House of cards, p.51
House of Cards, page 51
Even by the generally chaotic standard that passes for the norm at a Wall Street investment bank, June 2007 at Bear Stearns was a particularly frenetic month. As trouble was brewing at the hedge funds, Cayne, Molinaro, and Robert Upton, Bear's treasurer, had invited a small group of executives from Moody's, the rating agency, for lunch in the executive dining room. The idea had been to try to convince Moody's to begin thinking about upgrading Bear's credit ratings. A better credit rating lowered the cost of the firm's borrowing and was, according to Upton, “a competitive weapon for derivatives issuance, in particular, but it just would be a good thing to keep going north in the ratings.” It was meant to be “a love-to-love lunch with Jimmy,” Upton said, “and Sam and I had some key points that we wanted to make about the business.” But because of the ongoing negotiations with the repo lenders, Molinaro kept getting pulled away from the lunch by frantic calls about the hedge funds. Upton worked hard to cover for Molinaro. In the middle of his comments about the relative strength of the firm's various businesses, the Moody's team kept returning the discussion to the hedge funds. Upton said it became embarrassing. “It was almost comical because you're a CEO of one of the most successful Wall Street firms, the hedge funds are blowing up, and he wasn't terribly engaged in that discussion on the phone— all the calls were to Molinaro, and he was running in and out of the room,” Upton said. “God bless Jimmy, he talked about people and stories. But at this very critical juncture in the firm's history—[with] what ultimately became the first in a series of death blows—while we were trying to deflect concern from rating agencies and ultimately convince them that not only were we healthy and okay but that we were an improving credit, the CEO and the guy who was supposed to have basically control of understanding what was going on everywhere just completely missed the boat. He didn't talk about anything other than when he had lunch with Walter Shipley from Chemical Bank. It was rather telling about what I think was going to happen over the course of the next nine months.”
AS THE FIRST margin calls came into the hedge funds during and after the creditor meetings, there was a “bit of a game of chicken” going on, according to one participant, whereby the two sides would argue about the valuation of the collateral and just how much additional margin was needed. After a few days of this macho behavior, one repo lender to the fund approached BSAM directly about negotiating to buy back its collateral, allowing the hedge funds to get the cash they needed and the lender to get its collateral back at a price it thought it could make money at whenever it chose to sell the securities in the market. On the advice of Blackstone, BSAM informed all the lenders about the opportunity for bilateral negotiations.
“Suddenly everybody wanted to do a deal, including Merrill,” one Bear executive said. “All these bilateral deals start getting negotiated. The problem is the bilateral deals are being cut at levels that are below book value, so every time we do one it nips away at the book value. There are so many moving parts—derivatives, which are very complex to value, and cash instruments that are very complex in their own right, and whole portfolios that have hundreds of millions of dollars and sometimes a billion dollars. All of that coming into the thin neck of the funnel of Ralph and Matt trying to do the valuations—you can imagine what kind of a shit show this was.” Another bottleneck came when Marin would not allow Cioffi to agree to any bilateral deals until both BSAM and Bear Stearns had signed off. That brought the executive committee into the mix. “Now Marin's talking to Warren all day long and Warren's talking to Ralph all day long,” said one observer of this bit of corporate theater. As the demand for one-off deals from the repo lenders escalated, Spector decided that Marin and Cioffi could no longer do the work themselves and decided to get his lead trader, Tommy Marano, involved.
Marano, an extremely experienced trader and Grateful Dead lover, moved over to help manage the unwinding of the High-Grade Fund. That left a big hole in the fixed-income department but was thought to be necessary under the circumstances. Marano was going to work with Paul Friedman, whom Spector had already asked to go over to the funds. The firm put out an announcement that Marano would be seconded to the hedge funds. The firm also asked Mike Alix, the firm's chief risk officer, to oversee BSAM. The firm furthermore announced that Marin would take “a stronger role” in running the two hedge funds, although Cioffi would still remain involved.
Then there was the problem of the intense pressure on the clerks, who worked for the funds, to be able to quickly and accurately reconcile the daily cash positions with all the transactions happening so quickly. “Under normal circumstances, they're perfectly competent to do that,” said a BSAM executive. “It's like an airline pilot who suddenly is in a dogfight. It's outside their range of experience. They don't know how to deal with all of the variables that come into play. Just trying to keep up with it in a twenty-four-hour day had proven to be impossible.” The pressure on everyone was mounting. “This is an unusual time, the shit is flying in every direction,” said one executive. “The people are trying to fend off creditors, and when you're trying to fend off creditors and everybody's trying to get a piece of you and you're trying to do this in an orderly manner, people will call up and say, ‘You didn't call me back. I called you an hour ago.' Well, he doesn't know that you've had fifty phone calls in that hour and you're trying to do a reconciliation. It was a nightmare.”
With everyone focused, the funds started to agree to various bilateral deals with the repo lenders. “In a free-fall market, if people are willing to do block trades, that's your best way forward,” explained one Bear executive. “We get one done, then we get a second and a third one done. It was like holding a yard sale before the sheriff comes. And we're watching the NAV of the fund collapse. But at least it's definable.”
Then pressure started increasing on Bear Stearns, the parent company, to step up and take out the repo lenders to the hedge funds. To that point, the firm's only exposure was its $45 million equity investment, and the rest of Wall Street was waiting for the firm to put together a serious rescue plan. Cayne decided to convene a meeting of the twenty most senior executives at the firm—a combination of the executive committee and the management and compensation committees—to get an update of what was going on with Cioffi's hedge funds and to decide whether or not the firm should agree to become the repo lender to the funds. Before going into the meeting, Cayne asked Steve Begleiter, the firm's head of strategy, how much money Bear had invested in the funds. Cayne said he thought the amount was $20 million, although there had been numerous articles in the press since the funds started blowing up suggesting the number was double that amount. Begleiter told him the firm actually had $45 million invested. “I said, ‘What?' He said, ‘Forty-five.' I said, ‘Forty-five? I thought it was 20. Where did the 25 come from?' He said, ‘I don't know.' I said, ‘You don't know where the 25 comes from?' He said, ‘No.' We walk in, I said, ‘Before we discuss what we're going to do, does anybody know about $25 million that was put into the funds at the last minute?' Spector said, ‘I did. Sorry.' No, he didn't say ‘I'm sorry.' He said, ‘I fucked up.' If he had said ‘I'm sorry,' it would have been different. He said, ‘I fucked up.' Now there's silence. People were expecting me to say, ‘What are you, fucking crazy? Unauthorized, you yourself authorized $25 million into a failing enterprise.' Well, I didn't, but I also didn't say anything for like a minute. I just let everybody hear him say, ‘I fucked up.’”
After shining the bright light of blame on Spector's decision to invest the extra $25 million into the funds on his own authority, Cayne asked the group what to do about the funds. ‘I said, ‘Okay, so what are our options? It seems to me the first option is we just bag the funds. We suffer a reputational risk, which we aren't really going to avoid anyway. And we save ourselves the heartache of that crap coming into us.' Nobody said anything. Greenberg says, ‘No, we can't do that. That'll kill the firm.' Somebody else says, ‘Yeah, that's really bad for the rep.' I hadn't carried the day. By blowing up the factory, which basically [happens] when you say ‘Bag the funds,' you're telling all the investors, ‘Go fuck yourself. We're not Goldman, which just poured $3 billion in to rescue its funds.’”
The decision about what if anything Bear Stearns should do about the funds was a complicated one. “You've got the problem that there are two funds with very different capital structures,” explained a Bear executive. “In one, you got Barclays and its facility, and the other one you don't. One is more leveraged and the other one isn't. It's kind of like you've got two children and there's a freight train coming and you can't save them both. Do you save one of them, or do you try and save both and maybe they both die? I mean, what do you do? It might cost you your life, too. That's the decision they had to make.”
THERE WAS QUITE a row at the executive committee about what to do. “In full disclosure,” Friedman said, “mea culpa. In the executive committee meetings when there was discussion of what to do—Jimmy, God bless him, he was right once—Jimmy is screaming, ‘Fuck them. Let the hedge funds go under. It's not our money. We didn't lend to them. Let the banks lose. Not our problem.' It was the right answer. I was one of the ones screaming, ‘We can't let this happen. There's equity here. We've got to try to do something, both because it will help the investors, and because if we tell all the banks to fuck off, we can't exist in this community having done that to all the banks. It was bad enough when we did it in 1998. They all still hate us from 1998. We can't do it again.' Ace in the end carried the day, and Ace's great line at the last executive committee meeting was, ‘We can't take these two hedge funds, throw them out on the sidewalk, and walk away,' and he convinced Warren and others that we had to do something, which is how we ended up bailing out the one, which was the least we could do, but we truly believed there was a lot of equity left in that fund.”
Cayne took a purely tactical and unemotional approach to the difficult facts presented. “He didn't care about our reputation,” Friedman said. “His view was Merrill, Citigroup, JPMorgan, and the others, if they were stupid enough to lend to Ralph against this stuff and we were smart enough not to, ‘Why should we bail them out just because they were stupid to lend to him at ridiculously low margins? It's not our problem. It's not our money in the fund, basically. It's not us lending to them. Let JP, Morgan Stanley, B of A, let all these guys blow them out. Screw ‘em. Who cares?' My view—and it turned out to be wrong—was both we needed it from a franchise value, and I still believed that if you took JPMorgan and Citi and B of A, and Deutsche and Dresdner and all the big banks, and told them to all pound salt, that they would strangle us to death. They'd pull all our loan facilities. We'd already spent a decade working our way back from everybody hating us from refusing to help with Long-Term, and were working our way through that. There had been so much bank consolidation in those ten years that everybody who was lending to Ralph was everybody we were borrowing from. It just seemed suicidal to stick it to them and go, ‘Too bad.' Jimmy didn't get it. He didn't care.” But he would be proved right.
The executive committee met nearly twice a day for two weeks in order to determine what decision to make regarding whether or not to become the secured repo lender to the hedge funds. The committee would get feedback from Marin and Cioffi about the creditors' meeting on the second floor and then meet together in Cayne's sixth-floor conference room to figure out what to do. There was a considerable cast of characters, from Marin and Cioffi of BSAM to the leaders of the firm's fixed-income business—Craig Overlander, Jeff Mayer, Tommy Marano, and Paul Friedman. “The group dynamics were fascinating,” Friedman said. “By this time, Jimmy had allowed Warren and Alan to basically run the meetings. Jimmy would sit there and smoke his cigars, and Alan and Warren would debate what to do. Jimmy, in fact, in a lot of cases, would come and go in the middle of meetings. It wasn't surprising that Jimmy wasn't dictating where we were going to go on all of this because he generally didn't. Whether he was smart enough to be working on a handoff to Alan and Warren or whether they were in the process of grabbing it from him, I don't know.”
Friedman said the five members of the executive committee were like the Politburo in addition to being “caricatures of themselves, in the sense that you almost don't need to have meetings because you know what everyone is going to say in advance. You can script it, particularly recurring things. You just know where everybody's going to come out. Alan was sort of the Socratic banker, negotiator, even-tempered, ‘Let's get all the things on the table and let's really work it out.' Warren was the trading genius, who got quicker to the map, got quicker to the answer, ‘Here's what we're going to do.' Jimmy was always sort of losing focus because he would come in and out. We were talking about bonds and stuff, and that was not exactly his best trick. Ace was the more grander, broader, ten-thousand-foot, philosophical, talking-about-the-seventy-five-year-old-firm sort of thing. Everybody fit into those roles.” In the case of what to do about the hedge funds, the dynamic was different. “Sam was, in this particular case, absolutely opposed to it,” Friedman said. “He kept using the phrase, ‘Why are we trying to catch a falling knife?' That was his favorite phrase through that whole episode. ‘Let it go. Let the knife fall on the ground and then we'll pick up what's left.' He and Jimmy were on the same page. There was a series of reasoned discussions. But it just came down to we ran out of time. There was just no more discussion available. We got to the last day, where everybody was threatening to blow us out, and we had to decide right now: ‘What do we do?' Jimmy's and Sam's approach of ‘Let's just give up' was not carrying the day. The mortgage guys felt fairly strongly that we could do something. We were going round and round, trying to figure out some compromise. Everybody was looking for a compromise.” Greenberg was said to believe the firm's “reputation” was paramount and that he thought there “was a good chance we'll get the money back.” Spector was “reluctantly in favor” of providing the repo financing “but very, very unhappy about having to do it,” said someone in the meeting.
That was when the consensus formed—against Cayne's better judgment—that the firm should agree to become the repo lender to the High-Grade Fund and let the Enhanced Leverage Fund fail. Then the problem quickly became figuring out what the securities in the High-Grade Fund were worth, since Bear was going to lend against them. To that end, according to one participant in the discussions, “The executive committee says, ‘What are these funds worth?' The best and the brightest from the trading desk are sitting there … not one of them makes less than fifteen million bucks, a fuckload more than I made, and not one of them will step up and say what it's worth—not one. These guys work in this market all day long, just in this market. I'm talking Tommy. I'm talking Jeff Mayer. I'm talking all of them. None of them would put a value on this thing. It was very hard to do. And they're prudent guys who understand that in a free-fall market you don't reach out for the knife while it's falling.”
One possible way to figure out what the collateral was worth was by examining the results of the bilateral deals. “The point is we kind of know where everybody has said they would do a deal at,” this participant remembered. “We can get a value based on that.” Based on quickly and collectively analyzing the bilateral deals, the consensus seemed to be that “the [Enhanced Leverage] fund will be worth this much in the end,” he said, “and it was nonzero. And the [High-Grade] fund will be worth this much and it was considerably nonzero. Isn't that the closest thing we have right now to a value?” After probing into the logic of this suggestion, the executive committee authorized the SWAT team to negotiate as many of the bilateral deals as they could.
By this time, Bear Stearns had also learned that Merrill's efforts to sell its $850 million of securities in the market had not gone well. “Merrill got stuck with a lot of bonds,” Friedman said. “That was an interesting but troubling data point for liquidity in this stuff, but it also was a reinforcement of the notion that you can't try to sell this stuff at an auction with twelve hours' notice. People just won't bid.”
Events at the hedge funds were transpiring so quickly that the Bear Stearns executives had little time to consider carefully what to do. The redemption notices were coming fast and furious, and to avoid a total meltdown, they thought it best to take out the repo lenders and allow for what they hoped would be an orderly liquidation of the fund over time. “It was over,” Cayne said of the firm's decision to make the $1.6 billion available. “Bids were coming in at 50 cents. Merrill was selling us out. There were no bids on half the items. That's when the world woke up. That could be the wake-up call. That margin call. They used the words ‘blow you out,' like a blowjob.” Paul Friedman said the firm had “to decide in about forty-eight hours what the stuff was worth. It realistically would have taken three or four weeks to really know what this stuff was worth. We guessed that we were lending $1.2 billion against stuff that we thought was worth at least $1.5 billion or $1.6 billion. We thought the hedge fund itself had a couple of hundred million of equity. Then it turned out it didn't. It seemed at the time like this was a pretty safe loan. The theory—which was a good theory—was if we were the only lender and if this thing actually had equity in it, then we could do an orderly liquidation and preserve the equity. Have more money to pay back the investors and reduce the lawsuits, reduce the losses, and reduce the destruction on the market. That was the theory. At that point we still believed that an AAA rating meant an AAA rating, and we all believed that these things were reasonably well structured.”
