his 6.8 million shares of Bear Stearns stock. In fact, by the end of 2006, Cayne was the
only
billionaire CEO among the titans of Wall Street securities firms—a fact that put an extra swagger in his step not because of what he could afford to buy that his brethren could not, but rather because of the fact that a college dropout and self-made man had bested the lot of them doing it his way. Thanks to
Forbes
and Bear Stearns, the memory of Cayne the mutineer during the Long-Term Capital Management debacle seemed a distant one.

Accordingly, it was not particularly surprising that in November 2006
Institutional Investor
made Cayne the subject of a lengthy cover story in the magazine. Along with recounting the firm's ongoing financial successes, the article also raised the question about whether the firm's huge investment in the mortgage-backed securities business would make it vulnerable when home sales inevitably fell along with the houses' value. The article's author, Pierre Paulden, noted that after the firm's $26 million purchase of Encore Credit Corporation, a subprime mortgage originator, and the 2005 initiation of Bear Stearns Residential Mortgage Corp., which originated mortgages in twenty-nine states through a (now defunct) Web site,
Beardirect.com
, the firm originated 31 percent of the loans it securitized in the third quarter of 2006, almost double the amount it had originated a year earlier. Bear also owned EMC Mortgage Corporation, a loan acquisition and servicing operation. The idea of these small acquisitions was to become a fully vertically integrated mortgage factory capable of originating mortgages, servicing them, packaging them into marketable securities, and selling them off. “Until lately, Bear has been running downhill,” Paulden wrote. “But now the playing field is starting to tilt upward.” He noted that the housing market was cooling off, with mortgage originations in the United States falling to $2.4 trillion in 2005 from $2.7 trillion in 2004, with a further 15 percent decline expected for 2006. “When the mortgage industry comes down, it comes down relatively hard,” said Richard Bove, then an analyst at Punk, Ziegel & Co. “If housing gets as weak as I think it will, the mortgage business won't be a contributor to their earnings. It will cause some deterioration in their results.” But Spector—the “fixed-income guru,” Paulden called him—remained confident. “We are not afraid of a bear market,” he said. “We've gained market share in these cycles.”

With Bear's stock now trading in excess of the four times book value that in 2000 Cayne had told Guy Moszkowski he would sell the firm for,
there was the inevitable question about whether the time had come to look for a merger partner. Paulden suggested that Bear Stearns “would be the perfect target” for JPMorgan Chase, which wanted Bear's prime brokerage and mortgage securitization businesses. “It could be a marriage made in heaven,” said research analyst Brad Hintz. Bruce Sherman, the big Bear shareholder, predicted it could go either way. “It's the right size for buyers, and if they were to put up a sale sign, I'm sure they would get a nice price,” he said. “But they've proven they can operate just fine in this environment.”

Cayne hated the article. For what must have been sport, he had Spector write a letter to the magazine in an effort to get Paulden fired. Cayne objected to a few minor errors that Paulden had made—for instance, reporting that Cayne dropped out of Purdue after two years instead of leaving one semester shy of a degree, and reporting that he crashed his car as a traveling salesman before he got married for the first time instead of after he got married.

Regardless of Cayne's nitpicking, there was no stopping investors' love affair with the Bear Stearns juggernaut. On January 17, 2007, the stock reached its all-time intraday high of $172.69 per share. At that moment, Cayne's 7.03 million shares of Bear Stearns alone were worth $1.2 billion. When he traveled around, mostly to bridge tournaments, it was by private jet or by helicopter. He had built a shingle-style palace in Elberon, New Jersey—this was where he took the helicopter on Thursday afternoons, often having it land near the first golf tee at the Hollywood Golf Club, in Deal, New Jersey—and was looking around for a bigger apartment with a more prestigious address in Manhattan. He seemed to be genuinely revered by many inside 383 Madison and grudgingly respected outside of it for his flinty ability to preside over such an impressive creation of wealth. After all, as the cliché goes, on Wall Street, wealth was the ultimate way to keep score. The other members of the executive committee were also not shy about accumulating and displaying the touchstones of wealth. Spector, also an aficionado of private jets, had his summer estate in Martha's Vineyard and his winter estate in Palm Beach, which he bought in 2001 after falling in love with the Spanish-style five-bedroom home. For daily use, he had a duplex apartment at 40 Fifth Avenue, at the southwest corner of Fifth Avenue and West 11th Street.

Like Cayne, Spector wanted a bigger place in Manhattan. In November 2006 he signed a contract for $33.148 million to buy a 55-foot-wide, 15,000-square-foot mansion around the corner from 40 Fifth Avenue. Unlike Cayne—and most other Wall Street executives—Spector was not the Upper East Side type. He had
moved downtown in 1985. He'd married an actress and was devoted to the Public Theater, of which he became chairman of the board in July 2005. By his own admission, he was neither a hip guy nor one who aspired to a
Town
&
Country
lifestyle. Indeed, he was a serious worrier, who bit his fingernails down to the quick. He was also plenty rich, having sold hundreds of millions of dollars' worth of Bear Stearns stock in 2005 and 2006 after Cayne forced the changes in the CAP. He even contemplated leaving Bear Stearns in 2006 as he came to the realization that his influence was waning and that Cayne had likely blocked his path to the corner office. “He used to joke that he didn't know who would last longer at the firm, him—who was in his forties—or Jimmy, who was in his seventies,” said one of Spector's colleagues.

In short order, both Cayne and Spector would have their King Lear turn. “I really do believe that ironically one of the things that hurt the firm most was that the stock price did so well,” said one former senior executive at the firm. “It emboldened Jimmy to stop listening, and that was the only thing he was really good at. He would listen. On the way up, he would always listen as he consolidated power. He always knew what was going on from a political point of view. When he got on top, he thought more about consolidating his power rather than leading. He started to rely on weaker people—for instance, Sam Molinaro, who was over his head. He was a fine controller and a good CFO, but he was also trying to be the risk manager, the business leader. Ace hated him: ‘Who is this dumb fucking accountant telling us what he thinks?' I thought Molinaro was a very valuable guy if you could get him to do the things he was good at. But Ace would say, ‘What the fuck does that stupid accountant know?’” For Spector, the turning point came when Cayne terminated the CAP and, in a fit of pique, Spector sold most of his stock at $100 per share, a decision made all the worse by the fact that the stock was now around $170 per share. “Now he's thinking he left money on the table, which pissed him off,” one Bear Stearns executive said. “So now it was just more … that he could shoot for the upside without taking as much downside risk as when he had his whole net worth tied up in the stock. That should have been an obvious signal to us that something had changed in him. Because when you know a guy like Warren is totally financially motivated, you should say to yourself after he sells so much stock, ‘Wow, that's a big change.' Instead, what you do sometimes is run it through another filter and say, ‘Well, he's still Warren, he's still got plenty of stock.' But in a guy who's very, very methodical and mathematical about things and just intuits them like a computer, that was a big change.”

J
UST WEEKS AFTER
Bear Stearns's stock hit its all-time high on January 17, cracks began appearing in the dam that held back the tidal wave of leverage pounding against it. On February 7, New Century Financial Corporation, a publicly traded twelve-year-old real estate investment trust that was a major mortgage lender (especially to borrowers with inferior credit ratings), announced that it had not properly accounted for home mortgages it had bought back from borrowers. As a result, its earnings for much of the previous year had been overstated and it had canceled its earnings call for the next day. The company's stock fell 37 percent, to $19.24, a fifty-two-week low. The same day HSBC Holdings, the huge European and Asian bank, announced it was increasing its provision for failed mortgage loans, and Toll Brothers, the big home builder, announced that its future economic outlook was diminishing rapidly.

Two days later, the
New York Times
wrote a flattering profile of Tim Geithner, the president of the Federal Reserve Bank of New York, titled “Calm Before and During a Storm.” The substance of the piece was Geithner's increasing concern about the massive—then $26 trillion and growing—credit derivatives market. “We've seen substantial change in the financial system,” Geithner said, “with the emergence of a very large universe of leveraged private funds, rapid growth in exposures to more complicated and less liquid financial instruments, all during a period of very low volatility. This means we know less about market dynamics in conditions of stress.” The article ended by saying: “The real test, of course, will be when a crisis hits, whatever the crisis may be.”

On February 12, Gyan Sinha, a senior managing director at Bear Stearns in charge of the firm's market research regarding asset-backed securities and collateralized debt obligations, held a conference call for some nine hundred investors where he spelled out his belief that the market had overreacted to the news about New Century and HSBC. “It's time to buy the [ABX] index,” he said, adding that based on his modeling, “the market has overreacted” and predictions of rising problems in the mortgage market should be taken “with a large grain of salt.” (The ABX index is a series of credit default swaps related to subprime mortgages, allowing bets to be made on the value of those mortgages.) Had Sinha been less well respected—he testified in front of Congress on April 17, 2007, about the subprime market—less attention might have been paid. “When you read the research [Bear] put out, you can think of one of two things,” said Thomas Lawler, a former Fannie Mae economist, after reading Sinha's research. “One is they weren't getting it as fast as others, or two, they were really trying to talk the market back up. I don't know which.”