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Ralph claimed that subprime was “actually a very small percent of Everquest’s assets.” He reasoned that on a market value basis the exposure to subprime was actually negative because Everquest hedged its risk. Technically, Ralph might have been correct—but the registration statement for the Everquest IPO itself suggested otherwise: “The hedges will not cover all of our exposure to [securitizations] backed primarily by subprime mortgage loans.”22

It is fine to talk about net exposure (left over after you protect yourself with a hedge), but one usually also discusses the gross exposure (of the assets you originally bought). Hedges cost money, so they can reduce returns.

Ralph Cioffi said CDO equity is “freely traded and easily managed.” I countered that CDO equity may be easy for Ralph to value, but investment banks and forensic departments of accounting firms told me they have trouble doing it. I told him that if this were a CDO private placement, it would have to be sold to sophisticated investors and meet suitability requirements, but since it is in a corporation, it can be issued as an initial public offering (IPO) to the general public. It seemed to be a way around SEC regulations for fixed income securities, and it was not suitable for retail investors in my view.

Ralph said he would talk to his lawyers about changing the IPO’s registration statement to add a line about third-party valuations. We seemed to be talking at cross purposes, since the registration statement already said that third-party valuation would occur at the time of underwriting.The problem with that was that the assumptions for pricing would be provided by a conflicted manager, and assumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management’s assumptions for pricing.

Ralph did not seem to want to end the discussion, so I asked him if there was something he wanted me to do. He said it would be great if I issued a comment saying I was quoted “out of context,” that my being quoted in Business Week lent credibility to the article and was not helping me, and that I would be “better served” writing my own commentary. I ignored what I perceived to be a thinly veiled threat. I told him that if he wanted me to write a commentary, I would do a thorough job of raising all of the objections I had just raised with him. Ralph seemed unhappy, but my thinking he was a hedge fund manager from Night of the Living Dead was the least of his problems.

At the end of January 2007, the Enhanced Leverage Fund had $669 million in investor capital and $12 billion in investments for a leverage ratio estimated at around 17 to 1. Some estimates said that leverage increased to more than 20 to 1 the following month as assets increased and capital decreased slightly. The less-leveraged fund was estimated to have been levered over 10 to 1, a high degree of leverage for risky assets. On May 15, just days after the Business Week article appeared, Bear Stearns asset management told investors in the Enhanced Leverage fund that April losses were 6.75 percent. Questions about both the Bear Stearns High-Grade Structured Credit Strategies and the Enhanced Leveraged fund flooded the marketplace. The funds’ credit line providers were alarmed.232425

Bear Stearns faced other challenges. In April 2007, Bear Stearns asked the International Swaps and Derivatives Association, Inc. (ISDA) to modify credit default swap documents to make it clear that it had the right to modify mortgage loan agreements. On the surface, trying to maximize recovery by allowing homeowners to stay in their homes while continuing to make payments is a good idea. Foreclosure costs are expensive, and one should try to minimize losses in any way possible. But Bear Stearns’s timing could not have been more unfortunate; it provoked its own public relations disaster.

A few weeks later, more than 25 hedge funds led by John Paulson, the heavy shorter of