Most of us use high degrees of leverage when we buy a home. A homeowner might buy a $1 million dollar home and mortgage $900,000 of the purchase. If the price drops to $950,000, the “homeowner” loses $50,000 of his initial equity of $50,000, or 50 percent of his equity. If the price drops to $900,000, the “homeowner” loses all of his initial investment. If a bank forecloses on the $900,000 mortgage, it does not even break even after fees. If the price drops below $900,000, the bank’s cushion of the first loss taken by the “homeowner’s” $100,000 is gone, and the bank, the creditor, will not get the full amount of the loan paid back. Some of the mortgage loans made in 2006 and 2007 had zero money down, were made against aggressively appraised homes, and defaulted almost immediately. The investors in the hedge funds are like the homeowners that make a down payment (the investor had equity in the hedge fund), and investment banks (that give the lines of credit to hedge funds) are like the bank that gives out the mortgage. If asset prices drop and wipe out investors’ equity, the investment bank is next in line to take losses on its credit lines.
Many hedge funds use total return swaps, a type of credit derivative, in order to borrow money and leverage up their investments.Warren saw the negative consequences of this strategy first-hand with Long-Term Capital Management.Total return swaps easily thwart the intent of margin requirements, they create much more leverage, and it is virtually invisible. At the end of April 2007,Warren told Susan Pulliam at the Wall Street Journal that the global financial system is so leveraged that it makes the leverage used before the Crash of 1929 “look like a Sunday-school picnic.”6 I told her that if cash-strapped funds are forced to sell assets in a market downturn it “could lead to a vicious cycle of selling that would feed on itself.”7
The collateral the hedge funds put up to back their borrowings is often illiquid and difficult to trade, and prime brokers such as Credit Suisse and JPMorgan do not disclose the amount of total-return swaps that they have made to hedge funds on their books.The strategy is very risky since the assets a hedge fund “buys” may come back on the balance sheet of the bank (the lender) if the fund implodes. For example, if a hedge fund uses 15 times leverage, and asset prices irreversibly drop just a tiny amount, investors lose some principal. If prices irreversibly drop just seven percent or more, investor capital is wiped out, and creditors have no choice but to seize the assets, some of which were sold by the investment banks in the first place.
Regulators fed the folly.Within days of Warren’s warning, the New York Fed claimed that despite market similarities to the risk levels at the time just before LTCM blew up, there were different causes then, so the existing market environment now was less alarming.8 England’s Financial Services Authority (FSA) piled on pablum. The FSA released results from a partial survey of hedge funds and thought that “average” leverage had declined.9
Dr. Sam Savage coined the term “flaw of averages.” He asserts that using an average number to forecast an outcome can lead to huge errors. For example, if a swimming pool’s average depth is four feet, but the deep end of the pool is eight feet, a nonswimmer is presented with lethal risk. A drowning man learns the hard way that the “average depth” mischaracterizes the peril. The average leverage number might suggest that hedge funds on balance are safer, but if an individual hedge fund employs a high degree of leverage, the average for all hedge funds is meaningless. Furthermore, hedge funds had massive hidden risks—inherently risky overrated assets. On May 7, 2007, I wrote the Financial Times that the regulators were dead wrong.The current situation was not less alarming that that presented by LTCM, it was more alarming. Hidden leverage does not show up by polling prime brokers. Hedge funds, structured investment vehicles, and other investors use structured products combined with derivatives and leverage, “illiquid structured products will experience a classic collateral crash when hedge funds try to liquidate these assets to meet margin calls.”10
A few weeks later, Bear Stearns Asset Management proved my point.
In May 2007, Ralph Cioffi was the senior managing director of Bear Stearns Asset Management (BSAM), a subsidiary of Bear Stearns, and cochief executive officer of Everquest Financial Ltd., a private financial services company. He reported to Richard Marin, the chairman and chief executive officer of BSAM. Warren Spector, cochief operating officer of Bear Stearns and a former trader of exotic mortgage products, was the key sponsor of Bear Stearns’ foray into hedge funds. Bear Stearns Asset Management managed several CDOs and it also managed several hedge funds. Before the summer of 2007 ended, my former colleagues Ralph Cioffi and Warren Spector (along with Richard Marin) lost their positions due to CDO investments combined with leverage in hedge funds managed by BSAM.
I had worked at Bear Stearns in the late 1980s and remembered amiable newcomer Ralph Cioffi to be Bear Stearns’ most talented and successful salesman of mortgage-backed securities. He was usually even tempered, always hard working, and thoughtful. I headed marketing for the quantitative group run by both Stanley Diller, one of the original Wall Street “quants,” and Ed Rappa (now CEO of R.W. Pressprich & Co, Inc.), a managing partner. Ralph was a popular salesman with my colleagues and a heavy user of our quantitative research. In gratitude for analytical work that helped him make sales, Ralph presented our group with an $800 portable bond calculator purchased out of his own pocket. When I was lured away from Bear Stearns by Goldman Sachs, Ralph Cioffi tried to persuade me to stay, matching the offer. Around 20 years had passed and since then we occasionally stayed in touch, but we were not close friends.
I knew Warren Spector, too. He had been a talented trader of exotic mortgage products, which at the time meant collateralized mortgage obligations including the volatile interest-only and principal-only slices of those deals. He had come a long way from the somewhat awkward young man who spilled red wine all over a white linen tablecloth at one of our client dinners. Before CDOs undid his career, he was a Bear Stearns favored son with a good shot at taking over Jimmy Cayne’s position as CEO.
We did not correspond. However, a couple of years previously I shared my concerns with Spector about a call I received from a fund representative. He claimed that Bear Stearns had agreed to underwrite his firm’s securitization backed by life insurance policies. The macabre idea was that when policyholders died, investors got the money from the life insurance policies net of expenses and fees—very heavy fees. Documents posted on the SEC’s Web site showed that if the holders of the life insurance policies did not die before additional money was needed to pay ongoing policy premiums, investors would be asked for more money. Investors could lose more than their initial investment if policyholders inconvenienced them by living a long life. I had done a quick background check on the fund representative. The SEC was conducting an investigation and alleged that the fund representative’s former employer was a Ponzi scheme. My concerns were bad news to Warren Spector as well. He checked into it and I missed his return call, so he left me a voice message: “There are lots of people peddling this idea and it’s extremely unlikely that we will do anything with any of them, so I appreciate knowing who’s dropping our name.”
The last time I spoke to Warren Spector, we discussed the hedging of synthetic CDOs that were constructed using credit derivatives. Bear Stearns’ proprietary trading desk had large derivatives positions with a number of investment banks. After JPMorgan Chase purchased Bear Stearns, the New York Fed estimated that Bear had around 750,000 derivatives contracts outstanding.11 Based on what I knew, I thought Bear Stearns had scary volume in tricky credit derivatives. Keeping track of the true risk and long-term profit is a complex task. As I discussed with Warren Spector, any manager would have difficulty determining whether traders were actually making money (or losing money) relative to a risk-neutral fully hedged position. One could temporarily create huge revenues, but enormous risk could soon turn revenues into losses. In contrast, Warren Buffett worked hard to reduce the number and complexity of derivatives contracts owned by Berkshire Hathaway. Wa
rren Buffett told me that after years of whittling down Gen Re’s derivatives positions, he knows (and understands) every derivative contract owned by Berkshire Hathaway.
Buffett and Spector are very different Warrens. Warren Buffett used derivatives to turn junk into gold.Warren Spector oversaw at least one Bear Stearns affiliate (BSAM) that turned “high grade” into junk.
Among other hedge funds, Bear Stearns Asset Management (BSAM) managed the Bear Stearns High Grade Structured Credit Strategies fund. By August 2006, the fund had a couple of years of double-digit returns. BSAM launched the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage fund taking advantage of the first fund’s “success.” There must be more money!
Both funds managed by BSAM included CDO and CDO-squared tranches backed in part by subprime loans and other securitizations (collateralized loan obligations) backed by corporate loans and leveraged corporate loans. In August 2006 when BSAM was setting up the Enhanced Leverage fund, other hedge fund managers (like John Paulson), shorted subprime-backed investments.
Investors in the two funds managed by BSAM had been getting double-digit annualized returns on high-grade debt at a time when treasuries were yielding less than 5 percent. In fixed income investments, that usually means investors are taking risk.
Ralph seemed to have similar views to mine on CPDOs, the leveraged product that I had said did not deserve a AAA rating. Ralph told me he thought the AAA rating could “lull the unsophisticated investor to sleep,” and that for the purposes of his hedge funds, if he liked an investment-grade-rated trade he could have the same trade without paying fees and “easily lever up . . . fifteen times.” To paraphrase Warren Buffett, if the price of your investments drops, leverage will compound your misery.
On May 9, 2007, Matt Goldstein called and asked me if I had a chance to look at the registration statement for a new initial public stock offering (IPO) called Everquest Financial, Ltd (Everquest). Everquest is a private company formed in September 2006, and the registration statement was a required filing in preparation for its going public.The shares were held by private equity investors, but the IPO would make shares available to the general public.12
Everquest was jointly managed by Bear Stearns Asset Management Inc, and Stone Tower Debt Advisors LLC, an affiliate of Stone Tower Capital LLC. I was curious, but I was swamped. I told him no, I was very busy and had not even had a chance to glance at it. He called again asking if I had seen it, and again I said no, “Go away.” Then Jody Shenn of Bloomberg left a voice message about Everquest, but I was still busy. The next morning I ignored Matt’s voice mails, but finally took his call the afternoon of Thursday, May 10, telling him that I still had not looked at the registration statement and had no plans to do so that day. My first call on the morning of Friday, May 11, 2007, was again from Matt Goldstein. He thought the IPO might be important.
I went to the SEC’s Web site, and as I scanned the document I thought to myself: Has Bear Stearns Asset Management completely lost its mind?There is a difference between being clever and being intelligent.As I printed out the document to read it more thoroughly, I put aside the rest of my work and said: “Matt, you are right; this is important.” I was surprised to read that funds managed by BSAM invested in the unrated first loss risk (equity) of CDOs. In my view, the underlying assets were neither suitable nor appropriate investments for the retail market. I did not have time for a thorough review, so I picked a CDO investment underwritten by Citigroup in March 200713 bearing in mind that if the Everquest IPO came to market, some of the proceeds would pay down Citigroup’s $200 million credit line. Everquest held the “first loss” risk, usually the riskiest of all of the CDO tranches (unless you do a “constellation” type deal with CDO hawala), and it was obvious to me that even the investors in the supposedly safe AAA tranches were in trouble. Time proved my concerns warranted, since the CDO triggered an event of default in February 2008, at which time Standard & Poor’s downgraded even the original safest AAA tranche to junk.
The equity is the investment with the most leverage, the highest nominal return, and is the most difficult to accurately price. The CDO equity investments were from CDOs underwritten by UBS, Citigroup, Merrill, and other investment banks.14
Based on what I read, Everquest’s original assets had significant exposure to subprime mortgage loans, and the document disclosed it, “a substantial majority of the [asset-backed] CDOs in which we hold equity have invested primarily in [residential mortgage-backed securities] backed by collateral pools of subprime residential mortgages.”15 Based on my rough estimates, it was as high as 40 percent to 50 percent.
If that was not bad enough, there was huge moral hazard. Bear Stearns Asset Management provided the assumptions for valuing the CDOs. Small changes in the assumptions could create huge differences in prices. Greg Parseghian, formerly of Freddie Mac, was listed as one of the outside directors of Everquest.16 Among the many criticisms levied against Freddie Mac (due to events at the time Parseghian worked there) was its failure to use third-party assumptions instead of concocting its own, thus exposing itself up to moral hazard. Parseghian’s bosses left under a cloud, and he was promoted to CEO of Freddie Mac. Parseghian himself stepped down after a couple of months. OFHEO—the Office of Federal Housing Enterprise Oversight—then Freddie Mac’s regulator, said that before Parseghian’s promotion to CEO, he “failed to provide the Board with adequate information . . . to make an informed decision” in regard to some transactions. In this respect Parseghian’s actions illustrated Freddie Mac’s “culture of minimal disclosure.”17
BSAM earned management fees for the hedge funds, management fees on some of the CDOs, and fees for managing Everquest. If Everquest’s Board replaced the managers, it had to pay a “break-up” fee of one to three years worth of the management fees—breaking up’s so very hard to do.18 The registration statement stated that one of the risks is “the inability of our financial models to forecast adequately the actual performance results.”19 Yet, fees partially depended on performance.
I explained my concerns to Matt in a general way. Among other concerns: (1) money from the IPO would pay down Everquest’s $200 million line of credit to Citigroup; (2) the loan helped Everquest buy some of its assets including CDOs and a CDO-squared from two hedge funds managed by BSAM, namely the Bear Stearns High-Grade Structured Credit Strategies Fund that had been founded in 2003 and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund (“Enhanced Leverage Fund”) launched in August 2006; and (3) the assets appeared to include substantial subprime exposure.
Matt Goldstein posted his story on Business Week’s site later that day. Initially it was called: The Everquest IPO: Buyer Beware, but after protests from Bear Stearns Asset Management, BusinessWeek changed the title to Bear Stearns’ Subprime IPO.20 I hardly think that pleased Bear Stearns more.
Bloomberg’s Jody Shenn also wrote an article on Everquest that day. I expressed to him that “the moral hazard . . . is just mind-boggling.” He noted that Lehman thought that CDO assets had lost $18 billion to $25 billion in value industrywide as mortgage delinquencies rose. I thought industrywide losses were already much larger, they just were not being reported.21
Ralph Cioffi contacted me about the BusinessWeek article. He said that dozens of IPOs like Everquest had been done—mostly offshore so as not to deal with the SEC. According to Ralph, BSAM’s hedge funds and Stone Tower’s private equity funds would own about 70 percent of Everquest stock shares (equity), and they had no plans to sell “a single share at the IPO date.” They planned to use the IPO proceeds to pay down the Citigroup credit line and possibly buy out unaffiliated private equity investors.
I responded that verbal assurances that there are no plans to sell a share at the IPO date are meaningless. Publicly traded shares can be sold anytime. But even if the funds kept their controlling shares, it was not good news. Retail investors would have only a minority interest, which would be a disadvantage i
f they had a dispute with the managers.
Ralph claimed that subprime was “actually a very small percent of Everquest’s assets.” He reasoned that on a market value basis the exposure to subprime was actually negative because Everquest hedged its risk. Technically, Ralph might have been correct—but the registration statement for the Everquest IPO itself suggested otherwise: “The hedges will not cover all of our exposure to [securitizations] backed primarily by subprime mortgage loans.”22
It is fine to talk about net exposure (left over after you protect yourself with a hedge), but one usually also discusses the gross exposure (of the assets you originally bought). Hedges cost money, so they can reduce returns.
Ralph Cioffi said CDO equity is “freely traded and easily managed.” I countered that CDO equity may be easy for Ralph to value, but investment banks and forensic departments of accounting firms told me they have trouble doing it. I told him that if this were a CDO private placement, it would have to be sold to sophisticated investors and meet suitability requirements, but since it is in a corporation, it can be issued as an initial public offering (IPO) to the general public. It seemed to be a way around SEC regulations for fixed income securities, and it was not suitable for retail investors in my view.
Ralph said he would talk to his lawyers about changing the IPO’s registration statement to add a line about third-party valuations. We seemed to be talking at cross purposes, since the registration statement already said that third-party valuation would occur at the time of underwriting.The problem with that was that the assumptions for pricing would be provided by a conflicted manager, and assumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management’s assumptions for pricing.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 16
