House of Cards (68 page)

Paul Friedman believed the decline in Cioffi's “buying power” in the market also led to a decline in the market's liquidity. “For products that were reasonably well constructed—not CDOs of CDOs of CDOs—there was a market that was plenty deep,” he said. “For the funkier stuff, there was never a deep market. Once that demand slowed, it rippled back through all the pricing of everything that was the raw material for complex CDOs, driving prices down and freaking people out.”

The final factor was the creation in January 2007 of an index— known as the ABX index—that for the first time allowed investors to bet on the performance of the subprime mortgage market. The ABX was an index of securities backed by home loans issued to borrowers with weak credit. “In previous times, if the market sold off, no one really knew how much,” Friedman explained. “Now you had a published index that people
could observe. More importantly, it was the only real thing they could short as a hedge. As a result, the index got driven lower and lower as people looked for a way to hedge, going far lower than the underlying bonds. Potential buyers then demanded to buy bonds at the levels that the index suggested they should trade [at] when in fact no one was willing to sell there. So you had a period of time when, for example, the index would trade at 90 but the underlying bonds traded—when they traded— at 95. Hence, there would be no trades.”

As a partial explanation for what happened to his funds during March and April 2007, Cioffi blamed a rally in the ABX index, which he had been short. (He had bet that subprime mortgages would decline in value during that time, and when they increased in value—as reflected in the higher ABX index—the funds lost value.) The index rallied, he said on the April 25 conference call with investors, because there was a slight decline in mortgage delinquencies and some talk about bailouts and refinancing possibilities. “There is definitely a market rationalization” going on, he said, “deals that are managed by good managers, deals that have good collateral. Specifically, those that are more seasoned and are not heavily concentrated in the 2006 subprime vintage, which is where the majority of the problems lie.” He said he thought the market was “significantly better” at the end of April than it was in either February or March. “A lot of it has to do with dealers being able to sell out of inventory,” he said. He then shared with the investors that the estimated returns for April would be a —.06 percent for the High-Grade Fund and —.07 percent for the Enhanced Leverage Fund (both of those numbers were wrong; the Enhanced Leverage Fund dropped 10 percent in April) and added that the ABX index had moved down in recent days, which benefited the funds. He reiterated the 14 percent and 11 percent annual return for the Enhanced Leverage and High-Grade funds, respectively.

Cioffi then turned the call over to Tannin. “The key sort of big-picture point for us at this point is our confidence that the structured credit market, and the subprime market in particular, has not systemically broken down,” he said. “The dislocation that we saw in February and March is simply one where the early high delinquency numbers in many of the subprime deals has spooked the market into a position where people are simply afraid that all of the historical data that the rating agencies and the structurers and the investors have been using to assess the relative ratings volatility of these sorts of structures, right, the people are scared that what has been will not be the case in the next few years.” He then explained away the “early delinquencies” as resulting from the ability of “weaker borrowers” to refinance their mortgages in 2003, 2004, and
2005 because of rising home values. Without the rising home values during those years, these borrowers would have already been flushed from the system. “When home price appreciation stopped, those weak people were already sort of on the edge and those weak people are the ones who have gone into delinquencies on their mortgages,” he said. “We believe that, overall, these portfolios are not going to be that far away from the historical numbers that we've seen over the last ten to twelve years.” He observed that “there's a fear” in the market that securities that the rating agencies had rated AAA—the least risky of all—were “actually going to be single-A in quality”—far more risky than thought, and that this had led to a widening of the interest rates investors were demanding to account for the increased risk.

But he remained sanguine. “We believe that that is simply not true,” he said. “That while there will be weak deals and that while attention to structure and to collateral is even more critical now than it was before, this is not a systemic breakdown in the entire structured finance market.” Indeed, as Cioffi had alluded to and now Tannin said explicitly, the two hedge fund managers actually told the funds' investors there was a
buying
opportunity in the market that they intended to exploit with their newfound liquidity. He said that 2005 and 2006 “was not the time to really take on significant amounts of risk” but “now is the time to do it. So the fact that we've been so cautious in the prior periods means that we have the capital and the flexibility to take advantage of spreads that are simply irrational.” As for the funds' losses to date, they would reverse and the “price appreciations will come over time” as the market rebounds. He said he and Cioffi had spent the first four years of the funds' existence planning for a “dislocation” to make sure they would never be “forced sellers.” He said, “The structure of the fund has performed exactly the way it was designed to perform,” and added that while “it is frustrating to have had a negative month” and “it is frustrating to be in an industry where people are writing articles daily about how the world is coming to an end, but our historical experience, having been through these sorts of things before, leads us to be comfortable in our credit models and not in the sort of headlines that appear now and then about the subprime market being completely misguided.”

In closing, Cioffi echoed Tannin's optimism. “We are consciously [
sic
] optimistic,” he said. “We have a plan in place that will get the funds back on track to generate positive returns. And most importantly, we have financing and we have significant amounts of liquidity.”

The call continued with questions and answers. At one point, Tannin responded to a question by saying, “It is really a matter of whether
one believes that careful credit analysis makes a difference, or whether you think that this is just one big disaster. And there's no basis for thinking this is one big disaster.” During the call, Cioffi also addressed the issue of investor redemptions, but he made no mention of the request by “Major Investor #1” to pull his $57 million from the funds and with whom Cioffi had met on April 18. He said the redemptions for June 30 were only “a couple million” and made no mention of the $67 million in redemptions scheduled for April 30 and May 31. In fact, he already was aware of another $47 million in redemptions for June 30, including a portion of that from “Major Investor #1” wanting to withdraw his $57 million. He also made no mention of his own personal $2 million redemption on April 1, and Tannin did not explain why he was not putting his own money into the funds despite telling investors he would.

S
LIPPED INNOCUOUSLY INTO
the conference call was the fact that Bear Stearns had decided to invest an additional $25 million on May 1 into the hedge funds, bringing the firm's total investment in the funds to $45 million, a relatively small amount in the overall scheme of things. (This investment should not be confused with the firm's $25 million investment in Rampart.) On his own authority—which the executive committee had granted him in writing—Spector had decided to make what one of his colleagues described as “an opportunistic investment” in the fund. Spector's decision seemed to be an impulsive one in the face of the redemption requests and what Cioffi was telling him about the potential opportunities as a result of the market dislocation. On the other hand, “At that moment, it didn't look like the world was blowing up,” said someone who knew his thinking, “and it shows our confidence in the fund and people thought we would make money.” The matter first came up during a Wednesday breakfast that Spector was having with Sam Molinaro, the CFO, and Steve Begleiter, the head of strategy. Suddenly, Rich Marin, the head of BSAM, appeared at the door, wanting to speak with Spector urgently. Marin came in, started talking to Spector about Cioffi's hedge funds, and recommended to Spector that the firm invest $25 million into the funds. (Marin had initially asked for a much larger investment.) “There were no analytics presented to Warren right then as to why we should be confident [that this was a good investment],” explained one of the participants. “It was Rich Marin saying he thought these things were cheap after talking to Ralph.” Spector told Marin to go ahead with the $25 million investment in order “to show strength to the market” in the face of redemption requests. While usually the executive committee— which Spector was on—would need to approve such an investment, one
person aware of the committee's routines said, “on small amounts they never didn't approve what Warren wanted to do in asset management, or other people wanted to do in other areas.” In truth, the firm had made investments totaling more than $500 million of its money in hedge funds and other seed-capital-type opportunities, many of which Spector made on his own authority as well.

Even as Spector approved the investment, there was not a consensus among those who were aware of it that it was a good idea at that moment. There were at least two reasons discussed for why the investment should not be made. “One was God forbid anybody took any comfort from the fact that we were investing, and then invested or didn't redeem and lost money; we would just worsen our liability from it because we're doing this to sort of show confidence,” one Bear executive said. “We're creating a false illusion. And two, we were telling people we were doing this because we wanted to calm them down. That's all the more reason not to do it. We hadn't done sufficient analytics to prove that the values were cheap. Plus, the $25 million of our shareholders' money is going to be put at risk. And if there was a problem in the fund, $25 million wasn't going to do any good. If we actually needed to have more money put in the fund to meet margin or do whatever, there's no way $25 million is the right number. The right number is probably $525 million or $425 million, and we should figure out what the right number is before we just start ladling in little dollops.” But, as Cioffi reported to his investors, Bear Stearns made the $25 million investment, effective May 1.

D
ESPITE WHAT THEY
said in the April 25 conference call, by early May both Cioffi and Tannin anticipated that the funds' April results were going to be rough. “Going into the month of May, when we were waiting for our April marks, there were no cash trades that you could look at,” one Bear Stearns executive explained. “That said to us, ‘Wow, this market was falling like a rock.' But when we were waiting for the April marks, [Ralph and Matt] were like, ‘No, let's see where they come out. We think they're going to be down. But we don't think they're going to be down outrageously.' And sure enough, we get in all these marks. And the marks are 99, 98, 97. They're still in that same ballpark. It was enough to have a second bad month. It was like down 6 percent but not disastrous. Not good, but not disastrous.” Cioffi published the NAV for the Enhanced Leverage Fund for April at —6.5 percent.

A week later, “knowing full well we've published our NAV,” according to this executive, Goldman Sachs sent, by e-mail, its April marks on the securities to Cioffi. As a counterparty to trades in the funds, Goldman
was obligated to report its thinking about the value of the securities in the funds on a monthly basis. “Now there's a funny little procedure that the SEC imposes on you, which is that even if you get a late mark, you have to consider it,” he said. “Suddenly we get these marks. Except these marks are not marks from 98 to 97. They go from 98 to 50 and 60. Okay? You get it? They give us these 50 and 60 prices. What we got from the other counterparties is 98. The SEC rules say that when you do this, you either have to average them—but they're meant to be averaging 97s and 98s, not 50s and 98s—or you can go and ask if those are the correct marks. But you can't ask the low mark. You've got to go back and ask the high mark. Everybody knows the procedure. So we got to go ask the high mark. We ask the 98 guy—another major Wall Street firm—and you know what he says? Remember, he knows he's high now. He goes, ‘You're right. We were wrong. It's 95.' In other words, he gave himself a margin of error, and he said, ‘I'm going to drop it severely.' He looked at it with great intensity and said 95. Now, we got nothing we can do but take the 50 and the 95 and average them. We have to repost our NAV. And now we go from minus 6 to minus 19”—minus 18.97 to be exact—“and that is game fucking over. By the way, the firm that sent us the 50 made a shit pot full of money in 2007 shorting the fucking market.”