House of Cards (70 page)

Tannin replied, “I was also thinking that it might be helpful to show where the losses have come from—i.e. How many bonds are responsible for the losses we've suffered. On the one hand, it focuses attention on how bad these bonds have become—and will cast doubt on our initial strategy where we leveraged these bonds so much—but on the other hand—it might explain the large loss—that it was the result of what amounts to a single very bad decision—after we made so many good ones. And this might bolster our argument that there is a way to make money now—and that we're going to do it.”

In the third week of May, “after the NAVs started crashing and the market went very sour,” according to one person involved, the BSAM and Bear Stearns teams that were focused on the problems in Cioffi's hedge funds—including, among others, Rich Marin, Cioffi, Tannin, Barry Cohen, Steve Begleiter, Mike Alix, and Bobby Steinberg, the latter two being the heads of Bear Stearns's risk management department—came up with the idea that Bear Stearns should invest $500 million into the funds because “the funds were in danger of failure and needed financial support” from the firm. Goldman Sachs had done something similar with one of its errant hedge funds, and this was the template the Bear group hoped Spector would follow. Also in May, UBS, the giant Swiss bank, announced it was shutting a Dillon Read Capital Management hedge fund with a large exposure to the subprime mortgage market after the fund had lost $123 million. But having Bear Stearns inject $500 million into the funds “was rejected flat out,” this person said of the meeting with
Spector. “He sent us back to the showers to fix the problem ourselves. It never went to the executive committee, to my knowledge, though I imagine Warren did advise them that there was a problem brewing.”

The hedge funds were spinning out of control. “When we got all these redemptions in,” a Bear executive remembered, “we started to say to ourselves, ‘We can meet those redemptions with the cash we have.' But if we meet those redemptions, it's a little bit like letting money out the front door when all the repo counterparties are going to say, ‘Wait a minute.' It's very easy to see at this point that you could have a rout and a panic. You want to do everything you can to reassure the repo counterparties. Suddenly, what's in the best interest of investors is to make sure that the repo counterparties don't put you in the tank. The nature of the repo market is such that it's so ungoverned and unregulated that basically it's like a demand loan where they can basically do whatever the freak they want. Even if you have what's called an evergreen line, that doesn't allow them to change the haircuts, so what? They mark everything down and they say margin call. Guess what? They always have that right. Always. That is the beauty, or the weakness, depending on how you want to look at it, of the repo market. It's all about confidence.”

On Saturday morning, May 26, Tannin wrote Cioffi and McGarrigal an e-mail reflective of the desperate position the three hedge fund managers found themselves in. Tannin was thinking about the “building of the plan” to potentially solve the crisis. They had been batting around the idea of having Cerberus—the large, secretive private equity and hedge fund that had bought Chrysler—either take a stake in the hedge funds or buy them entirely. “Two years ago Ralph went to see Bill Gross”— the billionaire investor and then CEO of PIMCO, the huge bond fund— “and came back with the following ‘Gross' observation: when involved with a trade, look around the room and determine who the chump is and if the chump is not clear to you, assume it is YOU. Well, as I sit here thinking about the Cerberus plan that we will present to Cerberus, Warren, Rich Marin and you guys, it is easy for me to see that I am the chump. Consequently I must assume that anything I could possibly think or understand is understood better and faster by the rest of the group.”

The idea of selling the funds to Cerberus never got much traction. “Warren got pretty mad at Ralph for chasing Hail Mary plays and wanted him to stop and just work the asset sale and deleveraging efforts more,” explained one Bear Stearns senior managing director. “What Warren wasn't realistic about was that Ralph was doing all that the market would allow, so he started chasing franchise-salvaging opportunities even though
they were long shots. Ralph was trying to salvage the business, not necessarily instead of the asset value, but in addition to it. He had a strong vested interest in doing so.”

The choices for the hedge funds were becoming extremely limited. The only choice that seemed logical was not to permit the redemptions to take place, essentially sealing the funds in amber so that, in time, value could be realized and investors made whole. “Suddenly we're faced with do you meet these redemptions coming up,” said a Bear executive. “If we get margin calls, how are we going to meet the rest of the cash needs? We started looking at liquidity issues. What can we sell? Where can we raise cash? What can we do? We thought that suspending redemptions was actually going to make the repo counterparties more comfortable. Because you figure, all right, you're stopping the front-door leakage for the benefit of creditors.”

On June 7, Cioffi announced that redemptions from the Enhanced Leverage Fund would no longer be permitted, regardless of whether a redemption notice had already been submitted. Two days later, Cioffi reportedly said, “If I can't [turn the funds around], I've effectively washed a thirty-year career down the drain.” On June 26, investors in the High-Grade Fund were told the same thing. The doors of the funds had been barred. And all hell broke loose.

E
VER SINCE
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Marin and the other executives at BSAM made the decision to put a moratorium on trading between Cioffi and Bear Stearns, some of the people running Bear's fixed-income business worried about what Cioffi was doing but had no authority to do anything more than worry. “All the grown-ups who were looking at him were pushed aside,” said Paul Friedman. “The guys who were managing him didn't know what the hell a hedge fund was, certainly didn't know what a mortgage was, and so it was inevitable that he would get to the point where his strategy—which was also a microcosm—of more and more leverage on more and more complicated stuff blew up. He kept saying to us, ‘Don't worry. I have all my funding locked up on a ten-year term, non-recourse basis. I can never get a margin call. They can never pull it from me. It doesn't matter.' We were thinking to ourselves, ‘Wow, that's a beautiful thing.' In fact, he had about $10 billion like that. But he had another $14 billion that was funded month-to-month.” Cioffi had supposedly figured out a way to get some long-term funding for his hedge funds by creating an “entity” that borrowed short-term in the commercial paper market and then used the proceeds to buy his long-term mortgage securities. This scheme was called “Klio Funding.” “Every time you asked him, Ralph
would say, ‘Yeah, I just did another Klio deal. I locked up another $2 billion with Dresdner Bank for ten years, another $4 billion with Citibank for five years. Isn't it great?' We'd go, ‘Wow, wish we had that.' We were jealous.”

On June 5, Spector walked into Friedman's office next door and dropped a bombshell. “I need you to go over to BSAM,” Spector told him. “I think Ralph's got a liquidity problem. Could you see if you could help?' Talk about your great understatement of all time.” By this time, BSAM had moved out of 383 Madison Avenue into a separate office down 46th Street, at 237 Park Avenue. Friedman said he knew that Cioffi had suspended redemptions in one of the funds, but little else. “I go over to see Ralph with the BSAM guys, and not surprisingly, the announcement that he was suspending redemptions had caused his fourteen lenders to raise their margin requirements, mark down the collateral, and start to squeeze,” Friedman said. “And so I sat with Ralph and I said, ‘Take me through it. You must be okay. You've got all your funding locked up, non-recourse, no margin calls for term, right?' He goes, ‘Yeah, most of it,' and so we go through the balance sheet, and he's got about $14 billion of mostly high-quality stuff, but not entirely, and his average funding is about a month, and I said to him, ‘How long would it take you to sell that?' He goes, ‘Well, I could probably sell a third in six months.' I said, ‘What are you gonna do if you get a margin call?' He goes, ‘Well, I've got some more of the same stuff fully paid for in the box.' I said, ‘How much?' He goes, ‘A few hundred million.' I went, ‘You're dead. There's no way this is going to happen.' We went round and round for a couple of days.”

They decided to call Tim Coleman, the partner at Blackstone in charge of the firm's restructuring group. Coleman was a friend of Marin's and a leader in the niche business of advising companies in financial distress both before and during a bankruptcy. “We went through it with Coleman,” Friedman said, “but it was pretty much hopeless.” They decided to call a meeting of the fund's creditors—chiefly the repo lenders at other Wall Street firms—and make a proposal to them that they hoped would stem the tide of margin calls and allow for a more orderly liquidation of the funds. The creditors' meeting, where Marin and Cioffi would present their proposal, was scheduled for June 14.

On June 6, a day before Cioffi sent out a letter to investors suspending redemptions in the fund,
Hedge Fund Alert
broke the story that the Bear hedge funds intended to block withdrawals. “Limited partners were seeking to yank about $300 million from the vehicle at the end of June—the next available redemption date,” the publication reported. “But Bear has notified investors that it is suspending withdrawals. By
halting redemptions rather than limiting them, Bear is seeking to prevent a run” on the Enhanced Leverage Fund. Incredibly, just before
Hedge Fund Alert
's accurate story came out, Joanmarie Pusateri called the repo department at Bank of America to notify them that the article would soon appear “but that the article was untrue” and “redemptions were not being suspended.” Pusateri made a similar call to Barclays.

That same day, BSAM issued a “Talking Points” document for use with investors when talking about what happened in the two hedge funds. The change in April NAVs was the “result of relatively large mark downs on a relatively small number of assets and our hedges have not moved up as much as our assets have moved down … The difference between the initial and revised estimates is due to dealers marking the book much lower than previously.” The memo said the Enhanced Leverage Fund had $240 million in redemptions for June 30. “We could meet these redemptions by selling the most liquid securities which would leave the fund with the least liquid and poorest performing assets,” it said. “This would be unfair to remaining investors and we will not do it.” As a result, redemptions would be suspended in the Enhanced Leverage Fund, effective June 30. The memo stated that the High-Grade Fund had $107 million of redemptions that it planned to meet “in an orderly way.” The memo also noted the
Hedge Fund Alert
article: “This is unfortunate but we can assume that more articles will be written about this topic.” A conference call for investors reiterated many of these same points and noted that “dealers had mismarked their positions” in April.

The June 7 letter to investors not only announced April's 18.97 percent decline in the Enhanced Leverage Fund—just three weeks after a May 15 letter said the loss was 6.5 percent—but also announced the news that redemptions, of some $250 million on a $642 million fund, would be suspended because the “investment manager believes the company will not have sufficient liquid assets to pay investors.” On a conference call with investors the next day to discuss the fund's poor performance, Cioffi and Tannin refused to answer investors' questions. “They didn't want to say anything,” one investor said. Inevitably, the increasingly angry investors in the fund put the word out about what was happening. Apparently, Cioffi was also spinning tales about the Enhanced Leverage Fund's performance in May. He told Bank of America on June 7 the fund was up “approximately 1.7 percent in May” and the next day told Barclays the fund was up “2.7%” in May. (The fund was actually
down
38 percent in May.) Between about June 8 and June 12, representatives from Barclays spoke at least twice with Tannin, where he described the recent April performance as stemming from a “pricing anomaly” in CDO-squared securities
in which the Enhanced Leverage Fund had invested. “There has not been any material deterioration in the underlying credit quality,” he told the bankers. “The market is stabilizing.”