Ralph did not seem to want to end the discussion, so I asked him if there was something he wanted me to do. He said it would be great if I issued a comment saying I was quoted “out of context,” that my being quoted in Business Week lent credibility to the article and was not helping me, and that I would be “better served” writing my own commentary. I ignored what I perceived to be a thinly veiled threat. I told him that if he wanted me to write a commentary, I would do a thorough job of raising all of the objections I had just raised with him. Ralph seemed unhappy, but my thinking he was a hedge fund manager from Night of the Living Dead was the least of his problems.
At the end of January 2007, the Enhanced Leverage Fund had $669 million in investor capital and $12 billion in investments for a leverage ratio estimated at around 17 to 1. Some estimates said that leverage increased to more than 20 to 1 the following month as assets increased and capital decreased slightly. The less-leveraged fund was estimated to have been levered over 10 to 1, a high degree of leverage for risky assets. On May 15, just days after the Business Week article appeared, Bear Stearns asset management told investors in the Enhanced Leverage fund that April losses were 6.75 percent. Questions about both the Bear Stearns High-Grade Structured Credit Strategies and the Enhanced Leveraged fund flooded the marketplace. The funds’ credit line providers were alarmed.232425
Bear Stearns faced other challenges. In April 2007, Bear Stearns asked the International Swaps and Derivatives Association, Inc. (ISDA) to modify credit default swap documents to make it clear that it had the right to modify mortgage loan agreements. On the surface, trying to maximize recovery by allowing homeowners to stay in their homes while continuing to make payments is a good idea. Foreclosure costs are expensive, and one should try to minimize losses in any way possible. But Bear Stearns’s timing could not have been more unfortunate; it provoked its own public relations disaster.
A few weeks later, more than 25 hedge funds led by John Paulson, the heavy shorter of the ABX index, all but accused Bear Stearns of seeking to manipulate the market. The seller of credit protection (perhaps Bear Stearns) on mortgage-backed securities, the other side of Mr. Paulson’s trade, could use its investment in residual or servicing rights on a mortgage-backed security to buy out and revive defaulted loans.The protection seller could buy a loan at par, instead of its deeply discounted price, and it would artificially prop up the prices of the trust investments and the underlying securities that made up the ABX and other indexes. Since a protection seller in a lower-rated index has a leveraged position, for a relatively small investment it would gain (or protect) tens of times what it paid out. John Paulson maintained that Bear Stearns was trying to avoid making billions of dollars in payments on credit default swaps. “We were shocked,” said Michael Waldorf, a vice president at Paulson’s firm: He said Bear Stearns introduced language that “would try to give cover to market manipulation.”26 In March 2008, less than one year later, many market participants remembered Paulson’s concerns when Bloomberg revealed that assets backing the ABX indexes appeared wildly overrated and credit default protection sellers (perhaps Bear Stearns?) would possibly have to come up with more collateral to back these trades.
Bear Stearns withdrew its request to ISDA for additional clarification, claiming it now realized that market participants understood its right to modify loans, but the damage was done.With voices stentorian, the hedge funds had given ISDA and the entire subprime market a vote of no confidence in the motivations of Bear Stearns Companies, Inc.
Warren Buffett had admonished his managers not to do anything they wouldn’t want to read about in the newspapers. Bear Stearns and its affiliates were seeing themselves in the press constantly—and not in a good way.
On June 6, 2007, Bear Stearns Asset Management froze redemptions on the approximately $600 million Enhanced Leveraged fund that had been founded the previous August, whereas up until then, investors were accustomed to withdrawing funds with 30-days notice. Its value had fallen 23 percent from the start of the year, and by June 7, BSAM restated its May 15 statement of April 2007 losses from a 6.75 percent loss to a loss of 18.97 percent. BSAM had little choice. Bear Stearns’s lenders: Citigroup Inc., J.P. Morgan Chase & Co., Merrill Lynch & Co., Morgan Stanley, Goldman Sachs Group, Inc., Barclays PLC, Dresdner Kleinwort, Deutsche Bank, and others had begun marking down the value of the funds’ assets and demanded more collateral; the banks made margin calls.The Enhanced Leverage fund faced $145 million of margin calls as of June 8, and the less-leveraged fund faced $63 million of its own margin calls.27
Bear Stearns asked for forbearance. When that didn’t work, BSAM met with the funds’ lenders, and asked for a moratorium on margin calls and a return of derivative collateral back to the fund. In effect it was asking for more leverage and an extended loan.
The meeting was punctuated with a breathtakingly arrogant flourish when BSAM distributed handouts ending with what it needed from the funds’ counterparties. The creditors were not rookies. They had expected BSAM to announce some sort of solution worked out in concert with its parent, Bear Stearns. Of all of the hedge fund managers in the world, the last thing they expected was that Bear Stearns Asset Management would ask them to bend over and think of Ben Bernanke.
BSAM and Bear Stearns Companies, Inc. seemed unaware they had just made an enormous tactical error. They must have been walking around in a dissociative fugue. Bear Stearns Asset Management wanted new conditions from lenders? BSAM was worried about the prices its creditors might put on the assets it managed? The mood of at least one of the funds’ creditors had just shifted from “let’s see what they’ve come up with” to “#*?! those guys.”
In 1994, Bear Stearns had been very quick—some said much too quick—off the mark to seize and liquidate exotic CMO collateral (the kind of assets Warren Spector traded early in his career) of three commingled funds managed by Askin Capital Management. Bear Stearns seemed to have made a fast profit—and a greater profit than the other creditors involved—after reselling seized assets.
Despite David Askin’s belief that he could consistently produce returns as high as 15 percent in both up and down markets, he ran into pricing and liquidity problems.28 At the end of February 1994, Askin did not use the mark-to-market prices supplied by Wall Street firms that had lent him money—including Bear Stearns—but a court-appointed trustee could not find Askin’s models, either. Askin’s disclosure to his investors the following month about not using dealer pricing was one of the triggers that sparked the market sell-off that led to that fund’s bankruptcy.29
Questions were also raised about the prices used by the investment banks that eventually liquidated the assets they seized from the funds. The investment banks did not seem to be using a defensible model based on observable assumptions. Prices seemed to be arranged over the phone between dealers and designed to show a “print” for the records, since customer business had dried up. The prices became a market joke: I’m just Askin’ . . . What’s the price of this CMO?
The final bankruptcy report for the Askin funds noted that Bear Stearns had a 12-hour head start and seemed to make much more profit than the other firms when it resold the assets it seized from Askin. The hasty liquidation may have made any attempt for a bailout moot. The report said Bear Stearns’s seizure and sale of collateral was “at prices below its own contemporaneous assessments of value.”30 To be fair to Bear Stearns, we will never know how it came up with new prices over the phone on that day, since—despite a court order—Bear Stearns said it “inadvertently”31 recorded over its trading floor telephone tapes several months after it was required to produce them. What happened to the evidence? We’re just Askin’.
Bear Stearns was consistent in its take-no-hedge-fund-prisoners philosophy. In 1998, after Long-Term Capital Management turned down Warren Buffett’s bid, the New York Federal Reserve Bank helped arrange a bailout for LTCM with 16 banks and investment banks. James “Jimmy” E. Cayne, Bear Stearns’s CEO, famously refused t
o help. The rest of Wall Street never forgot it.
The head of risk management for J.P. Morgan wasn’t askin’ anything when he pointed out to Ralph Cioffi and his boss Richard Marin that they might have to seek help from Bear Stearns, their parent company, to figure out a way to meet margin calls. He thought they were “underestimating the severity of the situation.” When you are playing for keeps in finance, you dispense with insults such as “you’re a lying scumbag,” and replace it with something along the lines of “you are gravely mistaken”—meaning take it back, or there will be war.
On June 23, 2007, Richard Marin later wrote on his blog, Whim of Iron (whimofiron.blogspot.com), that he had spent the previous two weeks defending “Sparta against the Persians [sic] hordes of Wall Street.” One of my business contacts joked that Marin meant me, since my last name is a Persian name, an artifact of my ex-husband. But Marin seemed to be referring to the popular film, 300, about the battle at Thermopylae, in which a small army of Greeks perished after battling and delaying tens of thousands of Persians. Their sacrifice bought time for the Greek armies, who ultimately drove back their enemy. Marin thought he had prevailed, but like the doomed soldiers in the 300, he lost his battle to maintain his top position at BSAM. On June 29, 2007, Marin moved aside and became an advisor to Jeffrey Lane, BSAM’s new chairman and CEO, an import from Lehman Brothers.32
Initially, Alan Schwartz and Warren Spector, Bear Stearns’s cochief operating officers, emphasized that they were not bailing out the funds. Ralph Cioffi tried to save the funds and announced to his creditors that he had hired a consultant, Blackstone’s Timothy Coleman, to help him restructure the funds. Blackstone owned a large private equity share of FGIC, a bond guarantor that insured risky subprime-backed CDOs (among other things). FGIC thought the tranches it insured were “safe,” but a fundamental analysis would have shown otherwise. In June 2007, FGIC was still rated AAA, but ironically, it was downgraded to junk in March 2007, just a few days before Bear Stearns failed.33
There was talk of Bear Stearns coming to the rescue with a $2.5 billion loan. “People close to the situation”34 claimed that losses would have little impact on Bear Stearns.They were wrong.
On June 15, Merrill Lynch seized collateral and others began testing the market. The news was dismal. Even though most of the assets on bid lists were nominally rated AAA, only some of assets fetched prices close to asking prices. Others were less than 50 cents on the dollar, and some of the harder to sell assets were not even shown around. Many people were angry that BSAM had not managed the funds better. Now that the bid lists were hitting the market, it would be harder than ever to avoid marking down the investment banks’ enormous exposures to CDOs. Bid lists from JPMorgan Securities and Morgan Stanley found their way to Reuters. It counted $1.44 billion in CDOs. Managers included Tricadia, headed by Michael Barnes, an alumnus of the Bear Stearns’s mortgage department and later UBS, Cohen Brothers’ Strategos—later to distinguish itself with highest notional amount of defaulted CDOs, and BSAM.3536
Among the funds’ assets were collateralized loan obligations partially backed by leveraged loans.The SEC had several pricing investigations underway into these types of securitizations. The leveraged loan market had not been getting as much attention as the mortgage market, but collateral quality was mixed. Some loans had assets backing them, and some did not. Investment banks looked at the bid lists and saw that they did not have time to drill down into the loans to figure out how to bid.37
By late June, Bear Stearns said it would invest $1.6 billion to bailout the Enhanced Leverage fund. BSAM had already begun reducing leverage. Bear Stearns also stated that the less-leveraged Bear Stearns High-Grade Structured Credit Strategies fund would not need to be rescued.38
By not stepping up immediately, Bear Stearns let BSAM circulate asset lists that aired Wall Street’s dirty laundry. At the end of June 2007 I told the Wall Street Journal’s Serena Ng that the poor bids raised the question of why investment banks were not reporting losses, and no one wanted to ask the question. “That would open the floodgates. Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced.”39
It wasn’t as if the coming market mess could have been avoided. Bear Stearns simply had the misfortune of an arrogant past, and now it was the first to show everyone’s losing cards. By the end of June, Bear Stearns’s share price closed just under $139 per share, down 15 percent for the year. The worst was yet to come. As Warren Buffett joked to me during lunch, you cannot multiply your investments when you multiply by zero.
Bear Stearns had only bailed out creditors, not fund investors. By mid-July, Bear Stearns told investors in the Enhanced Leverage fund that they would probably get back nothing. Investors in the less-leveraged fund were told they would probably get only 10 cents on the dollar.40 In the eyes of some investors, Bear Stearns Asset Management went from hero to zero.
Iain Hamilton, a portfolio manager for Infiniti Capital, a fund of funds in Zurich that had invested a 3.25 percent allocation in BSAM managed hedge funds, felt misled. At a conference in Sydney, Hamilton exclaimed that BSAM represented the subprime exposure was “6 percent, but it had 40 percent hidden elsewhere.”41 He could take losses. He had losses in another fund, but hadn’t felt misled. According to him, it was misrepresentation. Whether this was a misunderstanding of net versus gross exposures, or something else, will have to be decided by the courts.
Ralph Cioffi left Bear Stearns by mutual agreement on November 28, 2007, at the age of 51. His compensation reportedly soared to eight figures during his BSAM days. The less-leveraged fund had positive returns for several years, and colleagues invested money with him after noting he was returning around 1 percent per month—more than 12 percent per year—in an interest rate environment in which 10-year Treasuries were yielding less than 5 percent. It was an old story: If it sounds too good to be true, it is.
Warren Spector did not last as long as Cioffi. Like Warren Buffett, Warren Spector and Jimmy Cayne are avid bridge players. On August 5, 2007, Spector became the highest ranking bridge player—one of the world’s top 300 contract bridge players—to lose his job over the mortgage lending crisis. Bridge is a great comfort in your old age. If it distracts you from business, it can help you get there faster. Spector had been the lead promoter for Bear Stearns to get into the hedge fund business, and Cayne held him responsible. Cayne’s ire may also have been sparked by the fact that while the funds faltered in July, Spector was at a bridge tournament playing perfect hands of bridge and racking up 100 master points. Cayne played less well at the same bridge tournament, and apparently he thought Spector should have been closer to the hedge fund problem, even if Cayne himself did not feel compelled to fly back to New York.
Unlike Cayne, Spector had sold millions of shares of his Bear Stearns stock in 2004. Bloomberg reported that Spector, 51, earned $228 million in cash from 1992 to 2006, and got another $372 million when he cashed in most of his Bear Stearns shares.42 Jimmy Cayne, 74, resigned in January of 2008, after serving 15 years as CEO. His Bear Stearns stock had been worth more than $975 million in January 2007 and was worth around half of that when he resigned in January 2008. Cayne did not liquidate until after JPMorgan’s March 2008 takeover. The stock was worth only $61 million.
Cayne may feel lucky in comparison to Ralph Cioffi and Matthew Tannin, Ralph’s cohead at BSAM. On June 18, 2008, they were indicted on allegations of securities fraud, among other charges .4344
Prosecutors focused on electronic exchanges between Tannin and Cioffi. The partners may have stumbled over the truth, picked themselves up, and hurried on. In late April, they saw a negative report prompting Tannin to write to Cioffi: “If the report was [sic] true, the entire subprime market was toast.”45 Yet they did not seem to share those concerns with investors. Perhaps the partners gave themselves unwarranted reassurance.
It reminded me of a bridge joke I sent Warren Buffett after our lunch. It was a partnership misunders
tanding. My partner thought I knew what I was doing.
Chapter 9
Dead Man’s Curve
I evaluate the probable loss myself. I don’t use a model.
—Warren Buffett
to Janet Tavakoli, September 2005
Benjamin Graham was not a fan of market timing, in which investors try to forecast stock market prices (or oil spreads, interest rate spreads, or prices of CDOs). He was sure those who followed forecasting would “end up as a speculator with a speculator’s financial results.”1 Instead, Graham advocated buying a stock if it was trading below its fair value and selling when it was above its fair value after doing a fundamental analysis. He knew that his views were “not commonly accepted on Wall Street.”2 Even after Warren Buffett achieved a successful track record following (and then modifying) Graham’s principles, many on Wall Street still did not accept these views.
A recent example is the demise of Bear Stearns, which was preceded and partly triggered by the deaths of Peloton, a European-based hedge fund cofounded by Ron Beller, and one of the funds of the Carlyle Group, a Washington-connected private equity firm. At the time of its demise, Peloton’s held long positions of the type that Bear Stearns’s research group touted in February 2008.
Ron Beller first made big headlines in 2004 when Joyti De-Laurey, personal assistant at Goldman Sachs to his wife, Jennifer Moses, went on trial and was convicted of forging the Bellers’ and Moses’ signatures to filch funds from their personal accounts. Beller and his wife asked De-Laurey to work for them personally when they both left Goldman Sachs, but De-Laurey stayed to become the personal assistant of another Goldman Sachs partner, Scott Mead. She was also convicted of filching funds from him. De-Laurey reportedly took £4.4 million (around $8.75 million in 2008 dollars) from the collective accounts of Scott Mead, Jennifer Moses (Beller’s wife) and Ron Beller. Neither of the Bellers noticed that De-Laurey had taken millions from their personal accounts for several months. Is it any wonder that during the trial De-Laurey referred to Mr. Beller as “an absolute diamond”?3 Yet, when Beller co-founded London-based Peloton in 2005, investors seemed eager to let him manage their money.
Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street Page 17
