House of Cards (66 page)

On February 28, Cioffi wrote the team that he was thinking of “very selectively buying at these levels” since that “in and of itself would stabilize the markets.” Tannin responded that he thought it would be a good idea. “Fear + illiquidity + a CDO ready and waiting = a good trade.” That same day, Ben Bernanke, now chairman of the Federal Reserve, testified on Capitol Hill that he did not believe a “housing downturn” was a “broad
financial concern or a major factor in assessing the state of the economy.” On March 1, Cioffi told an economist who worked for the hedge funds, “Don't talk about [the funds' February results] to anyone or I'll shoot you.” He also went on to say that he thought the funds might have their first down month ever and that he was disappointed by that fact. On March 2, Cioffi met informally with Tannin and two other members of the funds' management team and spoke “about the extremely difficult month” February had been for the funds, though he claimed that the funds “had averted disaster.” With his team around him, Cioffi “led a vodka toast to celebrate surviving the month.” Then he “directed those present not to talk about the Funds' difficulties with others, including other members” of the team.

Cioffi was becoming increasingly concerned about the funds' exposure to the subprime market, even though the monthly statements sent to investors stated that only 6 percent of the funds' money was invested in supbrime. Cioffi was concerned because he knew that actually the funds had closer to 60 percent of their money invested in subprime mortgages. On March 3, he told Tannin that at least “we have our health and families … [w]e are not a 19 year old Marine in Iraq.” That same day, Cioffi told Tannin, “The worry for me is that sub prime losses will be far worse than anything people have modeled.” By March 11, Cioffi knew March was not going to be a good month, either. “We will be hard pressed to be up” in either fund, he concluded. On March 15, he wrote a colleague by e-mail, “I'm fearful of these markets. Matt [Tannin] said it's either a meltdown or the greatest buying opportunity ever. I'm leaning more towards the former. As we discussed it may not be a meltdown for the general economy but in our world it will be.” By the end of March, Cioffi had taken to going around the office and telling his colleagues, “I'm sick to my stomach over our performance in March.”

Then there were the margin calls from the funds' repo lenders, which forced Cioffi to try to sell assets at unfavorable prices. “We do need to take positions down in [the High-Grade Fund],” he told a team member on March 14. “We are getting loads of margin calls.” Cioffi and Tannin even discussed merging together the High-Grade and Enhanced Leverage funds as a way to increase the liquidity of the High-Grade Fund. Despite his growing concern about the liquidity of the High-Grade Fund, Cioffi made a “false statement” to a repo lender in March that the funds “had more than enough liquidity to meet any likely eventuality.”

He also kept encouraging investment in the funds even though his concerns were growing. On March 7, Cioffi told a Bear Stearns broker who had more than forty of his clients invested in the funds that “we have
an awesome opportunity” with the funds. That same day, Tannin told the same broker, “I think [Cioffi] and I are in agreement that we are looking at some great possibilities for the coming months. I don't know where you are putting your money now but I would suggest we speak about adding more to the fund. That's what I'm thinking.” On March 15, Tannin told an investor, “We are seeing opportunities now and are excited about what is possible. I am adding capital to the Fund. If you guys are in a position to do the same I think think [
sic
] this is a good opportunity,” and he added that “it was a very bad time to redeem.” Tannin never did invest more of his own money in the funds.

At the end of March, Tannin sent a colleague, Steven Van Solkema, an e-mail. Tannin had been walking around the office speaking to potential investors using his headset and thought his conversations might have been disturbing Van Solkema. “I hope I don't disturb you with all my ranting and raving,” he wrote. “Believe it or not—I've been able to convince people to add more money—which I am doing as well. No one has redeemed as far as I've seen. Please please please tell me if you think I'm not saying anything clearly or if you think there are things to say that I'm not saying. I apologize for the fact that you have to hear all of this [and] if it takes you away from your concentration. But what would be VERY helpful is if you could continually feed me the ‘market intelligence' you see and hear.” At the same time, though, Cioffi remained worried about the funds' liquidity. The funds “have to be very light on the investment side and continue to raise cash [in the High-Grade Fund] and maintain cash [in the Enhanced Leverage Fund]” to meet margin calls. He also told investors, “We wouldn't have made money in February if we were long, or overexposed to subprime.”

Bear Stearns, meanwhile, kept rolling along despite the cracks in the subprime market. On March 15, Cayne announced the firm had made $554 million in the first quarter of 2007, up 8 percent from the first quarter a year earlier. “We are pleased with this excellent performance,” he said, making no mention about whether he was also pleased to be paid $40 million for fiscal year 2006 (putting him on a par for the year with Dick Fuld, CEO of Lehman Brothers). The firm's stock had fallen to around $145 per share since its January 17 peak, but the solid first-quarter performance announcement caused the firm's stock to rally to near $149 per share. “Even though Bear's bread-and-butter has historically been in fixed income, given the slowdown in the residential mortgage market—meaning lower demand for mortgage-backed securities—we were impressed that Bear's credit derivative and distressed debt products more than picked up the slack,” research analyst Philip Guziec wrote. An
analyst at Standard & Poor's, Matthew Albrecht, wrote that although he remained “concerned by the firm's exposure to the subprime mortgage market … we believe much of the recent selling on the news has been overdone and we see a number of positive catalysts for the business.” His twelve-month target on Bear's stock was $157 per share.

That same day, IndyMac Bancorp, a thrift based in Pasadena, California, announced that its exposure to subprime mortgages was small and that the bank had been “inappropriately categorized by many media sources as a subprime lender.” (On July 12, 2008, the federal government, through the FDIC, seized control of IndyMac, which at the time was the second-largest bank failure in U.S. history.)

On March 23, Cioffi was growing increasingly nervous about his hedge funds and initiated the process of removing $2 million of the $6 million that he personally had invested in the Enhanced Leverage Fund. He moved the money to another Bear hedge fund, Structured Risk Partners, of which Cioffi had oversight responsibility beginning April 1. For appearance purposes, hedge fund managers were expected to invest in the hedge funds they managed, and Cioffi's defenders suggest that this alone was the reason he moved the cash. “At least Structured Risk Partners keeps getting better,” Cioffi told Rich Marin on March 22. Cioffi's concerns about his funds' performance in March proved well founded. The High-Grade Fund lost 3.71 percent for the month. The Enhanced Leverage Fund lost 5.41 percent. Although both funds' March 2007 investor statements showed that 86 percent of the collateral was in asset-backed securities and 6 percent in subprime mortgages, Cioffi's commentary described two reasons for the losses: “continued weakness in CDOs with exposure to subprime collateral caused additional markdowns in our long asset exposure” and “our short positions rose in price as many investors who were short the subprime default index covered their positions.” He added, “Our losses in March are frustrating. The widening we've seen in these asset classes will not tighten again nearly as quickly as they have widened but this market dislocation has created many opportunities.”

T
HESE WERE BIG
losses and of major concern to the executives at BSAM as well as to Cioffi and Tannin. “In an illiquid market, like for these instruments, you have to wait until the end of the month and you get marks from your trading counterparties—the Street,” explained a Bear Stearns executive. “It's usually the people that you trade with that give you the marks. We have a procedure. It's all documented. There's a valuation committee at Bear Stearns. The people on the committee do their valuations. Only if there's a problem does it get elevated. The procedures call
for us to get as many independent marks as we can and then average them. Clearly as this market started to get a little bit dicier, in 2007, it was harder to get marks in shops. People didn't want to value things. They were worried about their own valuations. But we were showing valuations that went from 100 cents on the dollar down to like 98. They were going down. But they were going a little bit down.” The losses, though, were magnified by the amount of leverage sitting on those assets. Warren Spector, the co-president of Bear Stearns, was one person who was un-fazed by what was happening in the subprime mortgage market at that moment. “The big question is will it have a broad impact on the housing market,” Spector said during a March 29 “investor day” at the firm. “I don't see it.” He also told investors, “We're very proud of the way we do risk management. It's an integral part of our culture…. We have a strong culture of no surprises.”

Both Tannin and Cioffi saw the dislocation in the mortgage markets as a buying opportunity for the hedge funds. On March 31, a Saturday, Tannin wrote Cioffi an e-mail noting that he was skeptical of the naysayers. “I simply do not believe anyone who shits all over the ratings agencies,” he wrote. “I've seen it all before. Smart people being too smug.” He wrote that the hedge fund team has “some important decisions to make” and his “experience is biased toward the positives of acting boldly in the face of uncertainty. We are in a unique position of having access to capital at a time when we might have h[a]d our hands tied.” He then laid out for Cioffi a series of trades he believed would be profitable. He wanted to “show our investors that we are acting aggressively,” he wrote. “I think they will reward us with time—which is critical at this point. My biggest fear is a flat few months while economic news continues to get worse. We face a risk that our investors will lose patience, not that they will become disappointed…. I think we can't afford not to be aggressive, whatever we do.”

On Passover, April 4, Tannin wrote Cioffi that he continued to “believe that the variables that end up contributing to subprime defaults are numerous and not subject to ‘contagion' … I would suggest that
EXACTLY
those factors which constitute the non-bubble phenomenon of housing prices … sum up to a very complicated series of variables leading to defaults in AAA CDOs or mortgages. AAA CDOs will have greater ratings volatility than other AAAs but good credit selection and good funding vehicles should mitigate the damage.” Twelve minutes later, Cioffi replied that he agreed with Tannin's observations. “There are good AAAs and not so good ones and that is our job to find those ones that are good.” On April 13, Steven Todd, a research analyst at Wachovia Securities,
wrote a report, “CDO House of Blues: How Strange the Change from Major to Minor,” which “critique[d] key tenants of the doom-and-gloom argument” regarding a “housing meltdown.” Todd pointed investors to the “unusual value in the market” for certain mortgage-related collateralized debt obligations. “Recent stabilization in the ABX index may signal this moment as a good entry point for bargain shoppers,” Todd wrote. His research report was required reading for Cioffi, Tannin, and the other professionals at the two hedge funds, who found it to be positive reinforcement for their idea that moneymaking opportunities lay before them.

At the end of April, Rich Marin, the head of BSAM, attended an executive committee meeting to discuss an asset management project then getting under way in Saudi Arabia. After he finished his presentation, Greenberg asked him if there was anything else going on at BSAM that the executive committee should be aware of. He mentioned the looming departure of one asset manager, and then said, according to someone who was there, “The other problem is that we don't know yet until we get the marks for April, but I think we might be heading into our second down month in the High-Grade Fund. That's going to be potentially problematic for redemptions. We've got to watch it closely.” This was hardly an earthshaking thought, but when Cayne heard Marin's words, he blew up. “What!” Cayne said. “That's kind of a harsh reaction. Isn't it?” When Marin wondered why, Cayne continued, “I've had lots of investments in hedge funds. And if I've had thirty good months and then I have two bad months, I'm not going to be redeeming and pulling my money out. Why would you be concerned about it?”

Some big investors in the hedge funds, though, were starting to get nervous. On April 18, one of the investors, who had $57 million invested, informed Cioffi that he was considering redeeming his money. Cioffi told him that the portfolio managers had $8 million of their own money invested, one-third of their liquid net worth. He did not tell the investor that he had taken $2 million of his own money out and invested it in his other hedge fund. The next day, the investor informed Cioffi and Tannin that he wanted his money out. That same day, the funds' management team produced a report showing the value of the CDOs in the funds to be worth “significantly less” than previously reported. On a call with investors on April 20, Tannin said there was “a dislocation in the market” in February and March caused “by a loss of confidence by the market in the ratings of CDOs with 2006-vintage subprime exposure” but that the funds had very little exposure to this collateral.