House of Cards (71 page)

O
N
J
UNE 12
, buried deep in the paper, the
Wall Street Journal
reported that the Enhanced Leverage Fund had fallen 23 percent in the first four months of the year and that redemptions from the fund had been blocked. “While the fund is down significantly, it is hard to tell what the actual losses will be because a few good trades could bring it back into the clear,” the
Journal
wrote. “Still, given the fund's heavy exposure to this deteriorating corner of the mortgage market, in which many people are struggling to pay down their home loans, the news isn't good.” The paper suggested that while the fund's losses would be a “blow” to Cioffi and Tannin, the “paper losses will have a limited impact on Bear” because the firm only had $45 million invested in the fund—the $20 million original investment and the $25 million Spector authorized for May 1.
BusinessWeek
's Matthew Goldstein also reported on the fund's problems on June 12. “At the end of the day, I'd like someone to be honest with me about what's going on,” Goldstein quoted an investor as saying.

Also on June 12, Bear Stearns's traders offered for sale a block of 150 high-quality mortgage-backed securities, with a face value of around $3.86 billion, from Cioffi's hedge funds as a way to raise cash for margin calls and for some agreed-upon redemptions. Goldstein, at
BusinessWeek,
reported that the auction for the securities was scheduled for June 14 at 10
A.M.
, just as the firm announced that its earnings for the second quarter of 2007 had fallen to $486 million (excluding a one-time charge) from $539 million in the same quarter a year earlier, “in part because of the implosion in the market for subprime mortgages.” The results showed definitively that the firm's fixed-income engine had slowed considerably, with revenue of $962 million, down 21 percent from the same period a year earlier. On the conference call about the second-quarter earnings, Sam Molinaro said that the problem in the hedge funds was “an issue that's getting a great deal of attention here. We're focused on trying to maximize the value of our clients' assets, and we're taking every action we can to ensure that we get a successful outcome.”

That same day, around noon, Tannin had a forty-five-minute conference call with Doug Sharon, the head of Bear's Boston office, whose clients had tens of millions of dollars invested in Cioffi's hedge funds. Sharon himself had a meaningful investment in the funds, around $500,000. One of Sharon's clients had put in a redemption request some months before as a result of some tax-related matters. But after forty-five
minutes of talking with Tannin, the client found Tannin's explanation for what had happened and the prospects for the future so reassuring that at the end of the call, the client said, “Based on everything I have heard here, I think what we're going to do is rescind our request to redeem. I should leave my money in this fund.” After that call with Tannin and his client, Sharon had a one o'clock meeting with Spector in his office. Sharon did not know Spector all that well and had had only around six face-to-face meetings with him during his twenty-year career at the firm. “Most people think he's a little bit standoffish or that he thinks he's better than everyone else,” Sharon explained. “But he's always been perfectly gracious to me, except for one situation where I had a regulatory dispute, and I just didn't like the way he handled it.”

He waited outside Spector's office for his meeting. “At this point, I had no idea these funds were going to collapse and go to zero within weeks,” he said. “I'm waiting to go in to see Warren, I'm outside of his office, and I hear this, ‘Slam!' and then I hear, ‘God damn it!' I thought, ‘Wow. This is probably not a good time.' Then I see some guy who I don't recognize go scurrying out of his office. I walk over to his two assistants and I say, ‘Look, this isn't a good day. This can wait. I definitely don't have to talk to him today. This is definitely not a ‘gotta happen today' type of thing. She says, ‘No, no, no—it's all right. We're just not having a good day today.' I sat back down, and a couple minutes later she said, ‘You can go in and see him now.' I went in to see him, and he had his game face on, because I don't know what rattled him, but it certainly didn't show.”

Sharon explained to Spector the magnitude of his clients. One had $4 million in the hedge fund, another $5 million in the firm's merchant banking fund and $200 million in municipal bonds; another two of his clients were among the top fifty private corporations in America. It was important for Spector to hear this from Sharon, he thought, because BSAM reported to Spector. “The reason I'm telling you this is that these are people who if these funds are in potentially the kind of dire straits that some people are suggesting, these aren't guys that are just gonna go away and say, ‘Aw, shucks!’” Sharon told him. “‘These are guys that do not need to use contingency lawyers. They have armies of lawyers themselves, and they're going to be pissed because I don't know what went wrong, but if these things are going to collapse, as some people have suggested, we're going to get our asses sued off.' His response to me was, ‘Look, they're big boys. It's a leveraged fund. And leverage works both ways.' I said to him, ‘I understand that, but this thing was sold and marketed as a very low-volatility, low-risk strategy, and that's the way people were using it. There are public corporations that have a small amount of
their corporate cash in this stuff. The portfolio manager was completely aware of it because he made the presentations to them.' He said, ‘Listen, what can I tell you? What was it that Ace once said? ‘Hey, you can't fly like the eagles and poop like a canary.’”

Sharon was stunned that Spector would be so dismissive of the problem. “I heard that from Warren,” he said, “and I basically said to myself, ‘You know something? These are people who are good friends of the firm. Sometimes we've made a lot of money for them, and sometimes we haven't. But it doesn't mean we didn't have our best intentions.' It was clear to me that he didn't get it and was taking the cavalier attitude of ‘Shit happens. They're big boys, hey, it's a leverage fund, and leverage works both ways,' and then he gave me that Ace Greenberg quote. I walked out of there more frustrated than ever.”

W
HILE
P
AUL
F
RIEDMAN
and executives at BSAM were working overtime to stave off the meltdown of the hedge funds, the not too surprising revelation was that gating the Enhanced Leverage Fund was not giving comfort to the repo lenders. Instead of reassuring them that the assets of the fund wouldn't be paid out to investors and would be reserved for them, the decision woke them up from whatever slumber some of them were in with regard to the fund's problems. “Suspending redemptions was like a red flag in front of a bull,” said one of the BSAM professionals. All the repo lenders—“This is the entire Street, for all intents and purposes. Big and small, domestic and foreign, they're all in this game,” explained one executive—began clamoring for more collateral for their short-term loans to Cioffi's funds. Seemingly overnight, the lenders wanted their money. “We would hear from them, ‘We're revaluing these assets. We're going to need margin of $60 million,’” he explained. “It was a little bit like, ‘I don't know how much money you have in your pocket, so that'll be five bucks today. Tomorrow it'll be ten bucks.' Okay? All of a sudden, they'll start asking, ‘How much cash do you have on hand? Are you getting other margin calls?' Then all of a sudden it's ‘Give me my $300. I don't care. I'll take $200. Give me the money.’” That day, a worried Barclays banker sent Cioffi an e-mail: “One of the repo counterparties dealing with your fund is apparently about to pull its line; I am sure this is just one of the rumours that spread at a time like this, but would like to confirm that this is just it, in order to avoid any sense of unease spreading.”

On June 13, BSAM issued a memo about how to answer for investors the question of “I thought I was invested in a high-grade fund but it sounds now like the funds may have invested in a fair amount of assets in subprime mortgages.” Here, for perhaps the first time in black and
white, was the admission—varnished repeatedly with gibberish—that all had not been what it seemed in the funds. “As of May 31, 2007, over 90% of the [Enhanced Leverage Fund's] assets are invested in securities rated AAA and AA. Much of the underlying collateral supporting these AAA and AA securities consists of subprime mortgages. Hence, although over 90% of the securities in the fund are AAA and AA rated, [b]ecause these securities are backed in part by subprime collateral, the press has referred to this portfolio as a subprime fund. Based upon our managements' analysis, the percentage of underlying collateral in our investment grade structures collateralized by ‘subprime' mortgages is approximately 60%,” or
ten times
more collateral in subprime mortgages than had previously been disclosed to investors.

With Blackstone's help, BSAM 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 the creditors for forbearance—first for a year and then reduced to three months—for the market to settle down so that an orderly liquidation in a less pressured environment could commence. Black-stone'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. If you pull back all your assets [from the funds] and you literally just seize assets and start to dump them in the market, that can't possibly be good for you.' But it was like any other panic. If you're out early enough, maybe it
is
good for you. Think of the burning movie theater. If you're the first guy out the door, great strategy. But if you're standing in the front of the theater and you jump up and yell ‘Fire!' and you can't get out the door: Very bad strategy. That's kind of a reasonable analogy for this because everybody had this problem. And it wasn't the problem of our assets that they repoed. That was the absolute thin slice of the tip of the iceberg.”

The repo counterparties' meeting took place in the second-floor auditorium at 383 Madison Avenue. About sixty people attended, representing around a dozen or so lenders. Even though Bear Stearns was the prime broker for Cioffi's hedge funds plus a derivative counterparty, the decision was made that no one from Bear Stearns's securities subsidiary should attend the meeting. Paul Friedman couldn't resist watching the
show, though, and he sat in the audio-video control room in the back of the room and watched the proceedings on a TV monitor.

Greg Quental, Cioffi's titular boss at BSAM—“Ralph didn't believe he reported to him,” Friedman explained—started the meeting by explaining to the bankers the funds' poor perfomance for the first four months of the year and how that performance had led to an avalanche of redemption requests totaling about half of the funds' $650 million of investments. “It was clearly a function of performance,” Quental said. “At that point, we actually had enough cash to meet the June redemptions, but what would have happened is … we would have sold off a lot of the more liquid assets,” and what remained was a fund “that looked a lot different than the one they bought into. So we made the decision at that point to suspend redemptions. We also knew that all of you would feel more comfortable if cash weren't leaving the fund to pay off those redemptions, so that was also a big factor in our decision.” At this point, Friedman said sarcastically, “We did it for you,” and then added seriously: “We did it because we had no choice, basically, but it's a good line.”

Quental then spoke about the margin calls coming from the people sitting in the audience. “Obviously, we've taken in a heavy level of margin calls,” he said. “All of you are aware of that. We've covered all those calls up until yesterday, when we asked all of you to hold off until we had this meeting. We have some pending margin calls, which Ralph will talk about in a minute. We've made every attempt to meet the margin calls that have come in over the last few weeks, but they have been quite significant. We're also experiencing high margin calls in [the] High-Grade [Fund] as well. Lastly, the portfolio team is working hard at selling assets and focusing on the things that could move relatively quickly. Then we've got some longer-term assets that we're working on moving, and Ralph's going to talk about those plans. So with that, I'll turn it over to him.”

Cioffi gave the group an update on the auction of the assets the funds were at that moment trying to sell through Bear Stearns to raise the much-needed cash. “We are seeing an unprecedented level of bids as it relates to the number of bids,” he said, “and the prices we're getting—I couldn't be more happy. We've gotten a lot of moral support and encouragement from the Street that people were going to be aggressive, that people were going to pay strong prices for the collateral.” On page seven of the accompanying presentation, Cioffi told them what they presumably already knew: He had $14 million in cash on hand to meet $145 million of “open margin calls” in the Enhanced Leverage Fund. At the end of July, after making the $145 million of margin calls, Cioffi predicted the fund would have a cash balance of $177 million.