Goldman questions Bear's marks
Despite what they said in the April 25 conference call, by early May both Cioffi and Tannin anticipated that the funds' April results were going to be rough. Cioffi published the net asset value (NAV) for the Enhanced Leverage Fund for April at -6.5%. A week later, Goldman Sachs sent, by e-mail, its April marks on the securities to Cioffi. As a counterparty to trades in the funds, Goldman was obligated to report its thinking about the value of the securities in the funds on a monthly basis.
"Now there's a funny little procedure that the SEC imposes on you, which is that even if you get a late mark, you have to consider it," explains one former Bear executive. "They give us these 50 and 60 [cents on the dollar] prices. What we got from the other counterparties is 98. The SEC rules say that when you do this, you either have to average them - but they're meant to be averaging 97s and 98s, not 50s and 98s.... So we have to repost our NAV. And now we go from minus 6 [percent] to minus 19 [percent] - minus 18.97 [percent] to be exact - and that is game f***ing over. By the way, the firm that sent us the 50 made a s**t-pot full of money in 2007 shorting the f***ing market."
Gary Cohn, the co-president of Goldman Sachs (GS, Fortune 500), 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 shop. 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 Fanlo. "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 marked our books where we thought we could transact because some of this stuff wasn't transacting," says Cohn. "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 moment the bid-ask 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.
As the BSAM funds collapsed, Bear Stearns co-president Warren Spector suspected Cioffi and Tannin might need help. On June 5, Spector walked into Paul Friedman's office, and Friedman remembers Spector saying, "I think Ralph's got a liquidity problem. Could you see if you could help?' Talk about your great understatement of all time." On June 7, Cioffi announced that redemptions from the Enhanced Fund would no longer be permitted, regardless of whether a redemption notice had already been submitted.
"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. (By this time, BSAM had moved out of Bear's headquarters at 383 Madison Avenue into a separate office down 46th Street, at 237 Park Avenue.) "And so I sat with Ralph and I said, 'Take me through it. You must be OK. 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.'"
On the advice of the restructuring team at the Blackstone Group, the BSAM team decided to call a June 14 meeting of the repo lenders to Cioffi's hedge funds. The basic gist of Bear's strategy was to ask these creditors to be patient so that an orderly liquidation in a less pressured environment could commence. Blackstone's theory of the situation was that the very same banks that were repo lenders to the funds were up to their eyeballs in the very same illiquid mortgage securities that Cioffi had. Therefore, no one would have any incentive to force a sale of the securities into a frozen market and thus establish a new, lower mark that everyone would have to adopt.
"It was the classic Mexican standoff, where nobody wins if everybody's dead on the floor at the end of this thing," explained one person involved with the strategy. "Our point was, 'All you guys have this problem. It doesn't help any of you to flood the market with this paper'...But it was like any other panic. If you're out early enough, maybe it is good for you."
The repo counterparties' meeting took place in the second-floor auditorium at Bear Stearns headquarters at 383 Madison Avenue. The tactic backfired completely. Two days later, Merrill Lynch ignored Cioffi's request for a thirty-day standstill and seized $400 million of its collateral from the funds with the intention of auctioning the assets in the market at noon on Monday. Says Friedman, "had he not been the first fund to go, it would have had a much lower impact as well.... But it was like the pebble being tossed into the pond. It was pulling on the thread. It was any analogy you want to use."
Around the middle of June 2007, Chairman and CEO Jimmy Cayne decided to convene a meeting of the twenty most senior executives at the firm to get an update of what was going on with Cioffi's hedge funds and to decide whether or not the firm should agree to become the repo lender to the funds. To that point, Bear Stearns' only exposure to Cioffi's hedge funds was its $45 million equity investment, and the rest of Wall Street was waiting for Bear Stearns to put together a rescue plan.
Before going into the meeting, Cayne asked Steve Begleiter, the firm's head of strategy, how much money Bear had invested in the funds. Cayne told Begleiter he thought the amount was $20 million; Begleiter corrected him and informed him the firm actually had $45 million invested. Cayne remembers saying, "Where did the other 25 come from?' So Begleiter said, 'I don't know.' I said, 'You don't know where the 25 comes from?' He said, 'No.' We walk in, I said, 'Before we discuss what we're going to do, does anybody know about $25 million that was put into the funds at the last minute?' Spector said, 'I did. Sorry.' No, he didn't say 'I'm sorry.' He said, 'I f***ed up.' If he had said 'I'm sorry,' it would have been different. He said, 'I f***ed up.' Now there's silence. People were expecting me to say, 'What are you, f***ing crazy? Unauthorized, you yourself authorized $25 million into a failing enterprise.' Well, I didn't, but I also didn't say anything for like a minute. I just let everybody hear him say, 'I f***ed up.'"
After shining the bright light of blame on Spector's decision to invest the extra $25 million into the funds on his own authority, Cayne asked the group what to do about the funds. 'I said, 'Okay, so what are our options? It seems to me the first option is we just bag the funds. We suffer a reputational risk, which we aren't really going to avoid anyway. And we save ourselves the heartache of that crap coming into us.' Nobody said anything."
By June 22, Spector was on the phone with other Wall Street executives. His message to them was that Bear Stearns had finally decided to step up in a significant way to help the hedge funds (Cayne's pitch to let them fail had not carried the day with his fellow board members). But the level of the rescue was not quite what the Street had expected. Spector outlined a plan in which Bear would become the new repo lender - up to a total of $3.2 billion - to the High-Grade Fund only and would do nothing for the Enhanced Leverage Fund, effectively signaling that the second fund would fail and be liquidated. (In the end, Bear Stearns lent around $1.5 billion to the High-Grade Fund.)
Now the hard work of figuring out what the firm had just agreed to buy had to begin. "It took two or three weeks to mark," explained Friedman. "It literally took a dozen people on the mortgage desk night and day, and a bunch of our research people night and day and weekends, three weeks to value this stuff, which tells you just how illiquid it was."
By the time they did figure out what most of it was worth, the firm had miscalculated badly. "We thought there was $400 million-ish of cushion, and in fact, as it turned out, we missed by like $1 billion out of $1.5 billion," says Friedman. "It was not even close. You would think you could get it to the nearest billion, and a lot of it was the market deteriorating dramatically in that five or six weeks. But it was just a guess to begin with."
On July 17, Cayne announced the seemingly inevitable news that the hedge funds were kaput. On July 30, the hedge funds' boards of directors authorized the funds to file petitions for liquidation under the Cayman Islands' Companies Law under the supervision of the Cayman Grand Court. Subsequently, both a U.S. bankruptcy court and a U.S. district court of appeals struck down the legitimacy of the Cayman Islands venue for the filing. As a consequence of the filing, Bear Stearns seized $1.3 billion of underlying collateral - Cioffi's panoply of illiquid mortgage-backed securities - that it had been financing for all of one month and absorbed it onto the firm's balance sheet. Not long after, Cioffi and Tannin were fired.
Excerpted from House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, to be published in March, 2009 by Doubleday Books, a division of Random House, Inc. Copyright 2009 by William D. Cohan.