All the Devils Are Here [179]
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,