House of Cards (67 page)

On April 22, Tannin wrote Cioffi an e-mail from his personal Gmail account to Cioffi's wife's personal Hotmail account with the subject line
“Things to Think about—Parts I and II.” He wrote at times with great emotion and about his personal feelings, which may have accounted for his decision not to write the e-mail on the Bear Stearns system. Tannin, a philosophy major, was certainly waxing philosophical in the correspondence. “In January 2003, I excitedly accepted your offer to become your partner,” he wrote. “While you may have had a fully fleshed out idea of where you thought we were going back then, I did not. I knew only that I trusted and respected you and that I had come to love to work with you (a feeling shared with just about everyone). So I considered myself tremendously fortunate to have been given the opportunity you gave me. Over the past four years a lot has changed—and a lot has not. We have been very successful measured in almost any conceivable way. We have raised a lot of money, we've made a lot of money, we've hired a lot of good people—but for me most importantly—we have spent our time well— and time is the ONLY thing in this life which one can't ever get back.” He said he was feeling “pretty damn good” about what was happening at the funds because he had no doubt “I've done the best possible job that I could have done. Mistakes, yep, I've made them—but they do not bother me as much as they did years ago…. So—fuck it—all one can do is their best—and I have done this.”

He went on to wonder whether the funds should be closed or significantly restructured. “Over the last few months,” Tannin wrote, he had come to believe the funds should be closed or “get very very aggressive.” The argument for closing the funds was based on the market and on a complex internal April 19 CDO report, which was a new analysis that Tannin had perused for the first time in previous days. “[T]he subprime market looks pretty damn ugly,” Tannin wrote. “If we believe the [new CDO report] is ANYWHERE CLOSE to accurate, I think we should close the funds now. The reason for this is that if [the CDO report] is correct, then the entire subprime market is toast…. If AAA bonds are systematically downgraded, then there is simply no way for us to make money—ever.” He wrote that he believed “we need to GUESS about the accuracy of the [new CDO report] NOW. It would be nice if we had the luxury of waiting a bit (and maybe we do—this is another discussion point)—but I do not think we have any time luxuries here.” One possibility was “the likelihood of a melt-down.” He concluded that “caution would lead us to conclude [the CDO report] is right—and we're in bad bad shape.”

On the other hand, he wrote, he had spoken with Andrew Lipton, a veteran residential mortgage-backed securities analyst, and “sat him down on Friday and asked how serious he thought the situation was. He
calmly told me that the situation was going to be as bad as people were saying…. We should EXTRACT every piece of information from him because I'm not sure there is anyone who knows more than he does.” But he said he had his doubts about Lipton, too. “He's just been too calm during this whole period.” He also said he thought their partner, Ray McGarrigal, had “lost confidence in the structures. Not long ago Ray had confidence in the structures. Ray does not fuck around. Ray has been paying attention. I trust Ray.” In closing, he wondered, “Who do we talk to about this? Marin? Spector? Outside counsel? (And here we have to be careful because our outside counsel is BSAM's counsel NOT our counsel. This is another very big issue we at least need to think about.)” That night Cioffi, Tannin, and McGarrigal met at Cioffi's house in Tenafly, New Jersey. Cioffi convinced Tannin that the new computer runs were actually “good for us,” not “bad for us,” and that his concerns about the potential meltdown of the subprime market were misplaced. After that night, Tannin was back on board with the strategy to use the moment as a buying opportunity. On April 23, Tannin urged Cioffi not to broadcast the funds' troubles to other employees. “I think we should be cautious of statements like ‘if we sold all the assets at the mark' while we are on the desk. We have a lot to do—and we'll do it—but I think it's important to keep everyone else as focused as possible.” On April 24, Cioffi and Tannin told “senior BSAM personnel” that they were “confident that the Funds were in good shape and would continue to be successful.”

The next day, April 25, Cioffi and Tannin held a conference call for the funds' investors. Their performance was Oscar-worthy. Cioffi kicked the discussion off with a review of the first-quarter performance at both funds. The High-Grade Fund was down a cumulative 0.34 percent in the first quarter, with the loss coming in March after a positive January and February; the Enhanced Leverage Fund had lost 4.74 percent year to date, with much of the loss coming in March. “At this point in time, the [Enhanced] fund has significant amounts of liquidity,” Cioffi said. He then reviewed the funds' financing strategy of “non-recourse term funding” in order to avoid margin calls or having repo lines “removed or terminated,” according to a transcript of the call. Despite what he and Tannin had been worrying about privately, he told the investors, “The repo market has been very solid and very liquid. We've had no increase in haircuts, actually, no increase in repo rates either. We've had margin calls that we've easily met. We've not had to force-sell any assets. And the reason we focus on that is if one believes their assets are good, and they are gonna pay off at maturity, the market volatility that creates mark-to-market losses is only realized if one has to sell because they lose their
financing. So we have been very careful, very cautious, very diligent on that front.”

He then launched into a jargon-filled discussion of how he hoped to close, in May, a $5 billion CDO financing with Bank of America—“the largest CDO of the year so far, I believe”—that would allow the Enhanced Leverage Fund to sell $2.6 billion of assets and the High-Grade Fund to sell $1.4 billion of assets to the bank. “The transaction adds significant liquidity to both funds,” he said, by putting “in excess” of $200 million of “cash and liquidity” in the Enhanced Leverage Fund and $125 million, “maybe slightly more,” in the High-Grade Fund after making some $100 million more in “new assets that we're in the process of identifying now in the CDO space and structured credit space.” He then predicted returns of 14 percent for the year in the Enhanced Leverage Fund and 11 percent for the year in the High-Grade Fund. The new Bank of America facility, he said, would also give the funds another $1 billion with which to buy assets while reducing the repo lines that could be called by the lenders. “With all the disarray and turmoil in the market,” Cioffi said, “there is some significant trade opportunities out there for us to put on. So we'll be adding carry and we'll be doing some total rate of return relative value on short trades in that space.” Tannin wrote Cioffi that successfully completing the Bank of America financing would give the funds “definite mark to market gains,” adding that “this is how we show investors what we can do—a few months of good positive returns and we'll be fine.”

“I
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HERE'S
F
RAUD
, W
E'RE
G
ONNA
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AY
”

y early 2007, there were many factors that exacerbated the exponential deterioration of the value of securities tied to the United States housing market. In no particular order, first there was the use of newfangled automated software that allowed mortgage lenders such as New Century, Countrywide, and First Franklin to process increasingly large numbers of mortgage applications far more quickly. The new software replaced the old-fashioned, labor-intensive process of collecting and reviewing a borrower's documentation. The software, of course, was
not what led to lower underwriting standards, but it allowed the processing of those applications to happen much more rapidly. Then there was the fall in housing prices, which, as Paul Friedman explained, started “to crack on a surprisingly broad basis across the country” and opened a window into “just how bad the 2006 vintage of subprime and Alt-A mortgages were and how much fraud was embedded in the loans.” People also began to realize that, as Friedman described it, “one of the bedrock concepts of the whole subprime securitization model, diversification”—the theory that a broad pool of borrowers provided inherent protection from price declines and defaults—“was fundamentally flawed. In fact, when we had declines around the country it became obvious that if you had a big pool of borrowers who had identical characteristics you really didn't have any diversification at all.”

This problem, too, was made worse by the behavior of the ratings agencies—Standard & Poor's, Moody's, and Fitch—that provided the desired ratings on the securities, for a fee paid by the investment banks, to allow the securities to be sold to investors around the world. “The story of the credit rating agencies is a story of colossal failure,” said Congressman Henry Waxman at a hearing of his Committee on Oversight and Government Reform held in October 2008. “The credit rating agencies occupy a special place in our financial markets. Millions of investors rely on them for independent, objective assessments. The rating agencies broke this bond of trust, and federal regulators ignored the warning signs and did nothing to protect the public.” As an example of this breach of trust, Waxman's committee released an internal e-mail exchange between Frank L. Raiter, head of mortgage ratings at Standard & Poor's for ten years, and Richard Gugliada, an S&P managing director. Raiter had been asked to rate a collateralized debt obligation called “Pinstripe” and requested from Gugliada highly detailed data about each individual loan, known as “loan level tapes,” to assess the creditworthiness of the security.

“Any request for loan level tapes is totally unreasonable!!!” Gugliada wrote Raiter. “Most investors don't have it and can't provide it. It is your responsibility to provide those credit estimates and your responsibility to devise some method for doing so.”

Raiter responded: “This is the most amazing memo I have ever received in my business career.”

Then there was this instant-message conversation between two S&P analysts, Rahul Shah and Shannon Mooney, in April 2007. “By the way, that deal was ridiculous,” Shah wrote to Mooney.

“I know right—[the] model def[initely] does not capture half of the risk,” Mooney responded.

“We should not be rating it,” Shah wrote.

“We rate every deal,” wrote Mooney.

“It could be structured by cows and we would rate it,” Shah responded.

“But there's a lot of risk associated with it—I personally don't feel comfy signing off as a committee member,” Mooney replied.

In his September 2007 congressional testimony, Kyle Bass, the managing partner of Hayman Capital who once worked at Bear Stearns, accurately defined the problem. “Unfortunately the relationship between the bond issuers and the [ratings agencies] presents a fundamental conflict of interest because the [ratings agencies] are dependent on the issuers for their revenues,” he said. “The bond issuers, as sellers of risk, have an incentive to see that the risk they are selling is priced as cheaply as possible—in the marketplace this means obtaining as high a rating as possible—because once they sell the bonds they are relieved of any risk burden. It is this incentive, and the fact that they work closely with, and provide payment to, the [ratings agencies] that places into question the objectivity of the ratings provided by the [ratings agencies]. The ultimate holders of the risk, the buyers of these bonds, have the most at stake in accurately pricing risk, but instead rely upon the ratings bought and paid for by the sellers. It would be like cattle ranchers paying the Department of Agriculture to rate the quality and safety of their beef. It would undermine the integrity of the system by casting doubt on the impartiality of the body that the ultimate buyer relies upon to keep them safe from harm. But it is becoming increasingly clear as each month passes, sub-prime credit has become the mad cow disease of structured finance. Nobody knows who consumed the infected product and nobody has any real faith in the [rating agencies] that gave it a clean bill of health.”