House of Cards (69 page)

The effect of the new marks from Goldman Sachs on Cioffi's hedge funds was immediate and devastating. “Let me see if I can make this clear for you. Minus 6 percent announced this week. Oops—19 percent announced next week,” he said. “Number one, 19 percent is a pretty damn big number. So we announce minus 19 percent. So what happens? Two fundamental things. One, this thing is in freefall—19 percent down. Number two, these guys are fucking idiots—6 percent one week, 19 percent the next week. How could that be?” Harder to understand, he said, was that Goldman's marks had been at 98¢ the month before. “Ninety-eight to 50?” he asked, incredulous. “They were at 98 the month before. There were no cash trades to imply anything like that. Nothing. There was nothing. And you know what? The way the procedure works, all we could [do] was go, ‘But, but, but, but, but …’”

With the hindsight of a few months, the Bear executive's fury at Goldman had not abated. “If everybody's getting overwhelmed by a tsunami and there's a couple of guys making a fucking fortune, that usually is grounds for at least taking a closer look to see what was going on, as to why they were making a fortune. Sometimes it's because they were smarter. Guess what? The presumption, in this case, is they were smarter. But I just told you a story that is about as relevant and about as potent as nitroglycerin, if you ask me.”

Gary Cohn, the co-president of Goldman Sachs, had a few reactions to the charges made by the Bear executive. First, he was clear that Goldman did not make nearly as much money in 2007 betting against the mortgage market as people think it did. “We don't disclose segment-by-segment reporting,” he said. “But the market would be really disappointed if they saw our actual mortgage results last year, because they think we made a lot of money.” As for the marks themselves, Cohn said that Goldman was aggressive about marking down these kinds of securities, especially during the third quarter of 2007, much to the detriment of its own income statement and those of some of their clients who would then have to account for the new Goldman marks.

He then shared an anecdote about a conversation he'd had with Nino Fanlo, one of the founding partners of KKR Financial Holdings, a specialty finance company started by KKR, the private equity kingpin. After Goldman sent out the marks in the 50¢ to 55¢ range, Fanlo called Cohn and told him, “You're way off market. Everyone else is at 80, 85.” Cohn then offered to sell Fanlo $10 billion of the paper at his 55¢ price and encouraged him to sell that in the market to all the other broker-dealers at the higher prices they claimed to be marking the paper at. In other words, Cohn was offering Fanlo a windfall: buy at 55 and sell at 80. “You can sell them to every one of those dealers,” Cohn told him. “Sell 80, sell 77, sell 76, sell 75. Sell them all the way down to 60. And I'll sell them to you at my mark, at 55, because I was trying to get out. So if you can do that, you can make yourself $5 billion right now.” Cohn had been trying to sell the securities at 55 for a period of time and people would just hang up on him. A few days later, Fanlo called Cohn back. “He came back and said, ‘I think your mark might be right,’” Cohn said. “And that mark went down to 30.”

Cohn said the market changed dramatically through the course of the year. “We respect the markets,” he said, “and we marked our books where we thought we could transact because some of this stuff wasn't transacting. Or where we actually had transacted. We were not misleading ourselves or our investors. We got blamed for this, by the way. We were not misleading people that bought securities with us at 98 on the first of the month, and we didn't feel like, ‘Oh, my God, we sold these to investors at 98.' How can we mark them any lower than 93? We sold stuff at 98 and marked it at 55 a month later. People didn't like that. Our clients didn't like that. They were pissed.”

The question was when Goldman changed its marks on these securities. Was it in early May, looking back to April, as the Bear executive suggested? Or did the dramatic shift in the marks come on July 3, when
Cohn had his conversation with Fanlo at KKR Financial? Cohn explained that Goldman had a record of every mark on every security, but that Goldman had no record of their marks changing as early as May. The moment the bid-asked spread on these securities widened to the point where there needed to be such a fulsome debate about their value was the beginning of the end. “My view of common sense is if it takes you two or three weeks to get a price, you don't have a clue what the price is,” one senior Bear executive said. “Perhaps their view was that ‘It took two to three weeks and we've gotten it exactly right, we know exactly what the price is.' But I think that it was that level of common sense that a shoe-shine boy wouldn't have been fooled by to say, ‘Yeah, if you take two weeks of computing to tell me what this thing is worth, it could be worth anything, or nothing.’”

D
ESPITE THE
A
PRIL
disaster, which was readily apparent to Cioffi by the second week of May, he and Michael Levitt, the founder of Stone Tower, decided to push ahead with the filing of a registration statement with the SEC for an initial public offering of stock for what had been Rampart and was now known as Everquest Financial. Given the ongoing decline in the mortgage market, the decision to move ahead with the filing of the IPO documents for Everquest—which was really nothing more than a landfill for increasingly toxic mortgage securities—was an act of colossal chutzpah. On Saturday, April 21, Cioffi wrote Levitt to update him on the S-l filing (the IPO document) and to see if Levitt wanted to play golf the next day. “Rich Marin is only waiting for an email from D&T”—Deloitte & Touche, the auditors—“stating that the 12/31/06 Everquest financials do not have to be restated to reflect the hedges [that were transferred from Cioffi's hedge funds to Everquest],” he wrote. “D&T has unequivocally stated that the financials do not have to be restated. (That's very good news.) Once we get that email, BSAM will give the go ahead to file.”

On May 8, at 1:58
A.M.
, Tannin sent Cioffi a spreadsheet of the positions that Everquest would take over from the funds, which required a true-up payment that “is much higher than we thought,” he said. “I was surprised by this initially.” He concluded with the thought, “I'm frustrated and tired.” The next day, May 9, Everquest filed its registration statement. Since it was a preliminary filing, no information about value was included. But there were twenty-one pages of warnings—known as “risk factors”—about the deal, including the fact that Everquest bought most of its CDOs from Cioffi's hedge funds based on valuations established, in part, by Bear Stearns that were “not negotiated at arm's length.” The filing also noted that Citigroup had provided the company with a
$200 million line of credit to buy the securities and that Cioffi's hedge funds received 16 million shares of Everquest and $149 million in cash in exchange for selling its CDOs to Everquest. Although Bear Stearns was the lead underwriter on the transaction and the company was nothing more than a way station for Cioffi's most illiquid mortgage-backed securities, it was surprising that Paul Friedman, one of the most senior executives in Bear Stearns's fixed-income business, had no idea about the S-1 filing until it occurred that day. “I never heard of it until it became public,” he said. “Can't say if Warren knew or if the trading desk knew, but I'm pretty sure none of us in control roles away from BSAM knew about it. I can't speak for the others or for the firm, but personally I thought the notion of packaging the most opaque and complicated securities into a complicated structure and then selling it via an IPO to the widows and orphans of the world was one of the most bizarre ideas I'd ever heard.” Others agreed with Friedman. “The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets,” Matthew Goldstein wrote in
BusinessWeek
two days after the IPO was filed. “But Everquest's portfolio could be a time bomb. A ‘substantial majority' of the CDOs are backed by mortgages to home buyers with risky credit histories…. Trouble is, the subprime market has imploded this year, with scores of home lenders going out of business and home foreclosures on the rise.”

The unsurprising result of the poor performance of Cioffi's hedge funds in April was that the number of investors wanting out expanded considerably in May. “As soon as that comes out, obviously we're starting to get into the papers,” one Bear Stearns executive explained. “I think that there was something like eleven days in a row where we were in the top column of the
Wall Street Journal.
It was just amazing by any standards. Either it was a slow news period or the beginning of a massive tsunami, or both. We started getting press around that issue because you can't send something out to all these investors that says, ‘Whoops, NAV's down 19' and not expect it to hit the papers right away, and it did. Immediately we start getting a lot of redemption noise and we're girding our loins for that.” As the redemption notices came in, Cioffi began to get a clear picture of the money that he would need to pay out on May 1, June 1, and July 1.

Even though between March 1 and May 3, thirteen investors, including two of the largest investors and Cioffi himself, had requested redemptions, Tannin told a repo lender “the funds anticipated no large redemptions.” On May 13, Cioffi wrote to Tannin and McGarrigal: “I think … the [Enhanced Leverage Fund] has to be liquidated which
seems to be somewhat certain given the redemption activity.” Notwithstanding that view, Cioffi continued to push Bank of America to complete the CDO financing. To facilitate the closing of the transaction, scheduled for May 24, Bank of America agreed to buy, on May 22, $2.89 billion of assets from Cioffi's hedge funds that would then be securitized. From that moment on, Bank of America bore the risk of holding the assets if the deal did not close. Of course, the bank claimed to be completely unaware of Cioffi's and Tannin's concerns about the viability of the funds. Late in the afternoon of May 23—the day before the CDO deal was to close—Cioffi called a Bank of America employee and said that, as a courtesy, BSAM would be sending Bank of America a letter about the redemption requests in the Enhanced Leverage Fund. Cioffi made no mention of the redemption requests in the High-Grade Fund.

At 6:30
P.M.
on May 23, Patrick Fleming, a BSAM managing director, e-mailed a letter—signed by Cioffi—to Bank of America about the redemptions. “As a result,” Cioffi wrote, “we expect redemptions in the months of June and July [in the Enhanced Leverage Fund] of approximately $324 million, representing 49.92 percent of the total equity capital of the fund. While we have not determined how to satisfy such redemption requests, we are considering all available options,” including asset sales, gating the fund (that is, halting redemptions), or an orderly wind-down of the fund. “We believe that the foregoing developments will not materially affect our ability to perform our obligations as collateral manager [for the CDO] and we further believe that the foregoing developments will not have a material adverse effect on our business, properties, financial condition or prospects.”

The next day, with the Bank of America CDO deal scheduled to close, Cioffi met with his bankers at that firm and acknowledged “that he had known of the redemption requests for some time” but had not advised the bank because “there was a possibility that investors would withdraw their requests.” He also repeated his belief that BSAM was “going to unwind or liquidate the Enhanced Leverage Fund” and said that the letter the previous day had “overstated the risks” that the Enhanced Leverage Fund would be liquidated. Cioffi also agreed in that meeting to sign a side letter—a condition of the imminent closing of the deal—giving Bank of America certain rights about selecting assets to be purchased. Cioffi never signed the side letter, but based on Cioffi's representation that he would sign the letter, Bank of America closed the deal. Approximately $290 million of the proceeds of the Bank of America deal were used to repay Bear Stearns for a one-month repo loan the firm had made—without telling anyone—to the Enhanced Leverage Fund to provide badly
needed liquidity. “It was a very temporary thing with a very finite end date,” Paul Friedman said. “The contract with B of A seemed bulletproof, so we viewed it that we had no risk as lender.”

On May 30, Cioffi told an investor that he had convinced other investors who had put in June redemption requests “of note (other than about $5M) to pull their redemptions,” but quite the opposite was true. According to a complaint filed against Cioffi and Tannin, they “lied about redemptions because they knew that the news of the redemptions would trigger further redemptions by investors as well as margin calls by repo providers, and that these events could cause the Funds to collapse.”

On May 31, well after Tannin and Cioffi knew that the Enhanced Leverage Fund was down 19 percent, Tannin wrote Cioffi, “I put in a call to [another major investor]. The issue is do we give them the —6.5% April or the larger down April?”

Cioffi answered eight minutes later, “Ah that's correct[.] I think that one deserves a phone call.”