House of Cards (5 page)

Logic suggested that major hedge funds who used Bear Stearns as a prime broker, keeping billions of dollars of their investors' money with the firm and clearing their trades through it, could have been buying the puts, for the simple reason that a bet that Bear's stock would fall rapidly was perhaps the only way these funds could actually hedge their exposure to the firm aside from taking out their cash balances (as many were doing). If there really was a problem at Bear Stearns and the firm was vulnerable to the proverbial run on the bank, putting access to their accounts at risk, then the only logical way to protect against this terrible outcome would be to bet against the firm in a major way. So if the money in the accounts was blocked by a disaster at the firm, at least the hedge fund would make a ton of money in the interim by betting the firm would fail. This thinking was perfectly logical, and not without a recent precedent in the form of the 2005 failure and liquidation of Refco, a broker of commodities and futures contracts. When Refco filed for bankruptcy protection, hedge funds that were Refco customers could not get immediate access to their money. The memory of Refco was still fresh in the minds of many hedge funds, and they were in no mood to get caught in that situation again. Any inkling of trouble at Bear Stearns led them to consider seriously taking their money out of the firm first and asking questions later.

The calls from the Office of the Comptroller of the Currency provided the perfect cover to perform this delicate hedging operation. “On
Monday, before the Thursday run, one of the heads of a small bank told me that he got a call, his CEO or president got a call, from the regulators, asking what their exposure was to Bear Stearns,” explained an incredulous Bear Stearns banker. “Not ‘What's your exposure to Bear, JPMorgan, Morgan Stanley, Lehman, UBS?' Just ‘What's your exposure to Bear?' He said his president walked into his office and said to him, ‘Hey, I just got this call. We've never gotten a call like this before.’”

The bank—Emigrant Savings—that received this call from the regulator was not a large bank. “They must have gone down the list,” this Bear Stearns banker recalled. “If they'd got to this guy, they'd called everybody else. The rumors were there, but now you're getting, ‘Well, look, the regulators called me.' What kind of a rumor is that? That's a self-fulfilling rumor. He said to me, ‘What did you think I was going to do? I got out of everything.’” Around this very moment, the Bear banker happened to be on the phone with a senior person at one of Bear Stearns's investment banking competitors and mentioned the conversation about the phone call from the regulator. During that second conversation, the Bear banker reported, the competitor said, “‘We got the same call, and they basically said to us, “Don't tell your traders and don't get out of any counterparty agreements that you have. But what's your exposure to Bear Stearns?’” He says, ‘What do you think I'm going to do? Of course I told my traders. I bought puts, sold short, and got out of everything I could possibly could get out of.' I was so blown away when the second guy told me about getting a call. This guy [is] just an incredibly well-respected risk manager on the Street, [so] I knew that this wasn't made up. Now the rumors were even there, okay. But imagine you're getting calls. I mean, what fucking institution with any sense in their head calls up and asks what's your exposure to one thing and then says ‘Oh, but don't do anything about it'?”

The outbreak of these significant rumors led to the huge increase in the purchase of the Bear puts—and also in their price. It also was not surprising that the cost of insuring Bear's obligations skyrocketed on March 10 to around $700,000 to protect against $10 million of debt for five years, an increase of fourteen times over the previous week and yet another sure sign that the vultures were circling with increased velocity. Rival firms were starting to prey on Bear Stearns with increasing intensity. “On Monday, we started hearing a lot of rumors,” explained one Bear senior managing director, “that Joe Lewis”—Bear's second-largest shareholder, who had invested more than $1 billion in the stock of the firm in the previous six months—“was starting to get margin calls, which were not true, to guys who aren't taking the other side of trades. And I think
it was Monday when our credit default swaps spreads started to really, really spike. I think a lot of people attributed that to the rumors around Goldman. Goldman was not willing to stand on the other side of the trade. Goldman [was] saying that we had DK'd”—essentially failed to make good—“on a trade, which was—the rumor might have been a real rumor, but the fact that we DK'd on a trade was not true. And so that clearly started, at least in my mind, what happened so quickly that week. It became very apparent—not what was going to happen, but what was happening as our credit default swaps started to just gap out huge. We couldn't do anything anymore. We couldn't do business. It was too expensive. We were completely paralyzed.”

Some senior executives inside the firm were pushing Sam Molinaro, the CFO, to release Bear's first-quarter earnings early. Molinaro, from Binghamton, New York, joined Bear Stearns in 1986 after six years at Price Waterhouse in Syracuse. He was the first significant hire into the firm's accounting department after the company went public. He rose through the ranks, becoming CFO ten years later and adding the chief operating officer title in August 2007. The firm had been profitable in the first quarter of 2008, even after the new marks forced by the Peloton liquidation, and the argument went that this news could calm the jittery throngs. “There was a lot of begging: ‘Can we release earnings early? Can we do something?’” remembered Paul Friedman. “Those of us who were doing conference calls with lenders and with customers were totally hamstrung. You couldn't talk about earnings. Theoretically, you weren't even supposed to talk about balance sheet or liquidity or risk or anything else until the earnings call. You'd have lenders and customers wanting to know what's going on and you'd go, ‘It's okay. Trust me.' I got in the mode [where] I would say to them, ‘Listen, we're in a blackout period. I can't talk about earnings, but let me preface this by saying we're trying to move up the date at which we announce earnings. I'll let you draw your own conclusions as to why somebody would do that.' That was the best I could do. So we danced. We all did it differently, but there were a bunch of us doing it. We gave a general picture of how our liquidity worked, how our funding worked, why we had this $18 billion funding reserve, and nobody needed to worry about a run on the bank or running out of cash. We would describe it as, ‘Here's where we were at the last quarter. I don't expect this quarter to be materially different.' You'd have to sort of dance around it. They wanted to hear about liquidity and they wanted to hear about earnings, and you really couldn't talk about either one.”

Meanwhile, Schwartz remained in Palm Beach. He discovered quickly that the 2008 media conference would not be all fun and games.
While he and Robert Iger, the Disney CEO, were preparing for Schwartz's late-afternoon interview of Iger, Schwartz was interrupted repeatedly by calls from the office in New York seeking guidance about how to respond to the growing list of rumors about the firm's liquidity. He felt he could not betray any concern in front of his powerful and important clients. Schwartz kept his cool and continued the preparation for the Iger interview.

That evening, Schwartz announced that the guests at the media conference could demo Rock Band—a full-blown band simulation game that combines guitar, bass, drum, and singing—“compliments of Viacom,” and enjoy cocktails and hors d'oeuvres “compliments of Martha Stewart.”

T
HE NEXT MORNING
, ING Group NV, another large Dutch bank, followed Rabobank's lead and pulled its $500 million in short-term financing for Bear Stearns. ING professionals told Bear that the bank's management “wanted to keep their distance until the dust settled.” Also, before the market opened Tuesday morning, the Federal Reserve did something that it had not done since the Great Depression. Through a new Term Securities Lending Facility, the Fed agreed to make $200 billion in Treasury securities available, starting March 27, to securities firms for a period of twenty-eight days, to be secured by pledges of other securities, including federal agency debt, residential mortgage-backed securities issued by federal agencies such as Fannie Mae or Freddie Mac, or highly rated non-federal-agency residential mortgage-backed securities. Previously, the Fed had made Treasury securities available to securities firms only on an overnight basis. Now the additional liquidity would be available through auctions for nearly a month and was designed to supplement the cash the Fed had made available the previous Friday. The new program was “intended to promote liquidity in the financing markets for Treasury and other collateral and thus to foster the functioning of financial markets more generally,” the Fed explained. In other words, the Fed was offering to swap Wall Street's toxic mortgage securities for easy-to-value Treasury securities that could be used as safe collateral.

While the import of the Fed's decision was substantial and Wall Street was initially elated, its near-term effect on the liquidity of Bear Stearns or Lehman Brothers was nearly meaningless, since the funds were not going to be made available until March 27 at the earliest. Indeed, the Fed had been discussing the creation of the new facility with Wall Street for months before it became a reality and very much would have liked to have made it available earlier than March 27. But it was such a radical departure for the central bank that the logistics required to implement the new system took time to coordinate. So while the intent was to permit
securities firms to swap some of their illiquid mortgage securities for highly liquid Treasury securities, the real effect was to further spook the market into wondering why the Fed would take such a radical step.

Some observers saw the Fed's decision positively. Certainly the market took a liking to the Fed's decision, as the Dow rose 417 points on the news. This was “a Fed-induced rally,” CNBC's Jim Cramer explained that night. “It's a coiled-spring rally.” He believed the market would likely go higher for the rest of the week, and called the jump “a respite from the gloom.” Even Christopher Cox, the commissioner of the Securities and Exchange Commission—the regulator of securities firms such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—added his imprimatur to the adequacy of Bear Stearns's capital, which he said was monitored on a “constant” basis, especially during the credit crisis. Asked March 11 by reporters about the firm's financial condition, he said: “We have a good deal of comfort about the capital cushions at these firms at the moment.”

Others were far more pessimistic about the Fed's move. “I don't see how this helps,” commented “DK” on the
Wall Street Journal
's “Real Time Economics” blog. “It will temporarily allow these banks to use crappy [mortgage-backed securities] as temporary collateral, but eventually these will have to be written down. I think this is just an attempt to cause markets to go down gradually, versus a huge crash.” And then “Clear Skys Ahead” wrote with an acid pen, “Now that the Fed is lending to primary dealers and accepting unimpeachable items, such as mortgage debt, as collateral things can get back to normal. Now what exactly do we do when the collateral turns out to be worth less than the loan? Thank goodness everyone woke up and realized that unless the taxpayers were the ones ultimately stuck with the bill, Wall Street couldn't rally! Let the party resume at least until sanity takes hold.”

Richard X. Bove, a research analyst at Punk Ziegel (now part of Ladenburg Thalmann), told his clients that he thought the Fed's historic move “may have been strongly influenced by Bear Stearns' problem.” (The president of the New York Fed, Tim Geithner, denied that the Fed's move had been motivated by the problems at Bear Stearns. “This was designed to cool the fever a little bit, to give people a little more confidence that they could finance stuff with us,” he explained. “But it was more for the market as a whole than it was going to be about an individual institution.”) Bove also wrote that Bear's business model was “broken” because it had relied too heavily in recent years on the origination and sale of mortgage-backed securities. Now that the market for those products had closed, Bear Stearns had not figured out a way to replace the
lost revenue. “Bear did not get out of the way fast enough,” he wrote. “Consequently, its balance sheet, its business operations, and its reputation were all hurt badly. One key result of this is that the firm's borrowing costs rose sharply according to reports.” The sale of the company was likely the only solution, Bove asserted.

The ever-provocative CNBC picked up on Bove's report on Tuesday around midday and stirred up a frenzy of negative implications. On-air Wall Street reporter Charlie Gasparino explained that “the market was saying” that Bove's claim about the Fed's action was correct, although he was quick to point out that he had not confirmed independently what the analyst had written. “This is trader talk we are engaging in here,” he said. Bob Pisani, the network's reporter in the Chicago trading pits, cautioned that he heard rumors all the time and discarded most of them. But not this time. “Here your radar is really high,” Pisani said, “because volume is titanic in the last couple of days and the trading range is titanic and more importantly the options trading is titanic. There is huge put volume in the $30 range for this stock, and that's telling you that people are making some bets here that something may be wrong.” He made no mention of the fact that buying the puts may have been a perfectly logical hedge against a run on the bank at Bear Stearns. Nor did he mention—he probably was not aware—that someone (who is still unknown to this day) had just made a $1.7 million bet that Bear Stearns stock would fall dramatically within nine days, first by buying 57,000 puts at $30 and then by buying 1,649 puts at $25. “Even if I were the most bearish man on earth, I can't imagine buying puts 50 percent below the price with just over a week to expiration,” Thomas Haugh, a general partner of Chicago-based options trading firm PTI Securities & Futures, told Bloomberg. “It's not even on the page of rational behavior, unless you know something.” Added Michael McCarty, chief options and equity strategist at New York—based brokerage Meridian Equity Partners: “That trade amounted to buying a lottery ticket. Would you buy $1.7 million worth of lottery tickets just because you could? No. Neither would a hedge fund manager.” Gasparino added to Pisani's comment, summing up the growing consensus: “Bear is the whipping boy right now because there is no confidence in that firm or its management…. The rumors might cause a run on the bank even though they deny it.”