All The Devils Are Here: Unmasking the Men Who Bankrupted the World (56 page)

Denial seemed to be rampant at Bear Stearns. On March 1, two Bear analysts
upgraded
New Century’s stock. The stock of Bear itself hit an all-time high of $172.69 on January 17, 2007; a few months earlier, S&P had upgraded the firm’s credit rating to A+ (one notch up from a single-A), partly due to the strength of its mortgage business. Thanks largely to Cioffi’s friendship with Warren Spector, Bear itself put $25 million into the funds in late April 2007.

And even as Cioffi and Tannin began to recognize that a triple-A rating might not mean anything, they clung to the belief that
their
triple-As were different. Van Solkema testified that after running his model, he still thought the funds would survive. On an April 25 conference call, Tannin told investors, “[I]t is really a matter of whether one believes that careful credit analysis makes a difference, or whether you think that this is just one big disaster. And there’s no basis for thinking this is one big disaster.”

By then, though, big investors were warning that they were thinking about withdrawing their money, and the funds’ repo counterparties were starting to demand yet more collateral. In fact, on March 11, Ray McGarrigal, who worked on the funds with Cioffi and Tannin, wrote to the others, “I would move as much away from Goldman as possible. I do not wish to trade them in any fashion at this point. I would highly recommend moving any and all positions away from them as soon as is feasible and only be a net seller to them going forward.” The Goldman “get closer to home” meeting in David Viniar’s office had taken place back in December, and the firm was aggressively reducing its marks, or prices, on securities that either contained or referenced mortgages. Which meant that Goldman was also getting more aggressive in demanding collateral to make itself whole. McGarrigal continued, “The only other group that makes me nervous is UBS. They are long a lot of super-senior.”

And so, the Bear hedge fund managers made two final, desperate efforts to raise cash. In the fall of 2006, they had started working on a deal to sell off the equity—the riskiest part—of ten CDOs to a new company called Everquest. Now, in the spring of 2007, they tried one last push to have Everquest itself sell shares to retail investors in an IPO. “The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets,” wrote Matthew Goldstein in a May 11 article in
BusinessWeek
. The Everquest deal would have allowed Bear to raise cash and pay down a $200 million line of credit from Citigroup. But the deal seemed so obviously self-serving that a furor erupted, and it became impossible to complete.

The Bear Stearns team also began rushing to complete another deal that had been in the works: a CDO squared made out of the funds’ holdings of CDOs. The idea was, as Cioffi put it in an e-mail, to “get as much of our assets off our books … as possible.” He was hoping it would result in more stable financing for a lot of the funds’ assets, instead of using increasingly fractious repo lenders. This deal did close, on May 24, 2007. Bank of America, the underwriter, wrote a liquidity put requiring the bank to buy the $3.2 billion
of commercial paper that was issued by the new CDO in the event of problems. Money market funds bought most of the commercial paper.

Later, Bank of America sued Bear Stearns, Cioffi, Tannin, and McGarrigal for allegedly hiding the funds’ true condition. As part of the lawsuit, the bank also claimed that it had gotten a verbal agreement from Cioffi that he wouldn’t put certain “high-risk” assets into the new CDO, but that Cioffi ignored that agreement. There was one asset in particular that Bank of America singled out in its complaint, an asset that quickly lost all its value: Goldman’s Timberwolf deal. (This lawsuit was also ongoing as of the fall of 2010.)

By the time the Bank of America deal closed, the funds were in serious trouble. Investors had demanded half their money back from Enhanced Leverage, leaving Cioffi and Tannin with little choice but to wind it down. Tannin, at least, seemed to finally recognize that the jig was up. In late May, a Bear salesman announced good news: Tokio Marine wanted to invest $10 million in the High Grade fund. When Tannin heard the news, he asked for a meeting with Greg Quental, who was the head of Bear Stearns Asset Management’s hedge fund business. After the meeting, Quental announced that the Bear funds wouldn’t be taking any new investments.

At the end of May, Cioffi e-mailed Spector, his longtime supporter at Bear. “Warren, I’m almost too embarrassed to call you,” he wrote. “I feel especially badly because you have been a big supporter of mine for so long … I know apologies are meaningless at this stage but I am sorry … Emotionally, I am obviously keeping a business as usual persona at work and on the job 24–7. I assure you of that. But it is very stressful and strange when it looks like one’s business is collapsing around him … we are running out of options.”

More bad news was coming. A few weeks earlier, Bear had told investors in the Enhanced Leverage fund that it had lost 6.5 percent in April. But at a meeting on May 31, Bear Stearns’s pricing committee, which determined the funds’ returns by surveying how its counterparties were marking the securities, decided the fund had actually lost 18.97 percent in April. One key reason for the stunning change was Goldman’s low marks.

According to the SEC, Cioffi tried to argue that his original marks were right. When he gave up, he wrote an e-mail to a member of the pricing committee: “There is no market … its [sic] all academic anyway −19 percent is doomsday.”

Which, in fact, it was. While Bear could and did prevent its investors from
taking their money out—a common tactic when hedge fund investors are all trying to exit at once—it was powerless to do anything about the repo lenders. “It’s like borrowing from the devil times three,” says one person who was there, speaking of the repo lenders. “They can come and say, ‘You pay me,’ and you can do nothing, nothing, nothing. There are no rules, and you have no ability to see where they’ve marked the same assets on their own books. It’s a grab.”

On June 11, Cioffi wrote to Tannin and George Buxton, who worked in Bear’s private client services, “Right now we’re fighting the Battle of the Bulge with our repo lenders. So far so good but it is very tough and stressful …” He was trying to convince the lenders that if they grabbed the collateral and tried to sell it into a shaky market, everyone would get hurt. After all, the Bear team argued, they all had the same positions, and panicked selling would turn theoretical declines in the market value of the securities into hard cash losses.

The men were also deeply frustrated. While Wall Street’s repo desks were demanding money, the trading desks at the same firms were refusing to reflect the value of the Bear team’s short positions. They were being squeezed from both sides. “The pressure was tremendous,” says one person who was there. “And everyone was scared.” On June 14, Bear held a meeting with the repo lenders to try to cut deals. At that meeting, according to
House of Cards
, William Cohan’s book about the fall of Bear Stearns, the Bear executives gave a presentation showing the exposure the rest of the Street had to the firm’s hedge funds. Overall, sixteen Wall Street firms had lent the funds $11.1 billion in the repo market. Among them were Citi, with nearly $1.9 billion outstanding, and Merrill Lynch, with $1.46 billion outstanding.

A few days later, one firm broke from the pack. Merrill Lynch seized $850 million in collateral, which it said it would sell on the open market. Any chance of an orderly wind-down of the funds was now gone. It was a classic run on a bank—except that those racing to pull their money out weren’t depositors. They were bankers.

When Merrill tried to sell the assets, it discovered that Cioffi had been right: nobody wanted to buy the collateral, at least not at the price that Merrill was valuing the securities. The firm largely abandoned the effort. J.P. Morgan and Deutsche Bank, which had followed Merrill’s lead, canceled their plans to sell assets, too. Here was the moment of truth: triple-A tranches of CDOs stuffed with subprime mortgages simply weren’t salable, not at a
hundred cents on the dollar, and maybe not at any price. In fact, mortgage-backed securities weren’t salable, period. “All these guys grabbed for Bear’s mortgage-backed securities thinking they’d be able to write them up, not realizing they’d have to write them down,” says one person who was there. “All of a sudden, it became an internal witch hunt everywhere. How much of this do
we
own?”

As Goldman’s Josh Birnbaum later wrote, “The BSAM situation changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage credit.” Goldman, which had covered its short position, quickly began to rebuild it.

Although Bear itself did eventually put up $1.6 billion to try to save the High Grade fund, it wasn’t enough. On July 31, 2007, both funds filed for bankruptcy.

But Wall Street was still too blind to see that the line between the Bear hedge funds—highly leveraged entities dependent on the repo market with big exposure to toxic subprime mortgages—and the firms themselves—highly leveraged entities dependent on the repo market with big exposure to toxic subprime mortgages—was a very thin one indeed. That lesson was yet to come.

As the prices on triple-A-rated notes plunged in the early summer of 2007, the rating agencies continued to insist to the outside world that everything was just fine. At the beginning of the year, S&P had predicted that 2007 would bring “fewer ratings changes overall, and more upgrades than downgrades.” As the year went on and the skepticism about the validity of the ratings increased, the agencies claimed that they had run stress tests and scrubbed the numbers. Moody’s told
Fortune
, for instance, that its investment-grade-rated products were “designed to withstand losses that are materially higher than expectations.”

The rating agencies were in the midst of a spectacularly profitable run. “The first half of 2007 was the strongest we had in five years,” Moody’s CEO Ray McDaniel would later say; its revenues had hit $1.2 billion over that period. Why? Because the Wall Street firms could all see the handwriting on the wall. With the ABX declining and triple-A tranches faltering, the CDO business was soon going to shut down. So Wall Street raced to shove as many CDOs out the door as it could; firms like Goldman wanted to get the bad
paper off their own books onto someone else’s while there was still time. In that same six-month period, from January to June 2007, CDO issuance peaked at more than $180 billion. “[B]ankers are under enormous pressure to turn their warehouses into CDO notes,” Eric Kolchinsky, the Moody’s executive in charge of rating asset-backed CDOs, wrote in an August 2007 e-mail. Amazingly, the rating agencies continued to facilitate that effort by rating large chunks of these deals triple-A.

Had the agencies noticed the increasing early payment defaults that had started in 2006? Of course. S&P and Moody’s had responded by increasing the amount of credit enhancement required to get investment-grade ratings on securities backed by subprime mortgages. But as the Senate Permanent Subcommittee on Investigations would later point out, neither agency went back to test old mortgage-backed securities or old CDOs using this new methodology. Thus, the old, flawed ratings continued to live on in portfolios all over Wall Street. Even worse, they were recycled into new synthetic CDOs, as old tranches were referenced in new securities. “Reevaluating existing RMBS securities with the revised model would likely have led to downgrades, angry issuers, and even angrier investors, so S&P didn’t do it,” said Senator Carl Levin, subcommittee chairman. Moody’s didn’t, either.

Despite the optimistic glow the rating agency put on things to the outside world, there were plenty of people internally who feared the worst. In an e-mail exchange in early September 2006 among S&P employees, Richard Koch, a director in S&P’s structured products group, cited a
BusinessWeek
article on the bad lending practices in option ARMs. “This is frightening. It wreaks [sic] of greed, unregulated brokers, and ‘not so prudent’ lenders … Hope our friends with large portfolios of these mortgages are preparing for the inevitable.” Six weeks later, Michael Gutierrez, another director in S&P’s structured products group, forwarded a
Wall Street Journal
story to several colleagues about how ever looser lending standards were leading to higher defaults. He wrote, “Pretty grim news as we suspected—note also the ‘mailing in the keys and walking away’ epidemic has begun—I think things are going to get mighty ugly next year!”

“I smell class action!” responded a colleague.

By February, S&P was having internal discussions about how to respond to the deteriorating value of mortgage-backed securities. “I talked to Tommy yesterday and he thinks that the ratings are not going to hold through 2007,” wrote Ernestine Warner, S&P’s head of global surveillance, to Peter D’Erchia, an S&P managing director. “He asked me to begin discussing taking rating
actions earlier on the poor performing deals.” She continued, “I have been thinking about this for much of the night.”