House of Cards (87 page)

One trade that Schwartz, after he became CEO, asked the team to explore was to sell the firm's stockpile of Alt-A mortgages. At that time, BlackRock and PIMCO were the only two potential buyers, in size, of these assets. But Schwartz quickly realized that these trades could not be done. “They both want financing,” one Bear executive said. “I've got a liquidity problem because my balance sheet is frozen, so I get out of my
inventory and I finance it for five years, which means when the market thaws I'm still illiquid. So I can't finance it, number one. Won't they buy it without financing? Maybe, but that's maybe down 40 points.” Compounding that problem would be the inevitable leak into the marketplace that the firm was exploring such a sale. “The next thing you would hear on the Street is, ‘Holy shit! Bear Stearns tried to sell its whole Alt-A portfolio and couldn't. Those guys are screwed,’” this executive continued. “It's one thing to say, ‘Just get out,' when you're out and you can announce to the Street: ‘I've sold my Alt-A's. I took my beating. I raised $2 billion from a sovereign wealth fund. It's dilutive, but I'm done. And oh, by the way, my business is going under.' So that you couldn't do.” Schwartz also determined the firm needed to continue its hedging strategies—even though by unwinding them there was some profit embedded in them that the firm could have benefited from—from time to time during the first three months of 2008. He decided to keep the hedges on and forgo the short-term profit. “For us to have a bad quarter in a market that is not falling apart, we can survive,” a senior executive said. “For us to be unhedged in a market that is falling apart, we go out of business. One is death; one is sickness. We're going for sickness.”

I
N THE WEEKS
after he relinquished his post, and aside from his random visits to the fixed-income floor, Cayne's time at the firm when he was there, three days a week, was spent trying to bring the Citic deal to conclusion, working with the firm's lawyers on the hedge fund litigation, and settling where possible with the angry investors in the firm's hedge funds. Many of these investors had sued the firm, and many others were threatening to sue. The firm also came up with a seemingly arbitrary plan of settling with investors based upon when they invested: Those who invested in May or June 2007 got all their money back, those who invested between January 2007 and April 2007 got two-thirds of their money back, and those who invested before January 2007 received one-third of their money back. Some corporate and institutional investors got some of their money back and some did not. No employees who invested got any of their money back. “I'm talking to a lot of individuals who are selling it for 30 cents on the dollar,” Cayne said.

What he was not doing after January 8 was participating in any way in the managing of the firm. “Out of nowhere, I now have zero management responsibility,” he said somewhat wistfully. On January 12, the august
Economist
magazine predicted the worst was yet to come for the financial sector. “The dawning of a new year is supposed to be about hope, but fear remains the dominant emotion among bankers,” it opined.
“This week saw another round of bloodletting as they grappled with the effects of the credit crunch,” including, “to nobody's surprise,” Cayne's departure. “Mr. Cayne's durability prompted one observer to dub him the ‘Harry Houdini of the boardroom.’” The magazine ticked through a litany of problems found at all the major firms: Citigroup, Merrill Lynch, Morgan Stanley, UBS, Countrywide, JPMorgan Chase, MBIA, Capital One (although, surprisingly, no mention was made about problems at Lehman Brothers). “Even Goldman Sachs, hitherto relatively unscathed, has suffered,”
The Economist
observed.

The future was murky indeed. “Investment banks … face a slowdown in a number of businesses, from advising on mergers to equity underwriting,” the magazine continued. “Some areas remain vibrant— commodities, for example, and emerging markets—but much restructuring lies ahead…. Bank shares may have further to fall. As Betsy Graseck of Morgan Stanley points out, they are still higher, relative to tangible book value, than their lowest level in the credit crunch of 1989—91. With futures markets predicting property-price falls of up to 30% and the pain spreading beyond mortgages, the bottom may be months away. As one American banking regulator puts it: ‘There aren't many places to look now and feel happy.' Unless you are an escapologist of Mr. Cayne's caliber.” As if on cue, three days later Citigroup announced it was taking a write-down of $18 billion, was cutting its dividend, and was raising $14.5 billion in new capital. That same day, Merrill raised another $6.6 billion in new capital. (Neither action would be of much help to these firms in the end.) On January 21, at six o'clock at night after the market had been closed for Martin Luther King Jr. Day, the Fed agreed to cut the federal funds rate by 75 basis points, to 3.5 percent, the largest one-day reduction ever and the first time since September 2001 the Fed had cut rates between its regular meetings. Eight days later, at a scheduled meeting, the Fed cut the rate again, to 3 percent.

On February 8, Molinaro spoke at the Credit Suisse Group Financial Services Forum. He spent time reviewing in detail with investors the steps the firm had taken since late 2006 to shore up its balance sheet and its liquidity. He pointed out that Bear's “funding mix” had “shifted dramatically” from being based on unsecured commercial paper and short-term borrowings to borrowing much more on a fully secured basis. The firm's secured funding increased to nearly $33 billion, from $5 billion, while unsecured funding fell to $10 billion, from $24 billion. Commercial paper borrowings fell to $3 billion, from $20 billion. “So a very dramatic shift in the sources of financing,” he said. He also was happy to report that the firm had a $17 billion cash “liquidity pool” at the parent
company, increased from $3 billion. “Essentially, it's a pool of cash, and that pool of cash is kept to protect the company from a variety of potential contingent draw-downs on liquidity or a potential need for additional margin on secured repo financing.” Finally, he explained that the firm's equity capital was $12 billion, with another $1 billion coming from the Citic deal (assuming it closed and ignoring the $1 billion Bear was to invest in Citic). “We think that our total capital position is in very strong shape as we come into 2008,” he concluded.

Among others, Robert Upton, the firm's treasurer, was not so sure. While Molinaro, his boss, was at the Credit Suisse conference, Upton was in Europe reassuring Bear's creditors. “Let's be honest,” he said. “There was creditor angst. There was fixed-income investor and creditor concern about Bear Stearns. It was particularly bad in overseas markets, arising first from the hedge funds, second from the belief—right or wrong—that our exposure to mortgage markets that were troubled was as big if not bigger than anyone else's. We were the smallest of the big five broker-dealers, and in overseas markets the perception was we were the essence of the subprime problem. That if Bear Stearns didn't exist, sub-prime would have never been a problem. As ludicrous as that is, that was the perception when you got overseas. I have presentations that speak to those concerns, as ridiculous as that is, because especially in Asia, that was the general perception. People were very concerned about holding our bonds, and they certainly weren't going to do a new debt deal. Banks that provided credit to us were obviously concerned.”

The message Upton delivered during his European voyage was generally an upbeat one. “I was an honest believer that everything was going to be okay,” he said. He told creditors the firm was likely to have a profitable first quarter and had been improving its liquidity. “We've changed our funding posture,” he told creditors. “We've changed our funding position. We've got $17 billion in cash, and that number was up to $18 billion when I went home.”

But on February 13, he started to get increasingly concerned. During a well-attended meeting with Molinaro, his boss, and the heads of the global equities division, Upton made a passionate plea that the firm stop using the free credit balances—essentially cash—in its hedge fund customers' prime brokerage accounts to fund other parts of the business. While the move was perfectly legal, if the hedge fund customer ever wanted his money back and it was tied up in other parts of the business, then Bear would have to use some of the precious $18 billion of cash at the parent company to pay back the customer what was his or otherwise
be forced to liquidate a position in an untimely manner. There were limits to how long this would work, of course, especially if many of the hedge fund customers wanted their money back at the same time. What they should have done, in retrospect, was keep a client's cash with a client's collateral with a client's margin loan. “We should fund his debit by using his collateral and lock up all the money,” Upton said. “Just put it away so that if they want it back, I can give it to them. What we did instead was we spent a lot of time getting really cute and used XYZ's money to fund ABC's margin loan. The problem with that was when short positions and free credit balances and customer cash started to fly out the door, the only way we could meet some of that was by using holding company money.”

Upton told Molinaro this practice should end immediately. “What I told them that day was that continuing to fund the prime brokerage business using free credits … [was like] they were betting the firm,” he said. “They quickly threw all the papers I put down aside and said to me, ‘You're full of shit. Free credits have never left. Debits and credits leave at the same time.’” Much to Upton's dismay, that was the end of the discussion. “But the CFO should have had the testicles to tell them, ‘Upton's right. We're going to fucking go down this road,’” Upton said. “But he didn't. Instead, we came up with some half-assed compromise piece-of-shit decision, which eventually could be completely gamed by the business unit, and only increased, not lessened, my exposure to confidence-sensitive overnight funding in the prime brokerage business.”

The next day, Valentine's Day, UBS announced that it was writing off $2 billion of Alt-A mortgages, the first time that a major Wall Street firm had fessed up to the fact a significant chunk of its supposedly higher-credit-quality mortgages—as opposed to the lower-quality subprime mortgages—were now toxic waste. UBS's Alt-A write-down caused firms across Wall Street—and other companies that do business with them— great consternation and forced them to mark down their own Alt-A mortgages. Thornburg Mortgage, for one, had used the Alt-A mortgages on its books as collateral for its overnight repo financing. After UBS's February 14 surprise, Thornburg's repo lenders were demanding more collateral for their overnight loans to Thornburg, depleting the firm's cash reserves to meet the margin calls. As a direct consequence of the UBS write-down and the margin calls at Thornburg, the exact thing that Upton had worried about the day before had come to pass. Nervous hedge funds started asking Bear Stearns for the return of their cash balances, as they had the previous August, forcing Bear Stearns to dip into its $18 billion of cash reserves to meet their requests. The dominoes had started falling.

C
OINCIDENTALLY
, V
ALENTINE'S
D
AY
was Jimmy Cayne's seventy-fourth birthday. He celebrated by agreeing to spend $28.24 million to buy two adjacent fourteenth-floor apartments at the recently transformed and reopened Plaza Hotel, at the corner of 59th Street and Fifth Avenue. The combined apartments, with 6,000 square feet of space plus maid service and room service, were around the corner from his longtime apartment at 510 Park Avenue. Although the new digs at the Plaza would require another year and millions of dollars more in cost before the Caynes could move in, it did have a spectacular view of Central Park.

T
HE
D
ELUGE

hen Sandy Lewis, at home on his 1,500-acre farm on the western shore of Lake Champlain in upstate New York, began to clue in to the unraveling of his father's firm during the summer of 2007, he called Mike Minikes, the former longtime Bear treasurer who was then running the firm's prime brokerage business, and asked him to locate the bronze bust of his father that at one time was a prominent feature of the executive hallway at the firm. The bust had been the work of Dr. Maurice Hexter, the executive vice president of the Federation of Jewish Philanthropies, in New York, who late in life became a highly regarded sculptor. Hexter had given the sculpture to Cy Lewis years before his death. “Maurice and the Federation wished to thank Dad for years of volunteering, and his strong likeness was placed in his office at Bear Stearns,” Sandy Lewis explained. “Mother would not have it around, she said.” When his father died, he asked for the bust back from the firm. “Alan Greenberg kept it,” he said. “Said it was Bear Stearns property.”

After Lewis's summertime 2007 call, Minikes found the Cy Lewis bust in storage. In March 2008, as the end was fast approaching for Bear Stearns, Sandy Lewis insisted that Minikes send him the heirloom. Bear Stearns shipped it to Essex, New York, on Wednesday, March 12. “Dad came to the farm that Thursday, delivered to a barn on a hill with a view,” Lewis said. “He shares that barn with Bruno Bettelheim. They will have lots to talk about. Clearly, Dad has not lost his timing. Wonder what he
thinks of all this. Dad was a smart man. I have not asked him, and do not hope to anytime soon.”

O
N
T
UESDAY NIGHT
, March 11, 2008, Richard Fuld, the chairman and CEO of Lehman Brothers, was at a dinner when he began to hear the rumors about Bear Stearns's financial health. “I'm hearing that some people are not accepting their counterparty exposure,” he told a colleague at the dinner. “I don't understand why.” The colleague recalled: “He was deeply troubled by it. That was on a Tuesday, and on Thursday Bear was gone.” The weekend that JPMorgan Chase, the Treasury, and the Fed negotiated Bear's sale, Fuld was in India. But upon hearing about the crisis, he flew back immediately to New York and participated in the Sunday night call with Paulson, Geithner, and other Wall Street CEOs to hear about the deal and about the Fed's decision to open the discount window to investment banks for the first time since the 1930s. “There's a lot of hubris in our business,” Erin Callan, then Lehman's CFO, said in a May 2008 interview. “I've found this just talking to my peers. No one ever thinks it'll happen to them, right? We're the only ones around who think it'll happen to us because it happened to us” in 1998, when the firm almost went under as a result of rumors and innuendo related to its role in Long-Term Capital Management.

On Monday, March 17, Lehman's stock plummeted to around $20 per share—another “near-death experience,” a Lehman banker said—as investors feared that the firm would be the next to fall, since it was just a bigger version of Bear Stearns and packed to the gills with hard-to-value and hard-to-sell mortgage and commercial real estate securities. “I don't think we're going bust this afternoon,” Fuld told Lehman's senior executives. “But I can't be 100% sure about that. A lot of strange things are happening.” But the market settled down after both Lehman and Goldman reported profitable first quarters that same day. Immediately afterward, Fuld set about trying to build a fortress. At the Fed's insistence, he brought down the firm's considerable leverage and raised more capital.

For instance, on April 1, Lehman sold $4 billion of preferred stock to the market. Callan boasted that the sale “demonstrates the confidence that investors have in Lehman Brothers” and was “reflective of the strength of the business model, the capital base and liquidity profile” of the firm. Two days later, Alan Schwartz and Jamie Dimon, along with Tim Geithner, Christopher Cox, the chairman of the SEC, and Robert Steele, an undersecretary of the Treasury, testified in front of the Senate Banking Committee looking into what had transpired at Bear Stearns two weeks earlier, and why. At this historic hearing, Schwartz had memorably testified
that although he took responsibility for what happened, he could not think of a single thing he could have done differently that would have saved his firm from its collapse. “The buck stops here,” he said. “And we and our shareholders paid a price.” As for what he might have done to change the outcome, he said, “I can guarantee you it's a subject I've thought about a lot, looking backwards and with hindsight, saying, ‘If I'd have known exactly the forces that were coming, what actions could we have taken beforehand to have avoided this situation?' And I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference to the situation that we faced.” For his part, Alan Greenberg seemed particularly cavalier about the firm's denouement. “These things happen,” he told
Forbes
in September 2008. “We had a great run. The firm grew, and we were highly profitable. And then things happened that maybe shouldn't have, but they did.”

On Friday night, April 11, Fuld had dinner with Paulson and later that night—2:52
A.M.
—wrote Tom Russo, the general counsel, a list of six “takeaways.” Among them were that “we have huge brand with treasury,” that Paulson “loved our capital raise,” that “they want to kill the bad H[edge] F[u]nds + heavily regulate the rest,” and that Paulson “has a worried view of ML”—Merrill Lynch. “All in all worthwhile,” he wrote. Fuld was said to be regularly in touch with Paulson throughout the credit crisis, according to Congressman Dennis Kucinich, who has referred publicly to voluminous “call logs” between the two men.

F
ULD'S FIRST SERIOUS
strategic initiative to shore up the firm's equity capital came during the week of May 26 as Jesse Bhattal, the head of Lehman in Asia and a member of the executive committee, had been teeing up the idea of Lehman forging a strategic relationship with the Korean Development Bank. “Korea situation sounds promising,” David Goldfarb, Lehman's chief administrative officer, wrote Fuld and Joe Gregory, Lehman's president, on May 26. “They really are looking to restructure and open up financial services and seem to want [an] anchor event to initiate the effort, which could be us.” Goldfarb wrote that he preferred a strategic deal with either AIG or GE to one with the Koreans, but “this could become real. If we did raise $5 billion, I like the idea of aggressively going into market and spending 2 of the 5 in buying back lots of stock (and hurting Einhorn bad!!).” (David Einhorn was the founder of the hedge fund Greenlight Capital and had been aggressively and publicly questioning Lehman's accounting while shorting its stock.) Goldfarb said that while it “sounds like the Koreans are serious … we know these things often don't go further than the rhetoric!!!” Fuld responded, “I agree
with all of it” and that he wanted the Koreans to “buy 10 com real estate,” a reference to wanting them to buy $10 billion of the firm's troubled commercial real estate assets.

On May 31, a team lead by Tom Russo flew overnight on one of the firm's Gulfstream jets to Seoul, South Korea, to meet with representatives of the Korean Development Bank (KDB) to discuss the possibility of the $5 billion strategic investment. The Koreans had indicated an interest in buying as much as 49.9 percent of Lehman, but the purpose of this trip was to see how far they could get on the $5 billion. When the Lehman team arrived, they were disappointed to discover that the Koreans had not hired a U.S. lawyer or advisor and seemed more focused on discussing an investment banking joint venture. “It was kind of a joke,” one of the Lehman participants said. “We ended up wasting several days there and decided to come back.”

The idea had been to be able to announce the Korean investment as part of the release of the firm's poor second-quarter results on June 9. Being able to talk about a large, deep-pocketed strategic investor would have mitigated some of the sting from the write-downs of the increasingly toxic assets on Lehman's books. Instead, at the same time the firm announced a second-quarter loss of $2.8 billion, it also raised $6 billion of new capital—virtually overnight—in the form of $4 billion of common stock, at $28 per share, and $2 billion of convertible preferred stock. Among the buyers of the common stock were the New Jersey Division of Investment, which manages $82 billion in state pension funds, and Hank Greenberg, the former CEO of AIG and the current CEO of C. V. Starr, an investment company that was AIG's largest shareholder.

At the end of the day on June 9, Benoit d'Angelin, the former co-head of investment banking at Lehman in Europe who had left the firm fifteen months earlier to join Centaurus Capital, in London, wrote Skip McGee, Lehman's head of investment banking, that “many, many bankers have been calling me in the last few days” because “the mood has become truly awful … and for the first time I am really worried that all the hard work we have put in over the last 6/7 years could unravel very quickly.” He recommended that “two things need to happen very quickly”: “Some senior managers have to be much less arrogant and internally admit that some major mistakes have been made. Can't continue to say ‘we are great and the market doesn't understand’” and “Some changes at the senior management level need to happen very soon. People are not and WILL not understand that nobody pays for that mess and that it is ‘business as usual.’” He concluded: “Sorry to be so blunt but a serious [s]hock is needed to allow the firm to rebound quickly and aggressively.”
McGee passed the e-mail on to Fuld. Three days later, Fuld announced that both Joe Gregory, the firm's president, and Erin Callan, its CFO, had been demoted. Fuld called the sacking of Gregory “one of the most difficult decisions either of us has ever had to make.”

On June 19, after a six-month investigation, U.S. Attorney Benton J. Campbell, of the Eastern District of New York, announced that a federal grand jury had indicted both Ralph Cioffi and Matthew Tannin on charges of conspiracy, securities fraud, and wire fraud in conjunction with their management of the two Bear Stearns hedge funds from their inception in 2003 to their bankruptcy filing in July 2007. Cioffi was also indicted on charges of insider trading related to his decision to move $2 million of his own money out of the Enhanced Leverage Fund—without telling investors—into another hedge fund he managed that had, to that point, superior returns. The indictment also revealed that both Cioffi's notebook and Tannin's tablet computer had disappeared after federal authorities had asked for them to be produced. The indictment alleged that by March 2007, both Cioffi and Tannin “believed that the [f]unds were in grave condition and at risk of collapse. However, rather than alerting the Funds' investors and creditors to the bleak prospects of the [funds] and facilitating an orderly wind-down, the defendants made misrepresentations to stave off withdrawal of investor funds and increased margin calls from creditors in the ultimately futile hope that the [f]unds' prospects would improve and that the defendants' incomes and reputations would remain intact.” The funds' investors and creditors have lost more than $1 billion since the funds collapsed. The same day, the SEC filed civil charges against both men. If convicted of securities fraud, they face maximum sentences of twenty years of imprisonment. If convicted of conspiracy, they each face a maximum sentence of five years. (At press time, there were no further public proceedings in this matter.)