House of Cards (82 page)

he problem for Bear Stearns, as the fall rolled on, was that events were no longer happening in a vacuum. The cancer that had been revealed in Bear's two hedge funds in June had now metastasized and spread throughout the world. On September 13, Northern Rock, one of the largest retail banks in England, sought liquidity support from the Bank of England. Four days later, the Bank of England guaranteed all of the bank's deposits. (Shortly thereafter, Northern Rock was nationalized.) On September 25, Moody's warned that the subprime “infection” had spread to companies such as AMBAC and MBIA that insure bonds of other companies and that these insurers would need more capital. On September 26, Chris Flowers, Bank of America, and JPMorgan Chase announced that they were all backing out of their previously announced $25 billion deal to buy and take private Sallie Mae, the student loan company. (Much threatened litigation followed before a settlement was reached and the deal scuttled.) Then came a myriad of write-downs among financial institutions—$5.9 billion at Citigroup, billions of dollars of home equity and leveraged loans at UBS, close to $1 billion of home loans at Washington Mutual—and Merrill Lynch was placed on “credit watch” due to impending losses and “poor risk management.” Both Merrill
Lynch and Citigroup were suffering billions of dollars in losses from their exposure to mortgage securities, and the drumbeat had started among investors and the financial press to blame their CEOs for the massive and unprecedented losses. On October 26, Merrill Lynch CEO Stan O'Neal “retired” and the firm gave him a $161 million pay package to ease his pain. On November 2 Citigroup CEO Chuck Prince offered to resign, and his offer was accepted. He walked off with $40 million.

Firms were also raising dramatic amounts of capital to replenish the equity written off as a result of these toxic assets. Citigroup raised $7.5 billion from investors in the Middle East. Freddie Mac raised $6 billion. Fannie Mae raised $7 billion. UBS raised $11.5 billion after taking a $10 billion write-down related to subprime mortgages. Merrill Lynch raised $6.2 billion and then another $6.6 billion; Morgan Stanley raised $5 billion.

Bear Stearns did nothing. In typical fashion, Cayne and Bear Stearns continued marching to their own drummer. There was no talk about raising capital. There was no talk of a Cayne coup. In fact, after the Citic deal, Cayne seemed more emboldened than ever and determined to stay in place, despite being seventy-three years old and having Alan Schwartz as his designated successor. There was also little likelihood of a genuine capital infusion finding its way onto Bear Stearns's balance sheet—although efforts to do so were ongoing—since Cayne had nixed the idea so publicly. The reasons Cayne and Schwartz were so dead set against raising equity capital were complicated. Part of it was that raising equity capital would be both a sign of strength and a sign of weakness, with Cayne thinking that, on balance, weakness was the more likely message. There was also his belief that the stock was way too cheap, at around $115 per share, to sell a big slug of it to a third party. After all, Cayne had only sold tiny amounts of his large stock holdings, so why should the firm sell at these deflated prices? There was also the feeling—shared by both Cayne and Schwartz—that capital should not just be obtained simply to prove the firm could raise capital; rather, it should be raised to serve some greater strategic purpose, such as in the case of the Citic deal (although technically no fresh capital was raised).

Part of the reason for their ongoing reluctance—which they of course deny—was that the executive committee got compensated based on the calculation of the firm's return on equity (net income divided by the firm's book value). Any increase in equity would increase the firm's book value dollar for dollar and would reduce the firm's return on equity, especially in a declining market for Bear Stearns's products. Any equity capital raised would immediately mean a smaller bonus pool for the executive committee.

But below the executive committee, the senior executives were still pushing various strategic initiatives, even after the Citic deal. Discussions were continuing with Fortress and its CEO, Wes Edens. “They have an awful lot of very smart people at Fortress,” Paul Friedman said. “There were many of us who felt that the notion of a massive infusion of talent and brainpower was very appealing.” But there were numerous issues that made that deal difficult to consummate. On one hand, there was the problem of the differing compensation systems at the two firms: Bear Stearns had the typical compensation structure favored by public Wall Street firms of paying bankers and traders relatively small salaries and then, depending on the revenue they generated in a given year, huge bonuses as well. This system resulted in millions of dollars in annual compensation for a wide swath of the firm's population, without a corresponding way of holding the bankers and traders responsible financially for their actions. By contrast, Fortress's compensation system was the typical one found in hedge funds and private equity firms (Fortress had both business lines), where, generally speaking, the firm received a 2 percent annual fee of funds under management plus 20 percent of the annual upside of a fund's performance. Combining these two plans was a high hurdle.

There was also a problem of meshing the firm's two business plans and the potential conflicts that might create for Bear Stearns in the market. “What Fortress did for a living was buy illiquid assets, way more illiquid than the stuff that we had,” Paul Friedman said, “and fund it on really good and aggressive terms from the Street. It was such a huge fee payer to the Street that it could use that to leverage what it needed to run its business. Can you imagine a Fortress/Bear person calling up Goldman Sachs and saying, ‘Listen, we need three-year nonrecourse financing on this aircraft because we're going to pay you some fees next year'? Slam that door! I didn't see any way Fortress could get any of the things done that it did if it were affiliated with a dealer. Not just us, but any Wall Street dealer. If they had been part of Goldman Sachs and we got the same call, we'd tell them to take a hike.”

But probably the biggest impediment to the deal was Edens's desire to be named the CEO of the combined firm, a slightly audacious request given that Bear Stearns had twice the market capitalization of Fortress at the time. On the other hand, there was no question that Edens, a hedge fund manager, had a better understanding of capital markets, trading, and mortgage securities than did Schwartz, an M&A advisor. “When the dust settles, Wes was going to be the CEO of Bear Stearns,” Friedman said. “It was the linchpin of the whole thing and, my understanding is,
one of the many reasons it fell apart. I didn't get the trade at all. I didn't understand it.” Complicating the transaction further was the fact that Fortress itself started having financial problems by the end of 2007. “They were having their own issues in a big way,” Friedman said. “They were having P&L issues. They were having liquidity issues. I think it just sort of withered away. I'm not sure at what point somebody pulled the plug, but I had heard that we killed it over the issue of Wes being CEO.” Soon enough, there would be other serious overtures as well, including from Sumitomo Bank, in Japan; PIMCO, the huge California bond fund; and ResCap, the residential mortgage business of General Motors Acceptance Corporation, or GMAC, a portfolio company of Cerberus, the hedge fund and private equity firm. These would all be turned down as well. The firm was simply too insular and too wedded to the status quo to consider any transformative transaction. “Very few people came in from the outside into senior positions,” one longtime Bear executive said, “and those that did often didn't last very long and were not ultimately accepted in the culture. The people who really did well were lifers. Jimmy was a lifer, Ace was a lifer, Warren was a lifer, Alan was a lifer…. They all grew up in that culture and they could speak it and they didn't really do well interacting with outsiders.”

Whatever modicum of control Cayne thought he might have had over his own and Bear Stearns's destiny—his moral authority to run the firm, his ability to be Solomonic in his decisions, and his ability to steer the firm through its most significant crisis of confidence ever—all changed after the morning of November 1, when the
Wall Street Journal
published a devastating front-page account of Jimmy Cayne and his odd behavior during the summer's crisis. While Cayne and Bear Stearns had never been known for the ability that some others on Wall Street had to manipulate the press into writing or broadcasting fawning stories, the
Journal's
story, written by Kate Kelly, was the worst kind of publicity imaginable at precisely the wrong moment and accelerated an already unfolding series of crucial events in the firm's denouement.

Kelly reported that Cayne was playing bridge “during 10 critical days of this crisis” in Nashville “without a cell phone or email device.” She reported—incorrectly—that Cayne had left the “tense” August 3 conference call “after a few opening words and listeners didn't know when he returned” (the truth, of course, was much worse). She reported that Cayne had been out of the office playing golf or bridge for “10 of the 21 workdays” during the “critical month of July.” Kelly made sure to include comments that refuted the central thrust of her article. “Anyone who thinks that Jimmy Cayne isn't fired up every day and ready to get to
work hasn't been living in my world,” Schwartz told
the Journal
. Schwartz noted that Cayne had flown to Beijing over Labor Day weekend to agree to the Citic deal. Kelly contrasted Cayne's “actions amid the turmoil” to the “hands-on roles of peers” across Wall Street. She even noted that Lloyd Blankfein, Goldman's CEO, “cancelled plans to spend the last two weeks of August at his beach house, missing a chance to spend time with his sons before they headed to college,” in order to take control of the unfolding crisis at his desk.

Kelly also reported that Cayne had rebuffed Jamie Dimon's 2002 offer to have Bank One buy Bear Stearns and would only consider it “for a significant stock price premium, a big personal payout and the use of a private jet.” She wrote that Cayne hated to travel for business and refused to meet with President Bush in Washington to discuss economic issues. If Bush wanted to talk to Cayne, they could meet in New York. But of all Kelly's zingers, the most embarrassing personally and professionally was the one that accused Cayne of being a regular consumer of marijuana. “After a day of bridge at a Doubletree hotel in Memphis, in 2004, Mr. Cayne invited a fellow player and a woman to smoke pot with him, according to someone who was there, and led the two to a lobby men's room where he intended to light up,” Kelly reported. “The other player declined, says the person who was there, but the woman followed Mr. Cayne inside and shared a joint, to the amusement of a passerby.” She also wrote that Cayne “used pot in more private settings, according to people who say they witnessed him doing so or participated with him.” In the article, Cayne “denied emphatically” the alleged pot-smoking incident at the Doubletree. “There is no chance it happened,” he said. “Zero chance.” He told the paper he would not answer questions about whether he smoked pot generally and would respond only “to a specific allegation.”

Kelly also reported on the “summertime ritual” of Cayne's $1,700 Thursday afternoon helicopter trips from New York City to the Hollywood Golf Club, followed by the rounds of golf on Friday, Saturday, and Sunday, followed by going home for “several hours of online poker and bridge and to play with his grandchildren.” Kelly and her boss, Michael Siconolfi, had had lunch with Cayne on July 12 at 383 Madison, where, Kelly reported, “Mr. Cayne seemed less interested in discussing the markets than in talking about a breakfast-cereal allergy and his stash of unlabeled Cuban cigars. On another occasion, he told a visitor he pays $140 apiece for the cigars, keeping them in a humidor under his desk.” For his part, Cayne does not deny the conversation at lunch with Siconolfi and Kelly but said it “was off the record,” which Kelly and Siconolfi violated. As for the August 3 analyst call, Kelly reported that there was silence
after he was asked a question because Cayne had “been summoned out by a lawyer advising him on the pending departure of Mr. Spector, who by then was planning to resign. Mr. Cayne later returned, but the hundreds of listeners weren't told this, leaving them with the impression that the CEO had left the call altogether.” As previously noted, of course, Cayne was there, according to people in the room, but did not know how to answer the question asked about stock buybacks. “The following day, a Saturday, Mr. Cayne scored a respectable 88 at the Hollywood golf course,” Kelly reported. She concluded the article with the idea that Cayne was concerned about his legacy, and she quoted John Angelo, a former Bear professional turned hedge fund manager who was Cayne's frequent golf partner at Hollywood. “It's one thing if you're 55,” Angelo said. “It's another if you're 73.” Angelo added that after the summertime events at Bear Stearns it would take “periods of time to get your reputation back.”