All The Devils Are Here: Unmasking the Men Who Bankrupted the World (55 page)

At 6:32 a.m. the next morning, Cioffi sent a message to Tannin, trying to put their stress in perspective. He wrote: “1. We have our health and our families. 2. We are not a 19 year old Marine in Iraq. 3. We have each other and a great team.”

Tannin responded: “We are not marines—in fact—we have all triple won a Powerball lottery a few times over.”

Within six months, both funds were bankrupt. A terrible storm was gathering.

The Bear team was in many ways a paradigmatic example of how Wall Street had evolved. Both Cioffi and Tannin were self-described “securitization people.” They believed in the models and the ratings and the notion that risk was being divvied up and tucked away. They bought supposedly safe securities that offered a little extra yield. To boost the yield and produce respectable
returns, they took advantage of the cheap, short-term money available in the repo market. “The borrowing was the absolute lifeblood of the funds,” Tannin’s lawyer later said.

Their first fund, the High-Grade Structured Credit Fund, which was part of Bear Stearns Asset Management, was started by Cioffi in the fall of 2003. Like many Bear employees, Cioffi had been a scrappy, lower-middle-class kid; during his eighteen years at the firm, he had risen to become a highly successful fixed-income salesman. Fearing that he would bolt to another firm, Bear staked him with $10 million and allowed him to start a hedge fund, even though Cioffi had never before managed money. Cioffi was soon making hedge fund compensation: $17.5 million in 2006, up from around $4.5 million just two years earlier. He owned a multimillion-dollar house in the Hamptons and became the executive producer of the indie film
Just Like the Son
. His lack of experience, though, was an issue. “Ralph was not a trader,” says one person who knew him. “He was an honest guy trying his hardest, sitting at his desk twenty-four/seven, but he was like a deer in the headlights.”

In 2003, Cioffi recruited Tannin to help him run the fund. Tannin had even less experience than Cioffi. A philosophy major who’d graduated from the University of San Francisco law school in 1993, Tannin had joined Bear’s capital markets group before moving to the derivatives desk. After a brief stint at a start-up, he returned in 2001 to work as a junior analyst in the structured finance division. Even in good times, he was full of angst, befitting a philosophy major. Working with Cioffi was a huge opportunity for him, and he knew it. As his pay rapidly climbed from meager (just $66,000 in 2000) to respectable, at least by Wall Street standards ($2.5 million in 2006), Tannin never forgot to whom he owed his good fortune. “I want to thank you again from the bottom of my heart for all you have done for me,” he wrote to Cioffi in early 2007. “I will be eternally grateful.”

The High Grade fund started small. Some of its investors were high-net-worth customers of Bear Stearns, one of whom would later say that he thought he was getting in on a special “club.” In truth, though, High Grade wasn’t all that selective. Eventually, the three biggest investors were so-called funds of hedge funds, meaning they pooled investors’ money and doled it out to hedge funds. Such funds often had a reputation for being “hot money,” meaning they had no loyalty to any hedge fund. They would yank their money at the first sign of trouble.

By the summer of 2006, the High Grade fund had become one of the biggest buyers of mortgage risk in the market. That was when Cioffi and
Tannin launched a second fund whose name could not have been more perfect for the times. The fund was called the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Limited Partnership (Enhanced Leverage, for short). Its point of differentiation was the enormous leverage it planned to use—as much as 27 to 1—to produce higher returns. Although High Grade had produced forty straight months of gains, spreads had continued to narrow and it had become increasingly difficult to earn more than Treasury bills. That also explains why, in 2006, Cioffi began focusing on the triple-A and double-A slices of CDOs, much of which was backed by subprime mortgages. Like IKB, he, too, was looking for that little bit of extra return. He bought $7 billion worth of highly rated tranches.

In addition to using the repo market, Cioffi developed a second source of funding, one that both was indicative of the market’s growing insanity and would serve as a powerful transmitter of the subprime virus.

In essence, the Bear funds set up their own CDOs. They sold assets they owned to the CDOs, which they then managed. They retained the equity piece of the new CDO and used the fresh cash to buy yet more assets. Tannin referred to this as “internal leverage.” For the Bear guys, this was indeed a savvy way to get low-cost, low-risk leverage; among other things, lenders couldn’t simply yank cash from the funds, the way repo lenders could. But the risk was still there—in this case, it resided at the bank that underwrote the CDO. That’s because instead of selling long-dated debt, the new CDOs sold very short-term, low-cost commercial paper. This paper, in turn, was bought by money market funds around the country. In order to make the commercial paper palatable for money market funds, the bank that underwrote the CDO—often Citigroup and, later, Bank of America—would issue what was called a liquidity put. That meant that if buyers for paper became scarce—in the event, say, of a disruption in the market—the banks would step in and buy it themselves. Cioffi raised as much as $10 billion this way, according to
BusinessWeek
, while Citigroup earned $22.3 million in fees for underwriting the CDOs and was paid another $40 million a year for providing the liquidity put. At the time, this appeared to be free money.

And yet, as early as the summer of 2006, the angst-ridden Tannin was worried. The Enhanced Leverage fund had been successfully launched and Tannin had been named a senior managing director. It should have been a happy time for him. But he would later note in his diary: “As I sat in John’s office”—John Geissinger, the chief investment officer at Bear Stearns Asset Management—“I had a wave of fear set over me—that the fund couldn’t be
fun the way that I was ‘hoping.’ And that it was going to subject investors to ‘blowup risk.’ ” He continued, “This all hit me like a ton of bricks—and the first result—almost immediately—was for me to lose my ability to sleep. Classic anxiety … Let me try and describe my mental state: I was incredibly stressed … why was I stressed? I became very worried very quickly … I was worried that this would all end badly….”

“Fear.” That was the subject line of an e-mail that Cioffi sent to the funds’ chief economist, Ardavan Mobasheri, on March 15, 2007, at 11:22 p.m. It was two weeks after his vodka toast with his two colleagues. “I’m fearful of these markets,” he wrote. “Matt said it’s either a meltdown or the greatest buying opportunity ever, I’m leaning more towards the former … It may not be a meltdown for the general economy but in our world it will be. Wall Street will be hammered with lawsuits. Dealers will lose millions and the cdo business will not be the same for years.”

The weeks since the toast had not brought better days for the Bear Stearns team as they had hoped. Both funds were now losing money. “Im sick to my stomach over our performance in march,” wrote Cioffi in another e-mail to Mobasheri as March drew to a close.

Ironically, during this stretch the funds were losing money because of their short position in the riskier tranches of the ABX, which was in the midst of a three-month rally. (The index rose from about 63 in late February to a high of about 77 in mid-May.) When the index hit its low in February, many of those who were short—including Goldman—began covering their positions, which forced the index higher. As Cioffi also noted in an e-mail, another reason the ABX might have been going up was that there was, as he put it, “significant rhetoric around certain types of bailout programs and financing and refinancing facilities that various banks were implementing.”

In fact, around this time there had been efforts by some of the big Wall Street firms to salvage their triple-A tranches by buying actual mortgages and preventing enough foreclosures to keep those tranches from eroding. Bear, which owned the mortgage originator EMC, announced the EMC “Mod Squad” in early April, which was supposed to help delinquent borrowers avoid foreclosure. Other firms, including Merrill Lynch and Morgan Stanley, were meeting to see if they could do something collectively to keep homeowners from defaulting. The simple act of buying up the mortgages and then forgiving the loans would not only save homeowners, but save Wall Street billions of dollars in potential losses.

But there were all kinds of problems. Regulators were deeply suspicious. The firms themselves were worried about antitrust concerns. And the servicers, as one person involved in the effort put it, “were largely controlled by people who might not want mortgages rescued.” Still, this source adds, “it should have been possible to overcome.”

It wasn’t to be. In particular, a number of the big investors who were short the triple-A tranches were furious when they discovered what was going on. They were going to make money if enough homeowners were foreclosed on! They didn’t want anyone helping out homeowners at the expense of their profits. Some of the controversy broke into public view in April, when the
Wall Street Journal
reported on an exchange between the Bear Stearns mortgage desk and John Paulson. Bear sent Paulson a copy of language it drafted to the basic ISDA swap contract. It unequivocally gave the underwriter of any mortgage-backed security the right to support failing home loans in a mortgage security. “We were shocked,” Paulson lieutenant Michael Waldorf told the
Journal
. Deutsche Bank and others with big short positions rallied behind Paulson. They said that the Bear proposal was tantamount to market manipulation.

The plan to prevent foreclosures went nowhere.

Despite their worries, Cioffi and Tannin never let on to their investors that anything was amiss. Doing so would have turned their fears into a self-fulfilling prophecy, causing panicked investors to yank their funds. Nor did they go out of their way to detail the extent of their subprime exposure. Their written communication to investors showed that only 6 percent to 8 percent of the funds’ assets were invested “directly” in subprime mortgages, when the actual exposure—including CDOs backed by subprime mortgages—was closer to 60 percent. Although they did give a fuller account whenever they were asked in conference calls about the subprime exposure, some investors would nevertheless feel that the Bear team had misled them.

And so would the government, which would later bring civil and criminal charges against Cioffi and Tannin, charging them with talking up the funds while entertaining deep private doubts. (Cioffi was also charged with insider trading for taking $2 million of his money out of the fund without telling investors.) But a jury found both men not guilty of the criminal charges, and when you read their e-mails in full, you can understand why. (As of the fall of 2010 the civil case was still open.) It wasn’t so much that the men were lying as that they were scrambling for salvation, trying to find ways to make
it all work, and grasping on to any small crumb of hope to help convince themselves that this market, upon which their fortunes depended, couldn’t really be disintegrating before their eyes.

On April 19, for instance, Van Solkema did some preliminary analysis with a new credit model he was working on, in which he reverse engineered some mortgage-backed securities, drilling down to the individual mortgages. He wanted to be able to play around with default scenarios at the homeowner level, to see how different default rates would affect CDO tranches. It is both telling and stunning that a firm of the size and supposed sophistication of Bear Stearns didn’t have the ability to do this before launching hedge funds whose prospects would be dependent on that very thing.

Van Solkema later told the jury that when he ran his model, “the bad [mortgages] looked even worse than what I thought they were.” After getting the results, Tannin e-mailed Cioffi’s wife, Phyllis, from his personal e-mail account: “[T]he subprime market looks pretty damn ugly … if we believe the runs Steve has been doing are anywhere close to accurate, I think we should close the funds now. The reason for this is that if [the runs] are correct then the entire subprime market is toast…. If AAA bonds are systematically downgraded then there is simply no way for us to make money—ever.”

In mid-March, Cioffi sent an e-mail listing “problem positions,” next to which he noted his stress level. Among them: $120 million worth of Abacus bonds, which he had bought from Goldman Sachs. Stress level: medium to high.

And yet at the same time, the two men simply couldn’t bring themselves to believe that the picture was as dire as the model suggested. In that same e-mail to Cioffi’s wife, Tannin stated that Andrew Lipton, the head of surveillance at Bear Stearns Asset Management—and a former Moody’s executive—was still positive. “I sat him down on Friday and asked how serious he thought the situation was. He calmly told me that the situation wasn’t going to be as bad as people are saying,” Tannin wrote. Tannin also wrote that Bear’s CDO analyst, Gyan Sinha, had issued an optimistic report about subprime mortgages in February.