House of Cards

PART I /
HOW IT HAPPENED: TEN DAYS IN MARCH

CHAPTER
1 /
The Ultimate Roach Motel

CHAPTER
2 /
The Confidence Game

CHAPTER
3 /
“Bear Stearns Is Not in Trouble!”

CHAPTER
4 /
The Run on the Bank

CHAPTER
5 /
The Armies of the Night

CHAPTER
6 /
Feeding Frenzy

CHAPTER
7 /
Total Panic

CHAPTER
8 /
The Price of Moral Hazard? $2

CHAPTER
9 /
The Fed Comes to the Rescue (After the Battle Is Over)

CHAPTER
10 /
Mooning at the Wake

CHAPTER
11 /
“New Developments from Hell”

CHAPTER
12 /
“We're the Bad Guys”

PART II /
WHY IT HAPPENED: EIGHTY-FIVE YEARS

CHAPTER
13 /
Cy

CHAPTER
14 /
Ace

CHAPTER
15 /
Jimmy

CHAPTER
16 /
May Day

CHAPTER
17 /
Haimchinkel Malintz Anaynikal

CHAPTER
18 /
The Joy of Mortgage-Backed Securities

CHAPTER
19 /
“Bullies Always Cave”

CHAPTER
20 /
The Math Whiz and the Baseball Star

CHAPTER
21 /
“We're All Going to a Picnic and the Tickets Are $250 Million Each”

CHAPTER
22 /
The Fish Rots from the Head

PART III /
THE END OF THE SECOND GILDED AGE

CHAPTER
23 /
The 10-in-10 Strategy

CHAPTER
24 /
Cayne CAPs Spector

CHAPTER
25 /
Cioffi's Bubble

CHAPTER
26 /
“The Entire Subprime Market Is Toast”

CHAPTER
27 /
“If There's Fraud, We're Gonna Pay”

CHAPTER
28 /
A Very Stupid Decision

CHAPTER
29 /
Nashville

CHAPTER
30 /
The Cayne Mutiny

CHAPTER
31 /
Desperate Times Call for Hare-Brained Schemes

Epilogue: The Deluge

Notes

Acknowledgments

H
OW
I
T
H
APPENED
:
T
EN
D
AYS IN
M
ARCH

T
HE
U
LTIMATE
R
OACH
M
OTEL

he first murmurings of impending doom for the financial world originated 2,500 miles from Wall Street in an unassuming office suite just north of Orlando, Florida. There, hard by the train tracks, Bennet Sedacca announced to the world at 10:15 on the morning of March 5, 2008, that venerable Bear Stearns & Co., the nation's fifth-largest investment bank, was in trouble, big trouble. “Yep,” Sedacca wrote on the Minyanville Web site, which is dedicated to helping investors comprehend the financial world. “The great credit unwind is upon us. Credit default swaps on all brokers, particularly Lehman and Bear Stearns, are blowing out, big time.”

Sedacca, the forty-eight-year-old president of Atlantic Advisors, a $3.5 billion investment management company and hedge fund, had been watching his Bloomberg screens on a daily basis as the cost of insuring the short-term obligations—known in Wall Street argot as “credit default swaps”—of both Lehman and Bear Stearns had increased steadily since the summer of 2007 and then more rapidly in February 2008. Now he was calling the end of the credit party that had been raging on Wall Street for six years. “I've been talking about it for years,” Sedacca said later. “But I started to notice it that fall. Because if you think about it, if you have all this nuclear waste on your balance sheet, what are you supposed to do? You're supposed to cut your dividends, you're supposed to raise equity, and you're supposed to shrink your balance sheet. And they did just the opposite. They took on more leverage. Lehman went from twenty-five to thirty-five times leveraged in one year. And then they announce a big stock buyback at $65 a share and they sell stock at $38 a share. I mean, they don't know what they're doing. And yet they get rewarded for doing that. It makes me sick.”

Sedacca had witnessed firsthand a few blowups in his day. He worked at the investment bank Drexel Burnham Lambert—the former home of junk-bond king Michael Milken—when it was liquidated in 1990 and lost virtually overnight the stock he had in the firm as it plunged from $110 per share to zero (Drexel was a private company but the stock had been valued for internal purposes). “It was enough that it stunned,” he explained. “It was more than a twenty-nine-year-old would want to lose.” Many of his Drexel colleagues had taken out loans from Citibank
to buy the Drexel stock and were left with their bank loans and worthless stock. “I know people with millions and millions of dollars of debt and the stock was at zero,” he said. They either paid off the loans or declared personal bankruptcy. “That's what happens when everyone turns off your funding,” he added.

He then moved on to Kidder Peabody and watched that 130-year-old firm disintegrate, too. As a result of these experiences and those at other Wall Street firms, he had developed a healthy skepticism of both debt and the ways of Wall Street. Starting in the summer of 2007, he began to feel certain that the mountain of debt building across many sectors of the American economy would not come to a good end. He started betting against credit. “I've watched enough screens long enough to know something was wrong,” he said.

The problem at Bear Stearns and Lehman Brothers, Sedacca informed his clients and Minyanville readers, was that both firms had huge inventories on their balance sheets of securities backed by home mortgages. The rate of default on these mortgages, while still small, was growing at the same time that the value of the underlying collateral for the mortgage—people's homes—was falling rapidly. Sedacca could not help noticing that the effects of this double whammy were beginning to show up in other, smaller companies involved in the mortgage industry. He could watch the noose tighten in the credit markets. “Look at what is happening to Thornburg Mortgage,” he wrote, referring to the publicly traded home mortgage lender, which specialized in making what were known as “Alt-A” mortgages, those greater than $417,000, to wealthy borrowers. Thornburg had been “overwhelmed” by margin calls from its lenders. “It supposedly only has a 0.44% default rate on its [$24.7 billion] mortgage portfolio that it services but the bonds it owns are getting pounded. Result? Margin call. The worst part is that the company went to sell some bonds to settle the margin calls but couldn't. The ultimate Roach Motel.”

That Thornburg, based in Sante Fe, New Mexico, appeared to be hitting the wall was somewhat surprising considering its customers' low default rate and high credit quality. The problem at Thornburg was not that its customers could no longer pay the interest and principal on their mortgages; the problem was that the company could no longer fund its business on a day-to-day basis. Thornburg had a liquidity problem because its lenders no longer liked the collateral—those jumbo mortgages—Thornburg used to obtain financing.

Unlike a bank, which is able to use the cash from its depositors to fund most of its operations, financial institutions such as Thornburg as well as pure investment banks such as Lehman Brothers and Bear Stearns
had no depositors' money to use. Instead they funded their operations in a few ways: either by occasionally issuing long-term securities, such as debt or preferred stock, or most often by obtaining short-term, often overnight, borrowings in the unsecured commercial paper market or in the overnight “repo” market, where the borrowings are secured by the various securities and other assets on their balance sheets. These fairly routine borrowings have been repeated day after day for some thirty years and worked splendidly—until there was perceived to be a problem with either the securities or the institutions backing them up, and then the funding evaporated like rain in the Sahara. The dirty little secret of what used to be known as Wall Street securities firms—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—was that every one of them funded their business in this way to varying degress, and every one of them was always just twenty-four hours away from a funding crisis. The key to day-to-day survival was the skill with which Wall Street executives managed their firms' ongoing reputation in the marketplace.