Inquiring minds are listening to a video of Janet Tavakoli on Fox news commenting on the acquittal of Ralph Cioffi and Matthew Tannin, former co-heads of Bear Stearns Asset Management on six counts of fraud.

Tavakoli said the prosecutors “relied on the wrong venue, the wrong issues, and the wrong evidence. So it’s no surprise that they lost a case like that. But there will be another trial, the civil trial.

Here is an excerpt from Dear Mr. Buffet by permission from John Wiley & Sons regarding her conversation with Ralph Cioffi in May 2007.

On May 9, 2007, Matt Goldstein [a writer on BusinessWeek] 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.

Everquest was jointly managed by Bear Stearns Asset Management Inc [BSAM], 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.” 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 website, and as I scanned the document I thought to myself: Has Bear Stearns Asset Management completely lost its mind? There is a difference between being clever and being intelligent.

As I printed out the document 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 assets 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 2007 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), 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.

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.” Based on my rough estimates, it was as high as 40 percent to 50 percent.

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, Business Week changed the title to Bear Stearns’ Subprime IPO. I hardly think that pleased Bear Stearns more.

Ralph Cioffi contacted me about the Business Week 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 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 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.”

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.

An Old Friend Revisited

I have written about the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund on many occasions. Please consider this flashback from A Bear’s Bath written June 13, 2007.

Hit by the subprime market’s collapse, investors in a highly leveraged—and losing—hedge fund find they can’t get out. Investors in a 10-month-old Bear Stearns (BSC) hedge fund are learning the hard way the danger of investing in risky bonds with borrowed money. The investment firm’s High-Grade Structured Credit Strategies Enhanced Leverage Fund, as of Apr. 30, was down a whopping 23% for the year.

The situation is so bleak that Bear Stearns’ asset management group is suspending redemptions at the onetime $642 million fund—meaning investors have no choice but to sit on their losses. And that’s got some hopping mad.

An investor in Europe, who didn’t want to be identified, says he’s been trying to get his money out of the hedge fund since February.

I Have Questions

  • Why was someone locked in all the way back in February?
  • How many others were prevented from selling that far back?
  • So what did the Bear Stearns really know and when did they know it?
  • Does any of this have anything to do with the planned subprime IPO of Everquest Financial?
  • Did Bear hope to hide the losses until the IPO? Are losses now just too big to hide?
  • In June, just what was it that made Bear Stearns realize that the April losses were not really 6.5% but a whopping 18.97%?
  • What about May? What about June? The treasury and housing markets have not exactly been robust these last two months.
  • What does this all say about the moral hazards of Bear providing the assumptions for valuing the CDO equity on the sale to Everquest and to hedge funds and pension plans?
  • What about that sales pitch “Everquest will provide attractive risk-adjusted returns” to shareholders? Attractive? Really? Risk-Adjusted? Who is determining risk?
  • Why is Bear Stearns not answering questions?
  • Bear Stearns is suspending redemptions because the “investment manager believes the company will not have sufficient liquid assets to pay investors.” Is time supposed to heal this? How?
  • How long will it be before this whole leveraged CDO mess blows sky high?
  • Who will be the scapegoat?

For More Bear Stearns Flashbacks Please Consider

July 05, 2007: The Redemption Trap & Merrill Lynch Cover-Up

Marked Down

No takers at 11 cents on the dollar should put a new perspective on the meaning of marked to market. The best bid was 30 cents on the dollar for assets held by the High-Grade Structured Credit Strategies Fund and a mere 5 cents on the dollar for the High-Grade Structured Credit Strategies Enhanced Leveraged Fund.

Wow. 5 cents on the dollar. That’s quite an enhancement for something supposed to be High-Grade. Given that redemptions are suspended there is no escape for many investors caught in the jaws of this Bear Stearns Trap.

See Who’s Holding The Bag? for comments from Buffett about derivatives, but my favorite has to be “the derivatives business is like hell easy to enter and almost impossible to exit”.

July 17, 2007: All Mortgage Tranches Take a Hit

You have to pity the investors that were locked in all the way back in February. A history of the Bear Stearns saga can be found in Bear Tracks & CDOs and A Bear’s Bath. Essentially Bear Stearns bet the farm (or rather its investor’s farms) by making extremely risky leveraged bets with customers’ money then locking them in. Had investors been able to bail in February they might have gotten 70% on the dollar. It’s hard to say. What is not hard to say is they would have gotten considerably more than zero cents on the dollar.

July 19, 2007: The Alt-A Word

Has contagion now spread to Alt-A? That’s what Kevin Depew on Minyanville was talking about in points 1 and 2 of Wednesday’s “Five Things“. Let’s take a look.
1. Worthless!

Bear Stearns (BSC) yesterday afternoon told investors in two troubled hedge funds it manages that one fund was worthless and the other had only about nine cents remaining for every dollar invested following bad bets on the US subprime mortgage market.

  • How fast can something like this happen?
  • Snap your fingers. The two Bear Stearns hedge funds, worth an estimated $1.5 billion at the end of last year, were reporting stellar returns even as recently as this spring.
  • Now, the net value of assets in in the High-Grade Structured Credit Strategies Enhanced Leverage Fund are zero, according to the Wall Street Journal.
  • And the net value of assets in its other, larger, less-leveraged fund lost about 91%.
  • The net-asset value represents the value of an investor’s holdings after debts have been paid.
  • Meanwhile, Bear Stearns, which last month said it would offer a $1.6 billion loan to shore up the more “conservative” of the two funds and help it sell its assets, nonchalantly reported yesterday that about $1.4 billion of the loan remains untapped, the New York Times said.
  • So, in other words, it appears Bear Sterns was able to either sell or take down internally all the holdings of the funds at a level that wipes out customers, but leaves the firm fairly well covered. Sweet!

July 20, 2007: Implications of Basis Capital Fund Missing Margin Calls

Creditors having learned a lesson watching the Bear Stearns hedge fund go to zero and may start acting quicker. The implication to those in leveraged hedge funds should be obvious: Get out ahead of trouble while you can (if you can). If you wait until you need to get out, it is simply too late. More and more hedge funds and pension plans are going to be finding out “It’s Already Too Late”.

Criminals and Scapegoats

On June 13, 2007 I asked “Who will be the scapegoat?”

So far the answer is no one. Clearly there are no criminals and no scapegoats either. Everyone is innocent.

Mike “Mish” Shedlock
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