All the Devils Are Here [178]
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