House of Cards (72 page)

Friedman translated Cioffi's pitch into layman's terms. “He froze redemptions,” he said, “and he's got his lenders here to try and tell them— they all have the right, if he has unmet margin calls, to blow him out—so he's telling them: ‘Sit tight. I'm going to do all these sales and I'm going to have enough cash.' What you have is a roomful of people, some of who are awake and have made these margin calls, and have suddenly realized there are issues, and have marked the collateral down and made margin calls. Some of them are going, ‘Holy shit! Everybody else is making margin calls and we're not.' Well, the first thing all this did, when we got done, the margin calls just flooded in.” Cioffi asked them all not to make any more margin calls. But that tactic backfired completely. “This is the beginning of the end. Had he not been the first fund to go, it would have had a much lower impact as well. But since it was at a time when everybody was a little squishy and there really hadn't been any significant hedge fund issues, this came out of nowhere. It was like the pebble being tossed into the pond. It was pulling on the thread. It was any analogy you want to use. This was the beginning.”

In the first meeting, Cioffi made what amounted to a modest proposal. “We're looking for thirty days of breathing room so that we can implement the plan,” he said. “At the end of the day, we're almost working for all of you. I mean, our job is to in an orderly and efficient manner raise liquidity and reduce positions down either through direct sales, whether it's competitive bids or otherwise. It's a thirty-day process that we think we can unfold in a workmanlike fashion. No one's interests are served if we get into a meltdown and you have ten or twelve dealers trying to sell collateral in a market that right now is very fragile.”

More than an hour into the presentation, one repo lender, John Hogan, head of risk management at JPMorgan, asked about whether Bear Stearns intended to play a role in trying to solve the problems in the hedge funds by infusing capital. Hogan said he thought BSAM was “underestimating the severity of the situation,” that the funds “needed to figure out how to meet margin calls,” and if that meant getting money from Bear Stearns, “we recommend you do that.” As the CEO of BSAM, Marin answered this question. “First of all, those of you who have asset management units, the asset management units are walled off pretty securely from the broker-dealer side of the firm,” he said. “BSAM is walled off. In fact, we're in a separate building. We don't even live in this building. So we are very separate. There are a number of issues that even prevent us, from a regulatory standpoint, in dealing with Bear Stearns as a counterparty. We've had a moratorium of trading against principal positions for over a year now, and haven't done so. We've recently lifted that
ban so that we could have the trading desk, which is very skilled in these particular instruments, help us in the liquidation process. We consider that to be the greater good. But they are not a major repo counterparty to us. They have not been a major repo counterparty to us. They have not been a big trading partner with us until now, as they're helping us with this process. I don't think we should look at Bear Stearns as a lender of last resort here. This is a fund that's run and owned by BSAM, and BSAM will manage its way through this process.”

That answer recalled for some participants in the meeting the jarring memory of Bear's unwillingness to participate in the rescue—nine years earlier—of the LTCM hedge fund. Steve Black, the co-head of investment banking at JPMorgan, was apparently so peeved by Marin's response that he placed calls after the meeting to both Spector and Schwartz, his Duke fraternity brother. “Is Bear going to stand behind your asset management company?” Black asked Schwartz. When Schwartz called Black back an hour later, the
Journal
reported, he said “that on the advice of Bear's lawyers the firm wasn't going to get involved.” Incredibly, as the meeting with the repo lenders was happening, a BSAM executive sent an e-mail to Barclays, with a copy to Tannin, with a spreadsheet attached that “showed gains through June 12 of almost 6%” in the Enhanced Leverage Fund and “a total NAV of more than $950,000,000.”

On June 16, the
Journal
reported that Merrill Lynch had ignored Cioffi's request at the June 14 meeting for a thirty-day standstill and had seized $400 million of its collateral from the funds with the intention of auctioning the assets in the market at noon on Monday. According to the June 14 presentation, Merrill had $1.46 billion in repo loans to the two funds, making the $400 million of collateral the firm seized equal to around 25 percent of its overall exposure to the funds. (Citigroup, with $1.862 billion in repo loans, and Dresdner Bank, with $1.487 billion, were the top two lenders to Cioffi's funds. In all, sixteen Wall Street firms had lent the funds $11.1 billion in repo financing.) Without saying why, the
Journal
said that Merrill's auction of a portion of its collateral could “trigger the [Enhanced Leverage] fund's dissolution” and “spur other lenders to seize fund assets,” leading to “the end of Mr. Cioffi's two funds.” The fear was rampant on Wall Street that the price Merrill would get for the assets—which were considered less liquid than the assets Cioffi had sold earlier in the week—would leave firms with little choice but to mark their similar securities to the new, lower, prices.

Over the weekend, Cioffi was in a panic. He managed to convince Merrill Lynch to hold off on the asset sale until he could present a new proposal—one that was to include a new short-term lending plan—to the
creditors on June 18 at one o'clock in the afternoon. He hoped that he could convince Barclays, which already had a $400 million line of credit to the Enhanced Leverage Fund, to put up another $250 million in cash that could be used as collateral for the growing number of margin calls. “We've got to go to them,” Cioffi e-mailed his team over the weekend. “There's no time to wait.” He spent Sunday scrambling but managed to convince Barclays to step up with the additional money.

A
FTER
D
OUG
S
HARON
met with Spector on June 12, he went back to Boston feeling more than just a little peeved by Spector's reaction. He started thinking, “You know something? These guys don't get it. They don't know what's going on, and I don't know if Warren is telling them, because based on the way he's handling it, I think he's just hoping it will go away.” Since he was an investor, he pulled together every monthly report that Cioffi had sent out and decided that he needed to go back to New York, meet with Cayne, and make sure the CEO of Bear Stearns understood just how serious the situation was becoming. Sharon and Cayne had known each other for twenty years by this time, ever since Cayne hired Sharon.

On the morning of Monday, June 18, Sharon called Cayne and told him he was at the airport and on his way to see him “about the hedge funds.” Cayne, who prided himself on always being accessible to Bear's people, agreed to see Sharon at three-thirty on Monday afternoon but wanted him first to meet with Michael Solender, the firm's general counsel. Sharon agreed to see Solender at one o'clock.

When Sharon arrived for his meeting with Solender, he found Dan Taub, the firm's head of litigation, in Solender's office. “I am here as a partner at Bear Stearns to tell you about why I'm concerned,” Sharon told the two men. “I am here because I think we have a very big problem, and if we don't address it head-on, it's going to spin out of control. Here's where I think we have a problem. It's not just because we have a lot of loyal, great customers that are very influential that are at risk of losing a lot of money in something they thought was a very low-risk, low-volatility investment. And by the way, guys, I am an investor in this fund also.” He took the sheaf of monthly statements that he had assembled and showed the two Bear Stearns lawyers month after month of Cioffi's commentaries about his high level of concern about the riskiness of various mortgage securities in the market and how he was avoiding those securities as a result. “You've got to understand something,” Sharon told Solender and Taub. “This guy has been predicting in print month after month Armageddon,
telling you he's avoiding the 2006 vintage, and on and on and on and on, and as it turns out, this guy jumped into a volcano.”

Sharon showed the lawyers the “collateral summary” on the back of each monthly statement that listed the breakdown of the securities in which the fund invested. “It would say,” Sharon recalled, “22 percent high-yield, 12 percent high-grade—and this is the smoking gun—the March 2006 collateral summary shows 6 percent subprime mortgage exposure.” Sharon even remembered one of his clients who agreed to invest $250,000 into the hedge funds in April 2007 based upon the fact that the March 2007 summary showed that only 6 percent of the funds were invested in subprime mortgages. The truth was very different. In June, as the funds were rapidly dissipating, Bear Stearns issued a document called “Talking Points” for how brokers should talk to their clients who had invested in the funds. The document posed typical questions and then answered them. One of the questions deemed likely to be asked was: “I thought the fund was diversified, and now it turns out it seems to have had a fair amount of exposure to the subprime mortgage market. What exactly was the exposure?” The answer: “60 percent.” “What became clear is that this fund was 60 percent exposed to the subprime mortgage market,” Sharon said.

As best he could explain it to Solender and Taub, Sharon said he informed them that Cioffi had loaded up the fund—which had been marketed as a safe, low-risk fund—with a host of risky securities. On Cioffi's monthly summaries, Sharon told the lawyers, “the asset-backed securities bucket was up to 80 percent. Now, when I grew up in the bond market, asset-backed securities were credit cards and auto loans. Turns out the asset-backed securities bucket was filled up with subprime-backed CDOs, and they were not under the subprime label because that wasn't known at the time when I was having the meeting with the lawyers. But I'm explaining to them this whole manager commentary [about] Armageddon, and they said, ‘Well, but these things all say “internal use only” on them.' I said, ‘The reason they say “internal use only” on them is because I had them printed off on my computer this morning. This is exactly what the clients get in the mail month after month. This is what we've been telling the clients.' Solender didn't say a whole lot. But I think Dan Taub understood the gravity of the situation.”

A
T THE SAME
time as Sharon was meeting with Solender and Taub, Cioffi, Marin, and representatives from Blackstone were meeting again with the funds' repo lenders at the 383 Madison auditorium to present a
new plan designed, Cioffi hoped, to keep the lenders from doing what Merrill Lynch was threatening to do—seizing collateral and selling it into the marketplace. Cioffi's new proposal called for Bear Stearns to provide a $1.5 billion repo line of credit for both funds that would be used to reduce the exposure of the funds' existing repo lenders by about 15 percent on a pro rata basis. Also, there would be a “fresh infusion” of $500 million of unsecured capital, subordinated to the repo lenders and split between the two funds. The new capital, $200 million of which was to be provided by Barclays and the balance of $300 million by an unspecified “consortium” reportedly led by Citigroup, would be used to provide the margin requirements of the existing lenders and for working capital purposes. The third component of the plan was to “sell [fund] assets in an orderly fashion and reduce credit exposure” during the coming year. But then there was Cioffi's “standstill” request to the repo lenders: For one year, the lenders would agree not to request any incremental margin calls or an increase in interest rates for the loans. The lenders would also agree not to sell any of their collateral in the market for one year. Cioffi also wanted the lenders to agree to an interim standstill through June 20 that included all of the previous requests plus a demand that all lenders agree to “pull existing bid lists” from the market and terminate any sales in progress—a demand no doubt directed at Merrill Lynch—with the hope that the lenders would sign the interim standstill virtually immediately. From June 18 to July 2, the proposal would be reduced to legal documents and negotiated, with an expected signing before July 9. “It was insane,” Paul Friedman said. “It was basically ‘We're going to do some sales. We can't tell you what. We're going to terminate some deals that would bring us some cash, and basically we need you to sit still for a year.’” According to the
Wall Street Journal,
both Merrill and JPMorgan “were taken aback” by the one-year standstill proposal but Citigroup, Barclays, and Dresdner Bank were “more amenable.” Said one participant in the meeting: “People had different perceptions of what was important.”