House of Cards (65 page)

On Valentine's Day, New Century announced that a wave of shareholder
lawsuits had been filed against it and that after two weeks of tough negotiations Goldman Sachs had agreed to a three-month extension of a line of credit to the company that had been set to expire the next day. Goldman had extracted its pound of flesh by insisting on the ability to get out of the agreement “at the first hint of trouble.”

That night, ironically, Steve Schwarzman, one of the two founders of the Blackstone Group, gave himself a boffo $4 million sixtieth-birthday party at the Armory on Park Avenue for 350 of Manhattan's glitterati. Martin Short emceed. Rod Stewart and Patti LaBelle sang. The menu included lobster, baked Alaska, and a 2004 Louis Jadot Chassagne-Montrachet. Cayne was there. “The festivities served as a coronation of sorts for Mr. Schwarzman, a billionaire several times over, an active Republican donor and chairman of the Kennedy Center in Washington whose influence reaches deep into the worlds of finance, politics and the arts,” the
Times
reported afterward.

On February 21, the stock of NovaStar Financial, which like New Century made loans to people with weak credit, fell almost 43 percent after the company announced a surprise loss of $14.4 million for the fourth quarter and told investors that it might not make enough money to pay dividends for the next four years.

Three days later, the
Wall Street Journal
interviewed Lewis Ranieri, the godfather of the mortgage-backed security and the pioneer trader of them when he was at Salomon Brothers from the 1960s until he was pushed out of the firm in 1987. The
Journal
reported that the “rumpled 60-year-old says he is worried about the proliferation of risky mortgages and convoluted ways of financing them. Too many investors don't understand the dangers…. The problem, he says, is that in the past few years the business has changed so much that if the U.S. housing market takes another lurch downward, no one will know where all the bodies are buried. ‘I don't know how to understand the ripple effects throughout the system today,' he said during a recent seminar.” The growing problem was that 40 percent of the subprime borrowers in 2006 were not required to produce pay stubs or other proof of their net worth, according to Credit Suisse Group, and lenders were relying more and more on computer models to estimate the value of homes. “We're not really sure what the guy's income is and … we're not sure what the home is worth,” Ranieri said. “So you can understand why some of us become a little nervous.” He worried further that with so many mortgages being packaged by Wall Street into CDOs and sold in slices to investors all over the world, U.S. home mortgage risks were being spead to a “much less sophisticated community.” The
Journal
made it clear that “Mr. Ranieri isn't predicting
Armageddon. Some of the riskier new types of mortgages probably will perform ‘horribly' in terms of defaults, leading to losses for some investors. But, he says, the ‘vast majority' of mortgages outstanding are based on sounder lending principles and should be fine.” On February 28, Reuters published a story about lurking dangers in the subprime market, citing the problems at New Century and HSBC. “We're looking at somewhat immature markets that are going through a growth phase,” Cioffi told the news service. “There is a catharsis and a cleaning out process.” The story also quoted him at a recent bond conference. “Up until now, any CDO manager, primarily new CDO managers with light staffing, very little technology and unbalanced capability, was able to get a CDO done,” he said. “I don't see that going forward.” Cioffi told his investors, “We're going to make money on this…. We don't believe what the markets are saying.”

On March 2, the problems increased for New Century. First, the company announced it could not file its 2006 10-K financial report with the SEC on time “without unreasonable effort and expense”—a clear sign of brewing trouble, especially given the material misstatements already announced. Then there were the margin calls from its repo lenders. Citigroup had demanded the company refinance about $710 million of Citigroup loans and assets, and on March 2, the company announced that Morgan Stanley had refinanced Citigroup and had provided another $265 million of financing secured by the company's “loan portfolio and certain residual assets.” Then came the dreaded statement: “The Company is in discussions with lenders and other third parties regarding a refinancing and other alternatives to obtain additional liquidity. No assurance can be given that any of these discussions will be successful.” Also that day, New Century announced the resignation of hedge fund manager David Einhorn, president of Greenlight Capital, from its board of directors.

Einhorn's departure was plenty ironic, too, coming as it did less than a year after he had waged a high-profile proxy fight against New Century to get three seats on the company's board. On March 15, 2006, Einhorn, a bridge and poker player, agreed to stop his proxy fight and take a seat on the board. Part of Einhorn's compromise with the company allowed Greenlight Capital to increase its ownership stake in New Century to 19.6 percent. “New Century is a unique and valuable franchise,” Einhorn said at that time. “I look forward to sharing my perspective as the Board oversees effective allocation of the company's capital to the most attractive risk-adjusted opportunities.” Just days later, the company announced it would accept no new mortgage applications and that it was
the target of investigations of wrongdoing related to trading in its stock. Then came the frozen credit lines and the demands by its repo lenders that the company buy back $8.4 billion in loans, money that it did not have. New Century had begun riding the mortgage finance wave in 1996, when it made its first loan to a borrower in Los Angeles. Ten years later, in February 2006, the company had 7,100 employees, 222 sales offices nationwide, and a compounded annual growth rate in its loan production of 64 percent per year, topping out at $56.1 billion in mortgages in 2005, up from $357 million in mortgages in 1996. On April 2, New Century filed for bankruptcy protection and was liquidated. Einhorn likely lost his entire investment—once worth $109 million—in New Century.

On March 7,
BusinessWeek
made it clear that the trouble in the subprime mortgage industry was spreading rapidly. “The canaries in the coal mine are keeling over fast,” the magazine observed, noting that “at least 25 subprime lenders” had gone out of business, declared bankruptcy, put themselves up for sale, or announced significant losses. “Now there's evidence that the pain is spreading to a broad swath of hedge funds, commercial banks and investment banks that buy, sell, repackage and invest in risky subprime loans.” The magazine quoted Jim Grant, the respected author and publisher of
Grant's Interest Rate Observer,
that the market was “starting to wake up to the magnitude of the problem” and had entered what Grant called “the recognition stage.” Terry Wakefield, the head of a mortgage-industry consulting firm, was even more blunt: “This is going to be a meltdown of unparalleled proportions. Billions will be lost.”

B
Y THE TIME
of the
BusinessWeek
article and New Century's bankruptcy filing, the problems in the mortgage market and the securities tied to mortgages had begun to show up in Cioffi's hedge funds at Bear Stearns. Of course, in terms of what the public was told, these problems might as well have been happening on Mars. In the firm's 2006 Annual Report, released in mid-February 2007, the theme was “Eighty-three years of profitability” and “Twenty years as a public company.” On $9.2 billion in revenue, the firm had made $2.05 billion of net income, the first time that milestone had been reached. Profit had increased 40 percent from 2005. “In the past twenty years, we have seen Bear Stearns thrive far beyond anything the founding partners could have imagined,” a beaming Cayne pronounced from the third page of the report. “This progress has been built on a firm foundation. Our balance sheet is now over $350 billion and the strong credit quality of Bear Stearns continues to be recognized by bondholders as well as ratings agencies. In 2006, Standard & Poor's upgraded Bear Stearns to A+ with a stable outlook—a rating that
we believe reflects the dedication to risk evaluation and management that has given us the ability to expand carefully and conservatively.” The Annual Report pointed with pride to Bear Stearns's number one positions in the United States for underwriting mortgage-backed securities, mortgage-backed residential securities, whole loans, and adjustable-rate mortgages. In 2006,
Euromoney
named the firm the best investment bank in North America and noted, “Bear's strategy may become the new investment banking business model of the near future.” Even BSAM, under Marin's leadership, was performing well. Net revenues increased 47 percent to $335 million in 2006, and assets under management increased to $52.5 billion, up 25 percent. The “cornerstone” of BSAM's philosophy, the report noted, was its focus on “repackaging risk,” or “developing a better understanding of risk, the investor's risk appetite and the balance between risk and return.” Pictured prominently in the annual report, at the start of the discussion of BSAM's performance, was Ralph Cioffi, unsmiling but formidable-looking in his bespoke suit.

Bear Stearns was certainly not shy about trumpeting its success in various mortgage-backed securities. The firm's “mortgage franchise continues to lead the industry,” the Annual Report said. “We ranked number one for the third consecutive year in US mortgage-backed securities underwriting, secured the top spot in the securitization of adjustable-rate mortgages, and ranked in the top five in the global collateralized debt obligation (CDO) market…. Our vertically integrated mortgage franchise allows us access to every step of the mortgage process, including origination, securitization, distribution and servicing.” The firm's CDO business grew by 50 percent in 2006. “Our success across all sectors of the CDO market and in both European and US issuance reflects our 10-year presence in this business, combined with strong overall market growth,” the firm trumpeted. “We are a leading underwriter of collateralized loan obligations, mezzanine asset-backed securitized debt obligations, and a range of types of CDOs, including those related to commercial mortgage-backed securities, trust preferred securities and CDOs of CDOs.”

Just as Bear's public stockholders were digesting all the supposed good news about the firm found in the Annual Report, Cioffi was digesting the fact that February 2007 had been a very difficult month indeed for his two hedge funds. The High-Grade Fund had reported a gross return of 1.5 percent—respectable, to be sure—but the Enhanced Leverage Fund had lost 0.08 percent, the first time either fund had lost money since Cioffi started in 2003. But that was not the message that Tannin sent to Barclays about the February performance of the Enhanced Leverage Fund. “You will be happy to know that we are having our best month
ever this February,” he e-mailed the bank on February 19. “Our hedges are working beautifully. We were up 1.6% in January and are up 2% so far in February.” On February 21, Tannin sent an e-mail to his team in which he sounded quite happy about all the doom and gloom over subprime mortgages in the marketplace. He cited such a report from a rival hedge fund manager, and said, “This piece is mostly unhelpful and more than a bit misleading. Scare mongering. I used to fly into a rage when I would read this stuff but now it makes me happy. We need some caution and naysayers in our market—it keeps spreads wider. So I'm glad this has been printed.”

On February 27, a banker at Barclays demanded that Tannin provide the written monthly performance statements, and Tannin replied to him: “Here is the relevant information for Enhanced Leverage. As you can see, despite the sell off in the subprime mortgage market—our fund continues to do well, quite well, in fact. Here are a few points I think you should be aware of: 1. Our hedges are working just as we discussed. Our hedges are lower quality than our assets—so in this market we've experienced a significant mark to market gain so far this month. 2. Our term-financed positions are not as sensitive to this market volatility—just as we've discussed. 3. We have been in touch with all of our repo counterparties—and they are uniformly very happy with all of our positions. In short, we are very pleased with our performance—but even more important than that we are pleased that our ideas about how to structure our risk and limit our volatility are once again proving to have been prudent.” The first page of the report that Tannin sent to Barclays on February 27 showed BSAM's calculation of a 5.5 percent gross return and a 4.3 percent net return through February 23. The day before Tannin sent this e-mail, Pusateri had asked Barclays for a $100 million increase to its debt investment used in the Enhanced Leverage Fund. Another $100 million request was made a few weeks later. Barclays agreed to both requests, in part because of a March 8 e-mail from Tannin. “Despite dramatic volatility in the structured finance market our Fund has been extremely stable,” he wrote. By the end of March 2007, Barclays had invested its total commitment of $400 million in the debt used in the Enhanced Leverage Fund.