Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street - Janet M. Tavakoli [73]
Based on what I read, Everquest’s original assets had significant exposure to subprime mortgage loans, and the document disclosed it, “a substantial majority of the [asset-backed] CDOs in which we hold equity have invested primarily in [residential mortgage-backed securities] backed by collateral pools of subprime residential mortgages.”15 Based on my rough estimates, it was as high as 40 percent to 50 percent.
If that was not bad enough, there was huge moral hazard. Bear Stearns Asset Management provided the assumptions for valuing the CDOs. Small changes in the assumptions could create huge differences in prices. Greg Parseghian, formerly of Freddie Mac, was listed as one of the outside directors of Everquest.16 Among the many criticisms levied against Freddie Mac (due to events at the time Parseghian worked there) was its failure to use third-party assumptions instead of concocting its own, thus exposing itself up to moral hazard. Parseghian’s bosses left under a cloud, and he was promoted to CEO of Freddie Mac. Parseghian himself stepped down after a couple of months. OFHEO—the Office of Federal Housing Enterprise Oversight—then Freddie Mac’s regulator, said that before Parseghian’s promotion to CEO, he “failed to provide the Board with adequate information . . . to make an informed decision” in regard to some transactions. In this respect Parseghian’s actions illustrated Freddie Mac’s “culture of minimal disclosure.”17
BSAM earned management fees for the hedge funds, management fees on some of the CDOs, and fees for managing Everquest. If Everquest’s Board replaced the managers, it had to pay a “break-up” fee of one to three years worth of the management fees—breaking up’s so very hard to do.18 The registration statement stated that one of the risks is “the inability of our financial models to forecast adequately the actual performance results.”19 Yet, fees partially depended on performance.
I explained my concerns to Matt in a general way. Among other concerns: (1) money from the IPO would pay down Everquest’s $200 million line of credit to Citigroup; (2) the loan helped Everquest buy some of its assets including CDOs and a CDO-squared from two hedge funds managed by BSAM, namely the Bear Stearns High-Grade Structured Credit Strategies Fund that had been founded in 2003 and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund (“Enhanced Leverage Fund”) launched in August 2006; and (3) the assets appeared to include substantial subprime exposure.
Matt Goldstein posted his story on Business Week’s site later that day. Initially it was called: The Everquest IPO: Buyer Beware, but after protests from Bear Stearns Asset Management, BusinessWeek changed the title to Bear Stearns’ Subprime IPO.20 I hardly think that pleased Bear Stearns more.
Bloomberg’s Jody Shenn also wrote an article on Everquest that day. I expressed to him that “the moral hazard . . . is just mind-boggling.” He noted that Lehman thought that CDO assets had lost $18 billion to $25 billion in value industrywide as mortgage delinquencies rose. I thought industrywide losses were already much larger, they just were not being reported.21
Ralph Cioffi contacted me about the BusinessWeek article. He said that dozens of IPOs like Everquest had been done—mostly offshore so as not to deal with the SEC. According to Ralph, BSAM’s hedge funds and Stone Tower’s private equity funds would own about 70 percent of Everquest stock shares (equity), and they had no plans to sell “a single share at the IPO date.” They planned to use the IPO proceeds to pay down the Citigroup credit line and possibly buy out unaffiliated private equity investors.
I responded that verbal assurances that there are no plans to sell a share at the IPO date are meaningless. Publicly traded shares can be sold anytime. But even if the funds kept their controlling shares, it was not good news. Retail investors would