Desperate Times Call For Hare-Brained Schemes

The following is an excellent excerpt from the book “HOUSE OF CARDS: A Tale of Hubris and Wretched Excess on Wall Street” by William D. Cohan from Part III: “The End of the Second Gilded Age” from Chapter 31 “Desperate Times Call For Hare-Brained Schemes” page 417 and I quote: “News of [Jimmy] Cayne’s departure leaked to the Wall Street Journal the next morning.  On January 8, Kate Kelly reported that Cayne was “stepping down” after developing “a reputation for being a hands-off leader last year as the current credit crisis unfolded.”   She reported that Cayne had started notifying directors of his decision and that [Alan] Schwartz would succeed him as CEO.  While the choice of Schwartz was a forgone conclusion, it also marked a radical departure for the heavily fixed-income-oriented firm to appoint an M&A banker to its helm at a time when the carnage in the mortgage side of the business was rising exponentially.  In her article, Kelly quoted Meredith Whitney, the research analyst.  “They have incurred so much franchise damage,” Whitney said, “that what investors are concerned about most is revenue replacement.  How the firm did as well as it did, with such a hands-off manager, is really impressive.”  There also seemed to be a consensus in the analyst community that it was a mistake for the board to keep Cayne as its chairman.  “Jimmy Cayne should be out of the company,” Dick Bove said.  “To leave him in there as chairman is, in my view, an outrage.”  The day before, Bear’s stock closed at $76.25, down 3.3 percent and nearly $100 per share below where it had been one year earlier.

The Journal story turned out to be the high point of Schwartz’s day.  He held a series of smaller meetings with the leaders of the firm’s business units and got an earful in each one.  He started by having breakfast with the heads of fixed income.  There were about twenty-five people together in the twelfth-floor boardroom.  “He took us through ‘Now that Jimmy is gone, we got a lot of things that we want to do.  I’m going to be meeting with a lot of people.  We really need to work together,'” Paul Friedman remembered.  “He spoke really well, as he always does.  He spoke for about twenty to thirty minutes, and when he got done, he was greeted by a fair amount of hostility.  The opening five questions were all about, ‘What are we doing to raise capital?’  He gave what became his standard speech: “There’s three ways to raise capital.  You don’t want to raise it the wrong way.  We have no immediate need to raise capital.’  We’re all going, ‘How about now?’  He’s saying, ‘Well, we’re not ruling it out but we’re going to work on it in an orderly process.’  People just pounded him again:  ‘Everybody else has raised capital.  Why aren’t we?'”  (By this time, Wall Street firms had raised in excess of $200 billion in capital; by June 2008 that figure would be more than $300 billion.)

The meeting broke up and the fixed-income leadership returned to the trading floor.  “The view was, ‘That wasn’t what I wanted to hear,'” Friedman said.  “He then had a similar lunch meeting with the equity guys, and I’m told it was somewhat of a similar tone, although they have fewer rude people than we do, apparently, so they were less in his face, but he got a similar response.”

Despite the exhortations, Schwartz seemed determined not to raise new capital at the firm just for the sake of raising new capital.  If there were a strategic purpose, he might consider it, but just getting cash in the door was of little interest to him.  He quickly set about scuttling some of the remaining potential opportunities still being bandied about the firm.  One of Schwartz’s first strategic decisions was to put the final nail in the coffin of the merger with Fortress for any number of reasons.  As for selling the company, he said early on and publicly “Being acquired is not a strategy. . . . We have tremendous opportunities for growth, as much as I’ve ever seen.”  On January 9, in an eighteen-minute television interview with CNBC’s David Faber, Schwartz reiterated his view that the firm was adequately capitalized and was unlikely to be part of a merger or acquisition anytime soon.  “The strategy has to be to grow our business profitably,” he said.  “We need to earn a good return on equity.  We need to grow our book value and need to do that in businesses we can grow organically.”  Only after that would a deal make sense, he said.

Schwartz seemed pulled in many different directions right from the start.  “I’m putting down my pen,” Wes Edens told Tom Flexner, the Bear vice chairman who’d introduced the Fortress merger idea.  “Let’s visit this in two or three months.  Maybe the markets will be a little bit better.  We’re not doing this because it’s two companies in distress.  We’re doing this because we think one plus one is going to equal three.  Obviously, too much is going on.”  Flexner was disappointed and blamed Schwartz.  “We just really spent a huge amount of time on the deal,” he said.  “At the end of the day, I actually think if we’d done that deal we’d be in business today.  Alan Schwartz could not pull the trigger, and I thought that it would have made a difference to our prospects.”

The next opportunity came from Sumitomo Bank, one of the largest banks in Japan.  Michel Peretie, the CEO of Bear Stearns in Europe and based in London, had repeatedly suggested to the New York leaders that Sumitomo had an interest in doing “something structurally” with Bear Stearns, but the response in the late fall had been one of indifference, especially since so much time and effort was being put into making the Citic deal a reality.  No one wanted to stop and try to figure out if the Citric deal would work alongside something Sumitomo might be contemplating.  On January 10, at a meeting of the management and compensation committees, Perete tried again.  This time he had a proposal in hand from the Japanese.  The idea was for Sumitomo to buy a stake in Bear Stearns of between 9.9 percent and 30 percent–the stock was then trading around $70 per share–and to use its sales force to help sell some of Bear’s warehouse of hard-to-sell assets.  In particular, the Japanese thought they could sell pieces of Bear Stearns’s $5 billion slug of leftover debt from Blackstone’s LBO of Hilton Hotels.  “This is January and things are getting pretty edgy,” Friedman said.  “To the outside world things may have seemed okay.  But when your stock is at $170 per share, $100 looks pretty dicey.  To those of us on the inside going, ‘We can’t sell anything.  We can’t raise any new money.  What’s our plan?’ it seemed like a pretty good thing.”

At the committee meeting, the Sumitomo proposal “gets a partial hearing,” Friedman said.  “But the issue that we kept getting hung up with is we’ve got this unformed, semicoherent joint venture pending with Citric.  Now, you’ve got this trillion-dollar bank, one of the largest and most financially solvent banks in the world, that wants to get involved with us.  How would you even structure this third-party joint venture with this unformed other joint venture?  Could you even do it?  We made this big thing about Citric.  We’ve put all these resources into it.  There was a lot of press.  This would be a loss of face.”  The collective wisdom at the meeting was that the Sumitomo deal was just too complicated.  They decided to keep the Sumitomo fish on the line, though, just in case the Citric deal fell apart, which was still a distinct nervousness about Bear’s near-term performance.

Next up was perhaps the wackiest idea of them all: a merge with Residential Capital, known as ResCap, the residential mortgage business of GMAC, both of which were owned by Cerberus, the private equity firm.  “This one was truly insane,” Friedman said.  Dubbed “Project Reno,” the idea–led by Schwartz and his colleagues Richie Metrick and Mike Offitt–was to somehow merge a cleaned-up ResCap into Bear Stearns’s mortgage business, in effect tripling down on the firm’s residential mortgage business at precisely the wrong moment based on a belief that there would be a financial opportunity coming in distressed mortgages.  There was a huge meeting on the forty-third floor of 383 Madison to begin the process of looking at this deal.  “Anybody who can spell ‘mortgage’ and anybody who’s even remotely involved in any aspect of the mortgage business gets invited to this thing,” Friedman said.  To make the failing business more palatable to Bear Stearns, Cerberus first planned to restructure the company’s balance sheet by “cramming down” the existing debt holders, forcing them to take equity in the business (and presumably wiping out Cerberus’s equity).  Additionally, Cerberus would fire five thousand employees, get rid of the mortgage origination business–who needed one of those anymore, anyway?–and then Bear Stearns would issue stock to the new equity holders of ResCap for the mortgage servicing business that remained.  “My initial thought was, ‘So on that day, if we ever actually do this, we would get downgraded to a single-B on the spot,'” Friedman said.  “I actually asked that question and was told, ‘Just hold all those thoughts until later.  We’ve got to work out our due diligence first.'”

Teams of Bear Stearns bankers and traders spent hundreds of hours exploring this deal–which would have raised no new capital for the firm–in due diligence meetings in Minnesota and Pennsylvania.  “You had twenty people from the mortgage department and all the senior people involved in this,” Friedman said.  Our treasurer’s department, the accounting department, the tax department, operations accounting, technology–everybody was involved.  All the best and brightest, maybe fifty to a hundred people, including Steve Begleiter from our corporate strategies group–all focused now on ResCap due diligence.  We’ve got people flying all around the country working on this trade that was just insanity.  Even if it could be done, it made no sense.  Our servicing portfolio at EMC Mortgage was going to go up by 500 percent.  The integration concept was crazy–of taking their technology and our technology, their operations, their people, and they owned a bank, GMAC bank, that was somehow going to be folded into our crappy little bank.  Nuts.  It was going to take every legal and regulatory mind we had to figure out how to do that and get the OCC, the FDIC, and the SEC and all the other C’s to approve it.  Insane.  Weeks and weeks of work go into this.  Then it just sort of stopped.”

The ResCap and Sumitomo opportunities were the last two to come Bear’s way until the end, in March, when the deal dynamics for the firm were very different.  “As the stock price gets lower and lower,” Friedman said, “it becomes less and less possible to do anything because somebody putting in a couple billion dollars now owns 40 percent of the company.  That wasn’t going to happen.  What the old line: ‘Hope is not a strategy? Well, hope was our strategy.  That was basically where we were: ‘Let’s get through the quarter.’  Everybody was focused on ‘Let’s get through the first quarter with good earnings and then see if we can get the Sumitomo trade approved.  If we get good earnings, the pressure will come off.  Life will go on.  We can get back to business.  Markets will see that we, and hopefully everybody else, will do okay, and things will get better.’ Since it was kind of the only thought we had and the only plan, and since it was a good quarter, it all seemed like that made sense.  Even through February.”

With [Walter] Spector long gone, both Cayne and Schwartz–neither of whom really knew very much about fixed income or exotic securities or how to make them or sell them–started spending more and more time on the seventh floor of 383 Madison trying to pick up the gist of what went on there.  Cayne’s visits were superficial and the source of great amusement to the traders.  Cayne’s visits were superficial and the source of great amusement to the traders.  “It was clear when Warren [Spector] left, Jimmy had no idea what we did for a living in fixed income,” Friedman said.  “Unlike Alan, who didn’t get it and knew he didn’t get it and tried, Jimmy had no clue.  He would now come up to the fixed-income floor and wander around and try to find some common ground: ‘How you doing?’ or ‘What’s going on?’ He’d have heard of some customer name–Thornburg, for example, was falling apart at that point–and he’d go.  ‘How’s Thornburg going?’  It’s like, ‘Fine.  Nothing changed since yesterday.’  He couldn’t find a point of intersection.  There was no way he could learn it unless he experienced it.  It was sort of hopeless.”

Schwartz’s visits were far more regular and more substantive.  He started taking up residence in Spector’s office on the seventh floor two mornings a week, while maintaining his office on the forty-second floor.  After all, he knew he was not Lloyd Blankfein–the CEO of Goldman Sachs and a former commodities salesman–and he was determined to get his arms around the problem if he could.  “But it was like Bonds 101,” Friedman said.  “You’re starting with,’Prices go up, yields go down.  And how do you calculate duration?’  Ad I say that not to denigrate Alan.  It’s not what he did for a living, and he picked up on it faster than most humans could.  But he never really got it.  It wasn’t what he did.  It would take you fifteen years to get up to speed on the funky shit that we owned.”

One trade that Schwartz, after he became CEO, asked the team to explore was to sell the firm’s stockpile of Alt-A mortgages.  At that time, Blackrock and PIMCO were the only two potential buyers, in size, of these assets.  But Schwartz quickly realized that these trades could not be done.  “They both want financing,” one Bear executive said.  “I’ve got a liquidity problem because my balance sheet is frozen, so I get out of my inventory and I finance it for five years, which means when the market thaws I’m still illiquid.  So I can’t finance it, number one.  Won’t they buy it without financing?  Maybe, but that’s maybe down 40 points.”  Compounding that problem would be the inevitable leak into the marketplace that the firm was exploring such a sale.  “The next thing you would hear on the Street is, ‘Holy shit! Bear Stearns tried to sell its whole Alt-A portfolio and couldn’t.  Those guys are screwed,'” this executive continued.  “It’s one thing to say, ‘Just get out,’ when you’re out and you can announce to the Street: ‘I’ve sold my Alt-A’s.  I took a beating.  I raised $2 billion from a sovereign wealth fund.  It’s dilutive, but I’m done.  And oh, by the way, my business is going under.’  So that you couldn’t do.”  Schwartz also determined the firm needed to continue its hedging strategies–even though by unwinding them there was some profit embedded in them that the firm could have benefited from–from time to time during the first three months of 2008.  He decided to keep the hedges on and forgo the short-term profit.  “For us to have a bad quarter in a market that is not falling apart, we can survive,” a senior executive said.  “For us to be unhedged in a market that is falling apart, we go out of business.  One is death; one is sickness.  We’re going for sickness.”

In the weeks after he relinquished his post, and aside from his random visits to the fixed-income floor, Cayne’s time at the firm when he was there, three days a week, was spent trying to bring the Citric deal to conclusion, working with the firm’s lawyers on the hedge funds.  Many of these investors had sued the firm, and many others were threatening to sue.  The firm also came up with a seemingly arbitrary plan of settling with investors based upon when they invested: Those who invested in May or June 2007 got all their money back, those who invested between January 2007 and April 2007 got two-thirds of their money back, and those who invested before January 2007 received one-third of their money back.  Some corporate and institutional investors got some of their money back and some did not.  No employees who invested got any of their money back.  “I’m talking to a lot of individuals who are selling it for 30 cents on the dollar,” Cayne said.

What he was not doing after January 8 was participating in any way in the managing of the firm.  “Out of nowhere, I now have zero management responsibility,” he said somewhat wistfully.  On January 12, the august Economist magazine predicted the worst was yet to come for the financial sector.  “The dawning of a new year is supposed to be about hope, but fear remains the dominant emotion among bankers,” it opined.  “This week saw another round of bloodletting as they grappled with the effects of the credit crunch,” including, “to nobody’s surprise,” Cayne’s departure.  “Mr. Cayne’s durability prompted one observer to dub him the ‘Harry Houdini of the boardroom.'”  The magazine ticked through a litany of problems found at all the major firms:  Citigroup, Merrill Lynch, Morgan Stanley, UBS, Countrywide, JPMorgan Chase, MBIA, Capital One (although, surprisingly, no mention was made about problems at Lehman Brothers).  “Even Goldman Sachs, hitherto relatively unscathed, had suffered,” The Economist observed.

The future was murky indeed.  “Investment banks. . . face a showdown in a number of businesses, from advising on mergers to equity underwriting,” the magazine continued.  “Some areas remain vibrant–commodities, for example, and emerging markets–but much restructuring lies ahead. . . . Bank shares may have further to fall.  As Betsy Graseck of Morgan Stanley points out, they are still higher, relative to tangible book value, than their lowest level in the credit crunch of 1989-91.  With futures markets predicting property-price falls of up to 30% and the pain spreading beyond mortgages, the bottom may be months away.  As one American banking regulator puts it: ‘There aren’t many places to look now and feel happy.’  Unless you are an escapologist of Mr. Cayne’s caliber.”  As if on cue, three days later Citigroup announced it was taking a write-down of $18 billion, was cutting its dividend, and was raising $14.5 billion in new capital.  That same day, Merrill raised another $6.6 billion in new capital.  (Neither action would be of much help to these firms in the end.)  On January 21, at six o’clock at night after the market had been closed for Martin Luther King Jr. Day, the Fed agreed to cut the federal funds rate by 75 basis points, to 3.5 percent, the largest one-day reduction ever and the first time since September 2001 the Fed had cut rates between its regular meetings.  Eight days later, at a scheduled meeting, the Fed cut the rate again, to 3 percent.

On February 8, Molinaro spoke at the Credit Suisse Group Financial Services Forum.  He spent time reviewing in detail with investors the steps the firm had taken since late 2006 to shore up its balance sheet and its liquidity.  He pointed out that Bear’s “funding mix” had “shifted dramatically” from being based on unsecured commercial paper and short-term borrowings to borrowing much more on a fully secured basis.  The firm’s unsecured funding increased to nearly $33 billion, from $5 billion, while unsecured funding fell to $10 billion, from $24 billion.  Commercial paper borrowings fell to $3 billion, from $20 billion.  “So a very dramatic shift in the sources of financing,” he said.  He also was happy to report that the firm had a $17 billion cash “liquidity pool” at the parent company, increased from $3 billion.  “Essentially, it’s a pool of cash, and that pool of cash is kept to protect the company from a variety of potential contingent draw-downs on liquidity or a potential need for additional margin on secured repo financings.”  Finally, he explained that the firm’s equity capital was $12 billion, with another $1 billion coming from the Citric deal (assuming it closed and ignoring the $1 billion Bear was to invest in Citric).  “We think that our total capital position is in very strong shape as we come into 2008,” he concluded.

Among others, Robert Upton, the firm’s treasurer, was not so sure.  While Molinaro, his boss, was at the Credit Suisse conference, Upton was in Europe reassuring Bear’s creditors.  “Let’s be honest,” he said.  “There was creditor angst.  There was fixed-income investor and creditor concern about Bear Stearns.  It was particularly bad in overseas markets, arising first from the hedge funds, second from the belief–right or wrong–that our exposure to mortgage markets that were troubled was as big if not bigger than anyone else’s.  We were the smallest of the big five broker-dealers, and in overseas markets the perception was we were the essence of the subprime problem.  That if Bear Stearns didn’t exist, subprime would have never been a problem.  As ludicrous as that is, that was the perception when you got overseas.  I have presentations that speak to those concerns, as ridiculous as that is, because especially in Asia, that was the general perception.  People were very concerned about holding our bonds, and they certainly weren’t going to do a new debt deal.  Banks that provided credit to us were obviously concerned.”

The message Upton delivered during his European voyage was generally an upbeat one.  “I was an honest believer that everything was going to be okay,” he said.  He told creditors the firm was likely to have a profitable first quarter and had been improving its liquidity.  “We’ve changed our funding posture,” he told creditors.  “We’ve changed our funding position.  We’ve got $17 billion in cash, and that number was up to $18 billion when I went home.”

But on February 13, he started to get increasingly concerned.  During a well-attended meeting with Molinaro, his boss, and the heads of the global equities division, Upton made a passionate plea that the firm stop using the free credit balances–especially cash–in its hedge fund customers’ prime brokerage accounts to fund other parts of the business.  While the move was perfectly legal, if the hedge fund customer ever wanted his money back and it was tied up in other parts of the business, then Bear would have to use some of the precious $18 billion of cash at the parent company to pay back the customer what was his or otherwise be forced to liquidate a position in an untimely manner.  These were limits to how long this would work, of course, especially if many of the hedge fund customers wanted their money back at the same time.  What they should have done, in retrospect, was keep a client’s cash with a client’s collateral with a client’s margin loan.  “We should fund his debit by using his collateral and lock up all the money,” Upton said.  “Just put it away so that if they want it back I can give it to them.  What we did instead was we spent a lot of time getting really cute and used XYZ’s money to fund ABC’s margin loan.  The problem with that was when short positions and free credit balances and customer cash started to fly out the door, the only way we could meet some of that was by using holding company money.”

Upton told Molinaro this practice should end immediately.  “What I told them that day was that continuing to fund the prime brokerage business using free credits. . . [was like] they were betting the firm,” he said.  “They quickly threw all the papers I put down aside and said to me, ‘You’re full of shit.  Free credits have never left.  Debits and credits leave at the same time.'”  Much to Upton’s dismay, that was the end of the discussion.  “But the CFO should have had the testicles to tell them, ‘Upton’s right.  We’re going to fucking go down this road,'” Upton said.  “But he didn’t.  Instead, we came up with some half-assed compromise piece-of-shit decision, which eventually could be completely gamed by the business unit, and only increased, not lessened, my exposure to confidence-sensitive overnight funding in the prime brokerage business.”

The next day, Valentine’s Day, UBS announced that it was writing off $2 billion of Alt-A mortgages, the first time that a major Wall Street firm had fessed up to the fact a significant chunk of its supposedly higher-credit-quality mortgages–as opposed to the lower-quality subprime mortgages–were now toxic waste.  UBS’s Alt-A write-down caused firms across Wall Street–and other companies that do business with them–great consternation and forced them to mark down their own Alt-A mortgages.  Thornburg Mortgage, for one, had used the Alt-A mortgages on its books as collateral for its overnight repo financing.  After UBS’s February 14 surprise, Thornburg’s repo lenders were demanding more collateral for their overnight loans to Thornburg, depleting the firm’s cash reserves to meet the margin calls.  As a direct consequence of the UBS write-down and the margin calls at Thornburg, the exact thing that Upton had worried about the day before had come to pass.  Nervous hedge funds started asking Bear Stearns for the return of their cash balances, as they had the previous August, forcing Bear Stearns to dip into its $18 billion of cash reserves to meet their requests.  The dominoes had started falling.

Coincidentally Valentine’s Day was Jimmy Cayne’s seventy-fourth birthday.  He celebrated by agreeing to spend $28.24 million to buy two adjacent fourteenth-floor apartments at the recently transformed and reopened Plaza Hotel, at the corner of 59th Street and Fifth Avenue.   The combined apartments, with 6,000 square feet of space plus maid service and room service, were around the corner from his longtime apartment at 510 Park Avenue.   Although the new digs at the Plaza would require another year and millions of dollars more in cost before the Caynes could move in, it did have a spectacular view of Central Park.”


LaVern Isely, Progressive, Overtaxed, Independent Middle Class Taxpayer and Public Citizen Member and USAF Veteran


About tim074

I'm a retired dairy farmer that was a member of the National Farmer's Organization (NFO). Before going farming, I spent 4 years in the United States Air Force where I saved up enough money to get my down payment to go farming. I also enjoy writing and reading biographies and I write about myself as well as articles and excerpts I find interesting. I'm specifically interested in finances, particularly in the banking industry because if it wasn't for help from my local Community Bank, I never could have started farming which I was successful at. So, I'm real interested in the Small Business Administration and I know they are the ones creating jobs. I have been a member of Common Cause and am now a member of Public Citizen as well as AARP. I have, in the past, written over 150 articles on the Obama Blog ( and I'd like to tie these two sites together. I'm also on Twitter, MySpace and Facebook and find these outlets terrifically interesting particularly what many of these people did concerning the uprising in the Arab world. I believe this is a smaller world than we think it is and my goal is to try to bring people together to live in peace because management needs labor like labor needs management. Up to now, that hasn't been so easy to find.
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