Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street

Chapter 8.

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In the mortgage loan securitization market, a statistical sampling of the underlying mortgage loans should verify: integrity of the doc.u.mentation, the ident.i.ty of the borrower, the appraisal of the property, the borrower"s ability to repay the loan, and so on. Rating agencies should take reasonable steps to understand the character of the risk they are modeling.Yet, they seemingly rated risky deals without demanding evidence of thorough due diligence.

When rating agencies use old data for obviously new risks, it is financial astrology. When rating agencies guess at AAA ratings (without the data to back it up), it is financial alchemy.When rating agencies evaluate no-name CDO managers without asking for thorough background checks, it is financial phrenology. In other words, the rating agencies practice junk science junk science.The result is that junk sometimes gets a AAA rating.

Since the rating agencies are effectively a cartel, investors do not have an alternative to this flawed system other than to do their own fundamental credit a.n.a.lysis. Like Warren Buffett, they should understand the investment. Like Warren Buffett, they should understand the investment.

The rating agencies are swift to point out that they do not perform due diligence on the data they use and take no responsibility for unearthing fraud; they merely provide an opinion. In past legal battles, rating agencies successfully claimed journalist-like privileges, refused to turn over notes of their a.n.a.lyses, and continued to issue opinions. Independent organizations exist, however, that perform rigorous due diligence for a fee. Underwriters can hire them, and rating agencies can demand to see the results.Yet it seems the rating agencies failed to do so for many structured finance transactions.The rating agencies protest they are misunderstood rather than miscalculating when it comes to rating structured products.They claim the market misapplies ratings by expecting ratings to indicate market price and liquidity, but the former are merely symptoms of the real problem. They take data at face value, slap a rating on a dodgy securitization, and pocket a fat fee.

The Bank for International Settlements (BIS) and the Federal Reserve (Fed) may have embraced the rating agencies because these inst.i.tutions are chiefly made up of economists. The Securities and Exchange Commission is loaded with lawyers. I do not expect lawyers to be rigorous in their a.n.a.lysis, but I expect more of the BIS and the Fed. While there is such a thing as "junk economics," economics itself is not considered a science. Even so, just because lack of rigor permeates economics, economists should not be allowed to let this seep into other fields, particularly when there is a scientific methodology that can be used as a basis. When they adopted the rating agencies labels as benchmarks, the BIS, Fed, and SEC enabled junk science.

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Although they shouldn"t, many investors rely on the rating and the coupon when buying structured financial products. Whereas Warren views an investment like a business, many investors view their jobs as getting an investment meeting consensus. That is similar to allowing the manic-depressive Mr. Market to tell you the right price. If you do not understand the value, neither Mr. Market"s prices nor (sadly) the rating agencies will help you understand the value of a structured product any better. Many money managers feel buying a AAA investment is prudent; but if they do not understand these complex deals, they can quickly lose a chunk of princ.i.p.al.

Problems are not limited to mortgage loan securitizations. Ratings on leveraged synthetic credit products are often misleading, too. For example, when the products first appeared, I pointed out the triple A rating should never have been awarded to constant proportion debt obligations constant proportion debt obligations (CPDOs). These products are largely leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies. (CPDOs). These products are largely leveraged bets on the credit quality and market spreads of indexes based on U.S. and European investment-grade companies.

The high leverage of the products related to market risk puts investors" princ.i.p.al at risk. Investors essentially take the risk of the first losses on leveraged exposure to the indexes, and that is the exact opposite strategy to Warren"s margin of safety and that is the exact opposite strategy to Warren"s margin of safety. "Once again," I told the Financial Times Financial Times in November 2006, "the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example." in November 2006, "the rating agencies have proved that when it comes to some structured credit products, a rating is meaningless. All AAAs are not created equal, and this is a prime example."11 After rating an early CPDO transaction triple A, Moody"s was criticized by industry professionals, including me. Moody"s then changed its rating methodology, applying a different standard for subsequent transactions.12 Investors were attracted by the AAA rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent. Investors were attracted by the AAA rating and the high coupons. The investment banks selling them were attracted to upfront fees of 1 percent plus annual servicing fees of up to 0.1 percent.

I thought the rating agencies may have been turning over staff too quickly and using incompetent rookies-who could be pushed around by aggressive highly paid investment bankers-to rate these deals. In May 2007, the Financial Times Financial Times put Moody"s actions in the harsh glare of a newly angled spotlight. It said Moody"s original AAA ratings for CPDO were the result of a computer "bug," and the ratings should have been (according to Moody"s) put Moody"s actions in the harsh glare of a newly angled spotlight. It said Moody"s original AAA ratings for CPDO were the result of a computer "bug," and the ratings should have been (according to Moody"s) four four notches lower. Fur flew. A friend joked: notches lower. Fur flew. A friend joked: Don"t they mean forty? Don"t they mean forty?

Moody"s doc.u.ments showed that after it corrected the "bug," it changed its methodology, resulting in the ratings staying AAA until January 2008, when the market fell apart and the original ratings seemed ludicrous.The CPDOs were downgraded several notches.

The part about Moody"s changing its methodology was not news to me. I had included that information in a letter to the SEC on proposed regulations in February 2007, and I specifically objected to the AAA rating on this product. I do not even recall who told me about the change. If it was a secret, it was an open secret. All three rating agencies" models have more patches than Microsoft software.

The news is that the AAA rating seemed to be due to something more than a serious disagreement with my opinion. Moody"s internal memo said that the bug"s impact had been reduced after "improvements in the model."13 This suggests that there may be a cause and effect-the inconvenient lower ratings may have been masked by the methodology change. Chairman of the House Financial Services Committee, Barney Frank, said: "Moody"s alleged conduct in this matter raises questions not only about its competence, but more importantly its integrity." This suggests that there may be a cause and effect-the inconvenient lower ratings may have been masked by the methodology change. Chairman of the House Financial Services Committee, Barney Frank, said: "Moody"s alleged conduct in this matter raises questions not only about its competence, but more importantly its integrity."14 By January 2008, just under a year after my written comments to the SEC, Moody"s a.n.a.lysts wrote that two of the originally AAA rated CPDOs would "unwind at an approximate 90 percent loss to investors."15 The CPDOs were projected to have a The CPDOs were projected to have a 90 percent loss 90 percent loss from the rating agency that claims its AAA rating is based on from the rating agency that claims its AAA rating is based on expected loss expected loss.

Standard & Poor"s had also rated CPDOs AAA. In fact, it was the first to do so, and Moody"s followed suit. S&P vigorously defended their ratings methodology, even after it downgraded CPDOs. In the wake of the negative news, it put Moody"s commercial paper on credit watch. S&P later disclosed that it too found an error in its computer models, but said: "This error did not result in a ratings change and was caught and remedied by our ratings process."16 Now we all feel better. Now we all feel better.

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In February 2007, Bear Stearns research a.n.a.lyst Gyan Sinha wrote a report encouraging investors to take a long position in the ABX.HE.06-2 BBB- index (an index based on the value of BBB- rated residential mortgage-backed securities backed by subprime home equity loans).17 Simultaneously, I wrote a letter to the SEC recommending it revoke the NRSRO designation for the credit rating agencies with respect to structured financial products, a.s.serting " Simultaneously, I wrote a letter to the SEC recommending it revoke the NRSRO designation for the credit rating agencies with respect to structured financial products, a.s.serting "ratings are based on smoke and mirrors."18 On February 20, 2007, Gyan Sinha appeared on CNBC with Susan Bies, a Fed governor who had recently tendered her resignation. Bies thought it could take a year or two for housing inventory to be worked out, and housing had further to fall. She was concerned that hidden inventory was high, houses built for investors were vacant, and the numbers did not reflect the problem. She was surprised that subprime mortgages originated in 2006 had gone bad so quickly. It usually took a couple of years for loan delinquencies and defaults to peak, but 2006 vintage loans were delinquent in just a few months. It seemed to her that loans were made that never should have been made. She echoed Warren Buffett"s 2002 complaint about mortgage lenders in the manufactured housing market.

Gyan Sinha agreed with Susan Bies"s a.s.sertion that subprime delinquencies could reach 20 percent or a bit higher. He too was concerned about the early delinquency trends, but said that based on his research, at 6 to 7 percent c.u.mulative losses, only 1 of the 20 residential mortgage-backed securities in the ABX index would experience a write-down. Furthermore, he stressed that 75 percent of the capital structure of a CDO is AAA rated.19 It seemed to me Sinha only had part of the story. He did not mention that ersatz AAA rated tranches did not deserve that rating, or that prices of AAA rated tranches in the secondary market were trading at discounts among savvy investors. I projected a 21 percent c.u.mulative loss rate for first-lien mortgage loans first-lien mortgage loans, and the ABX included home equity lines of credit and second liens second liens, so losses would hit the loans backing the ABX much harder than that. Based on my projections, the ABX index would plummet.

In January 2007, I had lunch with Bethany McLean, coauthor of The Smartest Guys in the Room The Smartest Guys in the Room, a bestselling book about the Enron debacle. She was intrigued about my a.s.sertion that AAA and AA rated products were overrated. That meant that bond insurers such as Ambac, MBIA, FGIC that also insured munic.i.p.al bonds would have substantial losses. It also meant pension funds, bank investment portfolios, mutual funds, and more were buying investments with a high-rated label, but in reality they had the risk of losing substantial princ.i.p.al. I told her: "No one believes the ratings have any value."20 Some AAA rated tranches traded around 95 cents on the dollar in the secondary market. Losses were already being absorbed by lower-rated, but still investment-grade, tranches, and first loss investors of conventionally structured deals were wiped out. Her article appeared on March 19, 2007, St. Joseph"s Day, the patron saint of the homeless.The rating agencies denied there was a problem: "All of the rating agencies say they have scrubbed the numbers, and slices of debt that are rated investment grade will mostly stay that way, even if the collateral consists of subprime mortgages."21 Investment banks kept up the front. None of them took the ma.s.sive write-downs I expected in the first quarter of 2007. Instead, they cranked up the CDO machines.They offered toxic product to unwary investors.

On March 22, 2007, I wrote Warren that John Calamos Sr., chairman and CEO of Calamos Investments, does not rely on the rating agencies, either:

He mortgaged his house to start his fund, and he did not seek outside money. . . . Initially they tried using Moody"s and S&P ratings as benchmarks, and they got smoked a couple of quarters. They set up their own credit models and use those to the exclusion of ratings.

The following year, on Tuesday, March 11, 2008, Bloomberg News Bloomberg News reported that AAA subprime residential home equity loan backed bonds were not being downgraded despite having delinquencies exceeding 40 percent. As Bear Stearns gasped its last breaths, I appeared on reported that AAA subprime residential home equity loan backed bonds were not being downgraded despite having delinquencies exceeding 40 percent. As Bear Stearns gasped its last breaths, I appeared on Bloomberg TV Bloomberg TV that morning to discuss the structured finance ratings folly. The rating agencies were that morning to discuss the structured finance ratings folly. The rating agencies were still still in denial. Incapable of accurately measuring the present, the rating agencies provided no useful information for predicting future performance.The ABX indexes referenced 80 faux AAA bonds, and according to in denial. Incapable of accurately measuring the present, the rating agencies provided no useful information for predicting future performance.The ABX indexes referenced 80 faux AAA bonds, and according to Bloomberg Bloomberg"s a.n.a.lysis, none none of them merited that rating. According to its interpretation of S&P"s data, of them merited that rating. According to its interpretation of S&P"s data, Bloomberg Bloomberg a.s.serted that only six of the 80 AAA rated bonds in the ABX index would merit a rating above BBB-, the lowest possible investment grade rating. a.s.serted that only six of the 80 AAA rated bonds in the ABX index would merit a rating above BBB-, the lowest possible investment grade rating.22 In other words, 90 percent of the bonds in the AAA index were not even investment grade. In other words, 90 percent of the bonds in the AAA index were not even investment grade.

Contrary to the a.s.sertions of Na.s.sim Taleb and the Talebites, the mortgage meltdown is not a black swan event (an unlikely occurrence-unless one lives in Australia or New Zealand). It is not even Benoit Mandelbrot"s gray swan gray swan, a flawed model that does not foresee disaster. 23 23 Those labels would have described the 1987 portfolio insurance catastrophe affecting around $60 billion in equity a.s.sets, when sophisticated mathematical models originated in academia failed to take into account what happens when a large crowd tries to sell at the same time. Those labels would have described the 1987 portfolio insurance catastrophe affecting around $60 billion in equity a.s.sets, when sophisticated mathematical models originated in academia failed to take into account what happens when a large crowd tries to sell at the same time.

Portfolio insurance is a form of "dynamic" hedging that mimics a series of put options-as the stock price falls, the program automatically sells a given amount of stock and invests in cash. If the price falls further, the program sells more stock. In the week before the "Black October" crash of 1987, the Dow fell 250 points, and a large backlog of sell orders acc.u.mulated. The following Monday, portfolio insurance kicked in, and portfolio stock and index futures were sold. The market fell more.The market dropped around 500 points, the equivalent of around 2,500 points today. This was a cla.s.sic liquidity crunch, brought on by model-driven selling, followed by the panic of general investors. The price at which managers were able to sell was much lower than the model"s price because they could not get out in time. To add insult to financial injury, the stock market as a whole was up 2 percent per year. If investors had simply held onto their positions during the "crash," they would have been much better off. Instead, the models sold at lows, and then repurchased as prices rose. Portfolio insurance is a form of dynamic hedging, which I call death by one thousand cuts. death by one thousand cuts.

Benjamin Graham was not a fan of market formulas or program trading: "Never buy a stock immediately after a substantial rise or sell one immediately after a substantial drop."24 At least not for the sake of it. As more people rely on formulas, they become less reliable. For one thing, At least not for the sake of it. As more people rely on formulas, they become less reliable. For one thing, conditions change conditions change. Secondly, when a formula becomes very popular, it may cause the stock market herd to "stampede."25 At the time, Warren also derided the models. If the At the time, Warren also derided the models. If the price falls price falls far enough, the model far enough, the model sells sells everything and the manager is 100 percent in cash; when prices everything and the manager is 100 percent in cash; when prices rise rise, the model tells you to buy buy. Warren loves to buy more when the price of a good value stock falls and seeks to sell, if ever, at a profit.

Instead, the mortgage meltdown was caused by Black Barts Black Barts. Black Bart is said to have robbed California stagecoaches without ever firing a shot, and the mortgage meltdown involved some bloodless robbery. The risk was fully knowable, fully discoverable in the course of competent work. The mortgage meltdown had a direct cause and effect, and the result was predictable in advance. At the outset, symptoms of financial disease were as obvious as an advanced outbreak of mad cow. If one examined the loans they looked like downer cows, stumbling and sickly. Financial professionals including Warren Buffett, Charlie Munger, John Paulson, James "Jim" B. Rogers, William "Bill" Ackman, William "Bill" Gross, Whitney Tilson, Jim Melcher, David Einhorn (head of Greenlight Capital), myself, and others had been specific in sounding the alarm both verbally and in print for many years.

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Money market funds and pension funds often rely on ratings.The SEC is proposing that mutual funds should not rely on ratings, but the SEC is missing a piece.The SEC should not allow an investment below a previously required rating. For example, if an investor relied on an AAA rating before and it did not work out, that should not mean the investor should ignore the requirement and invest in something with a lower rating, either. Rather, the investor should still be required to have an AAA rating and and should be required to understand that the value of the investment lives up to the rating. should be required to understand that the value of the investment lives up to the rating.

There is often a difference between an investor with a lot of money to manage and a sophisticated investor. For example, munic.i.p.al funds usually lack the sophistication of Goldman Sachs a.s.set management. That is why many compliance departments at investment banks ask that brokers and inst.i.tutional salespeople "know the customer." The idea is to sell complex products to investors that have the ability to understand and a.n.a.lyze the risk.

Or better yet, do as Warren does. Don"t make your investments unnecessarily complex and thoroughly understand the risk. That way, if you make a mistake, it is very unlikely it will be a big one.

In spite of this wisdom, funds in Europe and the United States-including local government-run funds-often find they do not understand the risks of complex structured financial products they own, because they rely on AAA ratings for guidance. These Main Street government investors have no choice but to cut costs, aggressively go after back taxes, and-if the problem is bad enough-raise taxes. Main Street"s list of investors that feel burned is long and growing. Main Street"s list of investors that feel burned is long and growing.

For example, the Springfield (Ma.s.sachusetts) Finance Control Board alleged that Merrill Lynch & Co. sold it AAA rated CDO products backed by subprime debt without fully disclosing the risk. State law limits Springfield"s investments to government securities and short-term liquid investments. Regarding Springfield, I told the Wall Street Journal: Wall Street Journal: "Merrill has to know its customers and sell them what"s suitable and appropriate.These CDOs are not." "Merrill has to know its customers and sell them what"s suitable and appropriate.These CDOs are not."26 Springfield was fortunate that its troubles received publicity. It seemed to own the chlorine trifluoride of CDOs. The AAA rated tranches were unstable and lethally toxic to portfolio value. The three CDOs Springfield originally purchased for $13.9 million in the summer of 2007 were valued by Merrill at around $1.2 million by January 2008. Merrill repurchased the CDOs for the full amount of $13.9 million.

Vickie Tillman, executive vice-president at Standard & Poor"s defends its AAA ratings: "of the 26,000 structured securities originally rated AAA by S&P between 1978 and 2007, fewer than 0.1 per cent [sic] subsequently defaulted."27 That may be true. It may even be true that AAA ratings on securities that were imploding did not have ratings withdrawn to remove them from the data set. But that is not the point. When it counted, when the U.S. housing markets and munic.i.p.al bond markets depended on the integrity of the ratings, the rating agencies failed. There were a lot of teeth marks in those "boxes" of CDOs backed by mortgage loans. There were a lot of teeth marks in those "boxes" of CDOs backed by mortgage loans. Smart investors avoided CDOs and ate some See"s Candies. Smart investors avoided CDOs and ate some See"s Candies.

In August 2008, a draft version of an SEC 38-page report on the rating agencies revealed that an S&P a.n.a.lyst emailed a colleague that they should not be rating a particular structured finance deal. The colleague responded that they rate every deal: "it could be structured by cows and we would rate it."28 Deal after CDO-squared deal brought to market in 2007 had AAA rated tranches downgraded below investment grade within months after the deals came to market. This is unprecedented. This is unprecedented. Deals brought in 2006 are similarly troubled as are deals brought in the last half of 2005. Dollar values involved are in the hundreds of billions. It is a travesty. Investors in AAA structured finance products are losing substantial princ.i.p.al. Some nominally, AAA bond insurers were downgraded from AAA to junk. The AAA ratings of others Slid lower. Munic.i.p.al bond markets and student loan markets are in confusion. Investment banks sold auction-rate securities with long maturities as if they were money market instruments.They told customers that the coupons reset at regular auctions at short-term intervals, and if the auctions failed to find buyers, the investment banks would step in and buy back the securities. Investors could not get their money. Investors from large corporations to condominium boards investing members" a.s.sessments held frozen a.s.sets. Yet they had been told the bonds are exactly like cash. By the fall of 2008, banks and investment banks were compelled to buy back auction rate securities from retail investors to settle claims with U.S. regulators that they improperly sold these bonds to uninformed customers. Deals brought in 2006 are similarly troubled as are deals brought in the last half of 2005. Dollar values involved are in the hundreds of billions. It is a travesty. Investors in AAA structured finance products are losing substantial princ.i.p.al. Some nominally, AAA bond insurers were downgraded from AAA to junk. The AAA ratings of others Slid lower. Munic.i.p.al bond markets and student loan markets are in confusion. Investment banks sold auction-rate securities with long maturities as if they were money market instruments.They told customers that the coupons reset at regular auctions at short-term intervals, and if the auctions failed to find buyers, the investment banks would step in and buy back the securities. Investors could not get their money. Investors from large corporations to condominium boards investing members" a.s.sessments held frozen a.s.sets. Yet they had been told the bonds are exactly like cash. By the fall of 2008, banks and investment banks were compelled to buy back auction rate securities from retail investors to settle claims with U.S. regulators that they improperly sold these bonds to uninformed customers. 29 2930 Larger investors are forced to settle their own disputes. Larger investors are forced to settle their own disputes.31 [image]

In the face of its contribution to enabling a cycle of shoddy home loans resulting in ma.s.sive foreclosures, declining housing prices, deteriorating ratings of bond insurers, and lack of liquidity due to shaken confidence in the markets, Standard & Poor"s demonstrates a curious combination of arrogance and truthiness.

The markets have nothing to replace the rating agencies other than individual initiative. Rating agencies are currently protected by government regulation, barriers to entry, inst.i.tutionalized investor reliance, and the profit margin of approximately 40 percent that they make on their traditional business of rating corporate credits. As maddening as the recent actions of the rating agencies might seem, they are like a fellow who knowingly sells a horse to an investment banker named Black Bart. Without investors" money funneled through investment banks to predatory mortgage lenders, the problems would have died an early death. It is very convenient for investment banks that Congress and the SEC are focused on the rating agencies, because investment banks-not the rating agencies-are the securities dealers obliged to perform due diligence appropriate to the circ.u.mstances.

The rating agency business will probably pull in steady business in the future because the market has nothing to replace them. That does not mean, however, that the market is satisfied with the cartel"s performance. Warren Buffett avoids interfering with the management of the companies with which he invests but he made an unprecedented statement during his European excursion to find new investments. In May 2008, he said if Moody"s management did something wrong, "they should go."32 Weeks earlier, Warren told me he is "not proud" of Moody"s. One could say the same for Standard & Poor"s and Fitch. Misleading ratings contributed to the global market meltdown, because many financial inst.i.tutions used "high" ratings as a sign of "safety" to justify their use of excessive leverage. Weeks earlier, Warren told me he is "not proud" of Moody"s. One could say the same for Standard & Poor"s and Fitch. Misleading ratings contributed to the global market meltdown, because many financial inst.i.tutions used "high" ratings as a sign of "safety" to justify their use of excessive leverage.

Chapter 8.

Bear Market (I"d Like a Review of the Bidding) It"s easy to put on leverage, but not as easy to take it off.

-Warren Buffett (Wall Street Journal, April 30, 2007)

In 2007, both Warren and I thought many hedge funds were overleveraged. If the book value of Berkshire Hathaway stock falls 5 percent, investors have "lost" 5 percent for the moment, but Berkshire Hathaway"s strong earning power (from subsidiaries and investments) will likely cause the price to rise satisfactorily again in the future. Berkshire Hathaway has value and its value is growing.A leveraged hedge fund that invests in collateralized debt obligations collateralized debt obligations (CDOs) can only rely on those CDOs for "earnings." If the CDOs deteriorate due to, say, defaults on the loans backing them, there is (CDOs) can only rely on those CDOs for "earnings." If the CDOs deteriorate due to, say, defaults on the loans backing them, there is permanent value destruction. permanent value destruction. There is no bouncing back from that. Furthermore, leverage magnifies the losses for investors. Bear Stearns a.s.set Management managed two hedge funds that provided cla.s.sic examples. There is no bouncing back from that. Furthermore, leverage magnifies the losses for investors. Bear Stearns a.s.set Management managed two hedge funds that provided cla.s.sic examples.

On January 30, 2007, Jim Melcher of Balestra Capital (a $100 million hedge fund) and I appeared on CNBC to discuss hidden price deterioration in subprime CDOs. Diana Olick, CNBC"s Washington-based real estate correspondent taped the segment. Olick may be the best reporter on any channel on this topic; she closely followed developments before the mortgage meltdown was big news. She reported that housing prices were softening and had risen only 1 percent the previous year for existing homes against the double-digit increases of the prior few years. Subprime mortgage loans had reached around $1.3 trillion in outstanding loans of the total $11 trillion (at the time) U.S. mortgage market. The foreclosure rate was already 13 percent (in the years before the 2005 risky loan explosion delinquency rates were in the low to mid-single digits) and climbing fast and steeply for more recent (2006) vintages.

Based on my projections, foreclosure rates for subprime loans made in 2006 could reach 30 percent and recovery rates would probably be only around 30 cents on the dollar. This was based on my experience during other times of severe mortgage loan stress combined with poor underwriting standards. This meant that recent subprime loan securitizations were in trouble. Most investment-grade-rated residential mortgage-backed securities were in serious trouble at the lower levels, and the AAA tranches did not have enough protection to merit that rating. CDOs compounded the problem and CDO-squared products amplified it further. For those deals, even the AAA tranches had significant risk of substantial losses.

I told Olick that investors who bought non-Fannie Mae and non-Freddie Mac securitizations should be very worried. Deals were overrated and overpriced, and prices would plummet. Jim Melcher was short the ABX index, the ABX HE 2 06 BBB- series, to profit on overrated and overpriced subprime-backed CDOs. He had tripled his money the prior two months and was one of the few hedge fund managers willing to publicly discuss the trade. He hung on antic.i.p.ating further profits. I explained to CNBC that one didn"t even need to own the securitizations, you could have a gain "if the price in someone else"s someone else"s portfolio takes a hit." portfolio takes a hit."1 Ralph Cioffi, a senior managing director of Bear Stearns a.s.set Management and a former colleague, had seen the segment and gave me unsolicited feedback."You sounded good," he said,"and you looked mahvelous as Billy Crystal used to say."When his leveraged hedge funds failed a few months later, I wondered if he had listened to the content.

In early February 2007, the shares of aggressive subprime mortgage lender, New Century Financial Corp., then the second largest subprime in the United States, plummeted after it alerted that it was short of cash. London-based HSBC Holdings Plc, the largest bank by market value in Europe, unexpectedly reported that it had $1.8 billion of losses due to subprime lending.2 Bear Stearns" fixed income research gave the horrific news a positive spin indicating that the worst might be over and recommended customers go long long-the opposite of Jim Melcher"s short short money-making position. money-making position.3 ResMae Mortgage Corporation went bankrupt on February 13, 2008, the day after Bear Stearns Fixed Income Research issued its report. ResMae was selling a.s.sets for mere pennies on the dollar. ResMae Mortgage Corporation went bankrupt on February 13, 2008, the day after Bear Stearns Fixed Income Research issued its report. ResMae was selling a.s.sets for mere pennies on the dollar.4 By the end of February 2007, New Century was trading at around $15 per share, after its share price fell around 50 percent during the prior three weeks. Rumors circulated that the lender was in its death throes. Perhaps Bear Stearns didn"t get the memo, even though it had a "longstanding"5 relationship financing New Century"s mortgage operation. On March 1, 2007, Scott R. Coren, a Bear Stearns stock a.n.a.lyst, relationship financing New Century"s mortgage operation. On March 1, 2007, Scott R. Coren, a Bear Stearns stock a.n.a.lyst, upgraded upgraded New Century, saying that $10 per share would be the downside risk, if New Century needed rescuing. About a week later, New Century announced it had probably been unprofitable during the last six months of 2006 and needed to restate its earnings. Lenders yanked their credit lines. In April 2007, New Century filed for bankruptcy, joining more than 100 failed mortgage lenders. Countrywide, the nation"s largest mortgage lender, also showed signs of strain. New Century, saying that $10 per share would be the downside risk, if New Century needed rescuing. About a week later, New Century announced it had probably been unprofitable during the last six months of 2006 and needed to restate its earnings. Lenders yanked their credit lines. In April 2007, New Century filed for bankruptcy, joining more than 100 failed mortgage lenders. Countrywide, the nation"s largest mortgage lender, also showed signs of strain.

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Hidden leverage threatened the global markets. Many hedge funds used CDOs" artificially high ratings as an excuse to leverage their "safe highly rated" investments. It is an extremely risky proposition. Debt purchased near full price has little or no price upside, but there is a lot of room for the price to go down when things go wrong. Combine that with leverage, and you have a very risky strategy. Debt purchased near full price has little or no price upside, but there is a lot of room for the price to go down when things go wrong. Combine that with leverage, and you have a very risky strategy.

What if prices drop because everyone finds out that the a.s.sets are overrated? What if prices drop because of defaults by overextended homeowners, defaults due to a collapse in housing prices, or permanent value destruction due to fraud? There is no other income to give you upside potential, and a leveraged position has no hope of springing back. If a fund does not have gobs of liquidity in reserve, investor capital is quickly wiped out. Investors take a stomach-churning toboggan ride straight down risk"s icy slope. Creditors that lent the fund money to buy a.s.sets are lucky if they do not lose money, too.

Most of us use high degrees of leverage when we buy a home. A homeowner might buy a $1 million dollar home and mortgage $900,000 of the purchase. If the price drops to $950,000, the "homeowner" loses $50,000 of his initial equity of $50,000, or 50 percent of his equity. If the price drops to $900,000, the "homeowner" loses all of his initial investment. If a bank forecloses on the $900,000 mortgage, it does not even break even after fees. If the price drops below $900,000, the bank"s cushion of the first loss taken by the "homeowner"s" $100,000 is gone, and the bank, the creditor, will not get the full amount of the loan paid back. Some of the mortgage loans made in 2006 and 2007 had zero money down, were made against aggressively appraised homes, and defaulted almost immediately. The investors in the hedge funds are like the homeowners that make a down payment (the investor had equity in the hedge fund), and investment banks (that give the lines of credit to hedge funds) are like the bank that gives out the mortgage. If a.s.set prices drop and wipe out investors" equity, the investment bank is next in line to take losses on its credit lines.

Many hedge funds use total return swaps, total return swaps, a type of credit derivative, in order to borrow money and leverage up their investments.Warren saw the negative consequences of this strategy first-hand with Long-Term Capital Management.Total return swaps easily thwart the intent of margin requirements, they create much more leverage, and it is virtually invisible. At the end of April 2007,Warren told Susan Pulliam at the a type of credit derivative, in order to borrow money and leverage up their investments.Warren saw the negative consequences of this strategy first-hand with Long-Term Capital Management.Total return swaps easily thwart the intent of margin requirements, they create much more leverage, and it is virtually invisible. At the end of April 2007,Warren told Susan Pulliam at the Wall Street Journal Wall Street Journal that the global financial system is so leveraged that it makes the leverage used before the Crash of 1929 "look like a Sunday-school picnic." that the global financial system is so leveraged that it makes the leverage used before the Crash of 1929 "look like a Sunday-school picnic."6 I told her that if cash-strapped funds are forced to sell a.s.sets in a market downturn it "could lead to a vicious cycle of selling that would feed on itself." I told her that if cash-strapped funds are forced to sell a.s.sets in a market downturn it "could lead to a vicious cycle of selling that would feed on itself."7 The collateral the hedge funds put up to back their borrowings is often illiquid and difficult to trade, and prime brokers such as Credit Suisse and JPMorgan do not disclose the amount of total-return swaps that they have made to hedge funds on their books.The strategy is very risky since the a.s.sets a hedge fund "buys" may come back on the balance sheet of the bank (the lender) if the fund implodes. For example, if a hedge fund uses 15 times leverage, and a.s.set prices irreversibly drop just a tiny amount, investors lose some princ.i.p.al. If prices irreversibly drop just seven percent or more, investor capital is wiped out, and creditors have no choice but to seize the a.s.sets, some of which were sold by the investment banks in the first place.

Regulators fed the folly.Within days of Warren"s warning, the New York Fed claimed that despite market similarities to the risk levels at the time just before LTCM blew up, there were different causes then, so the existing market environment now was less alarming.8 England"s Financial Services Authority (FSA) piled on pablum. The FSA released results from a partial survey of hedge funds and thought that "average" leverage had declined. England"s Financial Services Authority (FSA) piled on pablum. The FSA released results from a partial survey of hedge funds and thought that "average" leverage had declined.9 Dr. Sam Savage coined the term "flaw of averages." He a.s.serts that using an average number to forecast an outcome can lead to huge errors. For example, if a swimming pool"s average depth is four feet, but the deep end of the pool is eight feet, a nonswimmer is presented with lethal risk. A drowning man learns the hard way that the "average depth" mischaracterizes the peril. The average leverage number might suggest that hedge funds on balance are safer, but if an individual hedge fund employs a high degree of leverage, the average for all hedge funds is meaningless. Furthermore, hedge funds had ma.s.sive hidden risks-inherently risky overrated a.s.sets. On May 7, 2007, I wrote the Financial Times Financial Times that the regulators were dead wrong.The current situation was not less alarming that that presented by LTCM, it was that the regulators were dead wrong.The current situation was not less alarming that that presented by LTCM, it was more more alarming. Hidden leverage does not show up by polling prime brokers. Hedge funds, structured investment vehicles, and other investors use structured products combined with derivatives and leverage, "illiquid structured products will experience a cla.s.sic collateral crash when hedge funds try to liquidate these a.s.sets to meet margin calls." alarming. Hidden leverage does not show up by polling prime brokers. Hedge funds, structured investment vehicles, and other investors use structured products combined with derivatives and leverage, "illiquid structured products will experience a cla.s.sic collateral crash when hedge funds try to liquidate these a.s.sets to meet margin calls."10 A few weeks later, Bear Stearns a.s.set Management proved my point.

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In May 2007, Ralph Cioffi was the senior managing director of Bear Stearns a.s.set Management (BSAM), a subsidiary of Bear Stearns, and cochief executive officer of Everquest Financial Ltd., a private financial services company. He reported to Richard Marin, the chairman and chief executive officer of BSAM. Warren Spector, cochief operating officer of Bear Stearns and a former trader of exotic mortgage products, was the key sponsor of Bear Stearns" foray into hedge funds. Bear Stearns a.s.set Management managed several CDOs and it also managed several hedge funds. Before the summer of 2007 ended, my former colleagues Ralph Cioffi and Warren Spector (along with Richard Marin) lost their positions due to CDO investments combined with leverage in hedge funds managed by BSAM.

I had worked at Bear Stearns in the late 1980s and remembered amiable newcomer Ralph Cioffi to be Bear Stearns" most talented and successful salesman of mortgage-backed securities. He was usually even tempered, always hard working, and thoughtful. I headed marketing for the quant.i.tative group run by both Stanley Diller, one of the original Wall Street "quants," and Ed Rappa (now CEO of R.W. Pressprich & Co, Inc.), a managing partner. Ralph was a popular salesman with my colleagues and a heavy user of our quant.i.tative research. In grat.i.tude for a.n.a.lytical work that helped him make sales, Ralph presented our group with an $800 portable bond calculator purchased out of his own pocket. When I was lured away from Bear Stearns by Goldman Sachs, Ralph Cioffi tried to persuade me to stay, matching the offer. Around 20 years had pa.s.sed and since then we occasionally stayed in touch, but we were not close friends.

I knew Warren Spector, too. He had been a talented trader of exotic mortgage products, which at the time meant collateralized mortgage obligations including the volatile interest-only and princ.i.p.al-only slices of those deals. He had come a long way from the somewhat awkward young man who spilled red wine all over a white linen tablecloth at one of our client dinners. Before CDOs undid his career, he was a Bear Stearns favored son with a good shot at taking over Jimmy Cayne"s position as CEO.

We did not correspond. However, a couple of years previously I shared my concerns with Spector about a call I received from a fund representative. He claimed that Bear Stearns had agreed to underwrite his firm"s securitization backed by life insurance policies. The macabre idea was that when policyholders died, investors got the money from the life insurance policies net of expenses and fees-very heavy fees. Doc.u.ments posted on the SEC"s Web site showed that if the holders of the life insurance policies did not die before additional money was needed to pay ongoing policy premiums, investors would be asked for more money. Investors could lose more than their initial investment if policyholders inconvenienced them by living a long life. I had done a quick background check on the fund representative. The SEC was conducting an investigation and alleged that the fund representative"s former employer was a Ponzi scheme. My concerns were bad news to Warren Spector as well. He checked into it and I missed his return call, so he left me a voice message: "There are lots of people peddling this idea and it"s extremely unlikely that we will do anything with any of them, so I appreciate knowing who"s dropping our name."

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The last time I spoke to Warren Spector, we discussed the hedging of synthetic CDOs that were constructed using credit derivatives. Bear Stearns" proprietary trading desk had large derivatives positions with a number of investment banks. After JPMorgan Chase purchased Bear Stearns, the New York Fed estimated that Bear had around 750,000 derivatives contracts outstanding.11 Based on what I knew, I thought Bear Stearns had scary volume in tricky credit derivatives. Keeping track of the true risk and long-term profit is a complex task. As I discussed with Warren Spector, any manager would have difficulty determining whether traders were actually making money (or losing money) relative to a risk-neutral fully hedged position. One could temporarily create huge revenues, but enormous risk could soon turn revenues into losses. In contrast, Warren Buffett worked hard to Based on what I knew, I thought Bear Stearns had scary volume in tricky credit derivatives. Keeping track of the true risk and long-term profit is a complex task. As I discussed with Warren Spector, any manager would have difficulty determining whether traders were actually making money (or losing money) relative to a risk-neutral fully hedged position. One could temporarily create huge revenues, but enormous risk could soon turn revenues into losses. In contrast, Warren Buffett worked hard to reduce reduce the number and complexity of derivatives contracts owned by Berkshire Hathaway. Warren Buffett told me that after years of whittling down Gen Re"s derivatives positions, he knows (and understands) every derivative contract owned by Berkshire Hathaway. the number and complexity of derivatives contracts owned by Berkshire Hathaway. Warren Buffett told me that after years of whittling down Gen Re"s derivatives positions, he knows (and understands) every derivative contract owned by Berkshire Hathaway.

Buffett and Spector are very different Warrens. Warren Buffett used derivatives to turn junk into gold.Warren Spector oversaw at least one Bear Stearns affiliate (BSAM) that turned "high grade" into junk.

Among other hedge funds, Bear Stearns a.s.set Management (BSAM) managed the Bear Stearns High Grade Structured Credit Strategies fund. By August 2006, the fund had a couple of years of double-digit returns. BSAM launched the Bear Stearns High Grade Structured Credit Strategies Enhanced Leverage fund taking advantage of the first fund"s "success." There must be more money! There must be more money!

Both funds managed by BSAM included CDO and CDO-squared tranches backed in part by subprime loans and other securitizations (collateralized loan obligations) backed by corporate loans and leveraged corporate loans. In August 2006 when BSAM was setting up the Enhanced Leverage fund, other hedge fund managers (like John Paulson), shorted shorted subprime-backed investments. subprime-backed investments.

Investors in the two funds managed by BSAM had been getting double-digit annualized returns on high-grade debt at a time when treasuries were yielding less than 5 percent. In fixed income investments, that usually means investors are taking risk.

Ralph seemed to have similar views to mine on CPDOs, the leveraged product that I had said did not deserve a AAA rating. Ralph told me he thought the AAA rating could "lull the unsophisticated investor to sleep," and that for the purposes of his hedge funds, if he liked an investment-grade-rated trade he could have the same trade without paying fees and "easily lever up . . . fifteen times." To paraphrase Warren Buffett, if the price of your investments drops, leverage will compound your misery. To paraphrase Warren Buffett, if the price of your investments drops, leverage will compound your misery.

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On May 9, 2007, Matt Goldstein called and asked me if I had a chance to look at the registration statement for a new initial public stock offering (IPO) called Everquest Financial, Ltd (Everquest). Everquest is a private company formed in September 2006, and the registration statement was a required filing in preparation for its going public.The shares were held by private equity investors, but the IPO would make shares available to the general public.12 Everquest was jointly managed by Bear Stearns a.s.set Management Inc, and Stone Tower Debt Advisors LLC, an affiliate of Stone Tower Capital LLC. I was curious, but I was swamped. I told him no, I was very busy and had not even had a chance to glance at it. He called again asking if I had seen it, and again I said no, "Go away." Then Jody Shenn of Bloomberg Bloomberg left a voice message about Everquest, but I was still busy. The next morning I ignored Matt"s voice mails, but finally took his call the afternoon of Thursday, May 10, telling him that I still had not looked at the registration statement and had no plans to do so that day. My first call on the morning of Friday, May 11, 2007, was again from Matt Goldstein. He thought the IPO might be important. left a voice message about Everquest, but I was still busy. The next morning I ignored Matt"s voice mails, but finally took his call the afternoon of Thursday, May 10, telling him that I still had not looked at the registration statement and had no plans to do so that day. My first call on the morning of Friday, May 11, 2007, was again from Matt Goldstein. He thought the IPO might be important.

I went to the SEC"s Web site, and as I scanned the doc.u.ment I thought to myself: Has Bear Stearns a.s.set Management completely lost its mind? Has Bear Stearns a.s.set Management completely lost its mind?There is a difference between being clever and being intelligent.As I printed out the doc.u.ment to read it more thoroughly, I put aside the rest of my work and said: "Matt, you are right; this is important." I was surprised to read that funds managed by BSAM invested in the unrated first loss risk (equity) of CDOs. In my view, the underlying a.s.sets were neither suitable nor appropriate investments for the retail market. I did not have time for a thorough review, so I picked a CDO investment underwritten by Citigroup in March 200713 bearing in mind that if the Everquest IPO came to market, some of the proceeds would pay down Citigroup"s $200 million credit line. Everquest held the "first loss" risk, usually the riskiest of all of the CDO tranches (unless you do a "constellation" type deal with CDO bearing in mind that if the Everquest IPO came to market, some of the proceeds would pay down Citigroup"s $200 million credit line. Everquest held the "first loss" risk, usually the riskiest of all of the CDO tranches (unless you do a "constellation" type deal with CDO hawala hawala), and it was obvious to me that even the investors in the supposedly safe AAA tranches were in trouble. Time proved my concerns warranted, since the CDO triggered an event of default in February 2008, at which time Standard & Poor"s downgraded even the original safest AAA tranche to junk.

The equity is the investment with the most leverage, the highest nominal return, and is the most difficult to accurately price. The CDO equity investments were from CDOs underwritten by UBS, Citigroup, Merrill, and other investment banks.14 Based on what I read, Everquest"s original a.s.sets had significant exposure to subprime mortgage loans, and the doc.u.ment disclosed it, "a substantial majority of the [a.s.set-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. 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 a.s.set Management provided the a.s.sumptions for valuing the CDOs. Small changes in the a.s.sumptions could create huge differences in prices. Greg Pa.r.s.eghian, 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 Pa.r.s.eghian worked there) was its failure to use Among the many criticisms levied against Freddie Mac (due to events at the time Pa.r.s.eghian worked there) was its failure to use third-party a.s.sumptions third-party a.s.sumptions instead of concocting its own, thus exposing itself up to moral hazard. Pa.r.s.eghian"s bosses left under a cloud, and he was promoted to CEO of Freddie Mac. Pa.r.s.eghian himself stepped down after a couple of months. OFHEO-the Office of Federal Housing Enterprise Oversight-then Freddie Mac"s regulator, said that before Pa.r.s.eghian"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 Pa.r.s.eghian"s actions ill.u.s.trated Freddie Mac"s "culture of minimal disclosure." instead of concocting its own, thus exposing itself up to moral hazard. Pa.r.s.eghian"s bosses left under a cloud, and he was promoted to CEO of Freddie Mac. Pa.r.s.eghian himself stepped down after a couple of months. OFHEO-the Office of Federal Housing Enterprise Oversight-then Freddie Mac"s regulator, said that before Pa.r.s.eghian"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 Pa.r.s.eghian"s actions ill.u.s.trated 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." 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. 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 a.s.sets 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 a.s.sets appeared to include substantial subprime exposure.

Matt Goldstein posted his story on Business Week"s Business Week"s site later that day. Initially it was called: site later that day. Initially it was called: The Everquest IPO: Buyer Beware, The Everquest IPO: Buyer Beware, but after protests from Bear Stearns a.s.set Management, but after protests from Bear Stearns a.s.set Management, BusinessWeek BusinessWeek changed the t.i.tle to changed the t.i.tle to Bear Stearns" Subprime IPO. Bear Stearns" Subprime IPO.20 I hardly think that pleased Bear Stearns more. 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 a.s.sets 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 [image]

Ralph Cioffi contacted me about the BusinessWeek BusinessWeek article. He said that dozens of IPOs like Everquest had been done-mostly offsh.o.r.e 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. article. He said that dozens of IPOs like Everquest had been done-mostly offsh.o.r.e 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 a.s.surances 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 have only a minority interest, which would be a disadvantage if they had a dispute with the managers.

Ralph claimed that subprime was "actually a very small percent of Everquest"s a.s.sets." He reasoned that on a market value market value basis the exposure to subprime was actually basis the exposure to subprime was actually negative 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." 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 net exposure (left over after you protect yourself with a hedge), but one usually also discusses the exposure (left over after you protect yourself with a hedge), but one usually also discusses the gross exposure gross exposure (of the a.s.sets you originally bought). Hedges cost money, so they can reduce returns. (of the a.s.sets 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 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. (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 a.s.sumptions a.s.sumptions for pricing would be provided by a conflicted manager, and a.s.sumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management"s a.s.sumptions for pricing. for pricing would be provided by a conflicted manager, and a.s.sumptions are critical in determining value. Moreover, on an ongoing basis, one had to rely on a conflicted management"s a.s.sumptions 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 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 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 Night of the Living Dead was the least of his problems. was the least of his problems.

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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 a.s.sets 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 a.s.sets. On May 15, just days after the Business Week Business Week article appeared, Bear Stearns a.s.set 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. article appeared, Bear Stearns a.s.set 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 [image]

Bear Stearns faced other challenges. In April 2007, Bear Stearns asked the International Swaps and Derivatives a.s.sociation, Inc. (ISDA) to modify credit default swap doc.u.ments 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 the ABX index, all but accused Bear Stearns of seeking to manipulate the market. The seller of credit protection (perhaps Bear Stearns) on mortgage-backed securities, the other side of Mr. Paulson"s trade, could use its investment in residual or servicing rights on a mortgage-backed security to buy out and revive defaulted loans.The protection seller could buy a loan at par, instead of its deeply discounted price, and it would artificially prop up the prices of the trust investments and the underlying securities that made up the ABX and other indexes. Since a protection seller in a lower-rated index has a leveraged position, for a relatively small investment it would gain (or protect) tens of times what it paid out. John Paulson maintained that Bear Stearns was trying to avoid making billions of dollars in payments on credit default swaps. "We were shocked," said Michael Waldorf, a vice president at Paulson"s firm: He said Bear Stearns introduced language that "would try to give cover to market manipulation."26 In March 2008, less than one year later, many market partic.i.p.ants remembered Paulson"s concerns when In March 2008, less than one year later, many market partic.i.p.ants remembered Paulson"s concerns when Bloomberg Bloomberg revealed that a.s.sets backing the ABX indexes appeared wildly overrated and credit default protection sellers (perhaps Bear Stearns?) would possibly have to come up with more collateral to back these trades. revealed that a.s.sets b

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