Hedge Funds Develop on Wall Street

Hedge Funds were a recent development on Wall Street. Profound changes impacted both commercial and investment banking during the late 1970s. Core investment bank businesses such as underwriting stocks and bonds, saw underwriting fees plummet. Seeing its traditional franchises in decline, investment banks refocused on mergers & acquisitions, leveraged buyouts, high-yield debt, securitization of financial instruments and proprietary trading. This last activity involved speculative investing using the firm’s own capital.

This new strategy required all investment banks to increase capitalization. Many firms merged and became publicly traded corporations. Most also expanded their trading activities. While bankers stalked corporate takeovers, a new class of aggressive traders pursued speculative gains in currencies, commodities, futures and options.

Eventually some of the more successful traders went out on their own. Raising capital, they promised investors superior returns based upon exploiting market inefficiencies. Capturing such inefficiencies usually carried a risk that markets would move in response, wipe out the discrepancy and turn the investor’s gains to losses. The traders told their investors that they could hedge such risks. Armed with new mathematical tools for modeling risk, traders sought to combine precisely calibrated “long” positions and partially offsetting hedges to capture outsized returns. Thus the Hedge Fund came into being. Attachment 1 provides a generic description of Hedge Funds, the strategies they employ and the pros/cons of investing in them.

Long-Term Capital Management (LTCM) was one such Hedge Fund. Founded by two Nobel Prize winners in economics, LTCM sought to exploit discontinuities in the fixed income market. As an example, LTCM noted that the “on the run” issue 30 Year U.S. Treasury bond (the newest issue) typically traded at a price premium relative to a “seasoned” Treasury bond with 29 years remaining to maturity. Once the “on the run” issue was superseded by a newer issue, it would fall toward price equilibrium with other seasoned 29-year bonds. LTCM’s basic trade involved buying the cheaper 29-year bond, selling the “on the run” issue “short,” and waiting until the latter bond’s price fell as it seasoned. Sometimes this realignment took only 1–2 months. Then LTCM would sell its seasoned bonds, using the cash to cover its “short” position at the new lower price. Although LTCM’s short position might be quite large, fund managers considered the position “hedged” because of the fund’s long position in a security of comparable quality and tenor.

In a cautionary tale, LTCM’s performance went from stunning to disastrous. In 1998, Russia’s sovereign debt default led markets to reprice risk and rein in credit. LTCM’s long positions turned negative; news of its losses caused LTCM’s creditors to demand large amounts of cash collateral. LTCM was forced to liquidate securities at progressively bigger losses, which fed their creditors’ frenzy to exit. Only a multibank rescue effort orchestrated by the N.Y. Federal Reserve Bank headed off the fund’s dissolution.

LTCM’s failure did not discourage others from establishing hedge funds. Quite to the contrary, the natural progression on Wall Street became one of traders proving their bona fides at a “name” firm and then leaving to form their own fund. Many funds racked up enviable track records; major institutional investors put increasing amounts of funds under their management. By the mid-2000s, state pension funds and Ivy League schools routinely placed money with hedge funds.

Bear Stearns Forms its Own Hedge Funds

Bear Stearns was regarded as the scrappy renegade investment bank. Part of this reputation came from its refusal to support the rescue effort of LTCM. But most of it reflected a style born of sharp elbows trading rather than well-tailored banking. Traders traditionally headed the firm, the most noteworthy being “Ace” Greenberg. By 2007, Ace had stepped aside in favor of another rough-knuckled trader, Jimmy Cayne.

Bear Stearns’ nimble trading culture and focus on specific market segments produced results. By 2005, the firm was among the leaders in fixed income securities trading and topped the “League Tables” in asset-backed securities. Wealth under management at BSAM was growing rapidly. These results flowed through to profitability. Attachment 2 summarizes Bear Stearns financial performance for the period 2005–06.

With its deep appreciation for trading talent, Bear Stearns took a unique approach to the hedge fund phenomena. First, they tended to give a wider range of individuals the opportunity to prove themselves as traders. If they succeeded, Bear Stearns would let them form hedge funds within BSAM. The approach had reasonable success in spotting new trading talent and keeping it with the firm.

One beneficiary was Ralph Cioffi. Joining Bear Stearns in 1985, Cioffi quickly established himself as the firm’s preeminent fixed income salesman. His specialty was structured finance products; these included collateralized mortgage obligations and asset-backed securities, which were then coming into vogue. Within a couple of years Cioffi was making $4 M in annual compensation.

Cioffi was promoted to manage fixed income institutional sales; he quickly demonstrated a lack of managerial talent. One colleague, who knew Cioffi well, described his performance this way:

“He had adult ADD … In management, you come in the morning and you’re working on what you worked on yesterday, and you’re trying to hire this guy, or build this business … Ralph didn’t do well with that stuff. He would hire salespeople, and we’d get to the end of the year and find out that he’d cut deals and forgot to write them down … He was just not a really good manager.”⁴

To rebound from these troubles, Cioffi volunteered an interest in managing a hedge fund. Bear Stearns tried him out managing $10 M of the firm’s own money in a mortgage-backed securities fund. Results were initially positive. Then in October 2003 Bear Stearns gave Cioffi the chance to set up a new fund with outside investor money. Matthew Tannin was brought along to help him. Tannin had nine years’ experience with the firm, seven of which were spent structuring collateralized debt obligations (CDOs). Tannin’s last two years had been spent in CDO research.⁵

Cioffi called his new vehicle the “High-Grade Structured Credit Fund” or High Grade Fund (HGF) for short. It was, in Wall Street parlance, a “carry fund.” This meant that the fund raised money, invested in securities and held (i.e., carried) them. Outside investors typically delivered only a small percentage of the fund’s capitalization. The rest was borrowed money of short-term duration. Most borrowed money was secured in the overnight “repo” or repurchase market. Cioffi’s fund would borrow money for 1 day, securing the loan using their “carried” securities as collateral. This approach allowed the fund to achieve low borrowing costs by concentrating its financing in the shortest maturity debt. So long as the Fund was earning money, a high ratio of debt-to-investor equity also produced high leveraged returns. Of course, the risk being taken involved the fact that funding from lenders was not locked-in. Should the High Grade Fund’s lenders become spooked, they could demand repayment as soon as the next day.

Cioffi’s strategy involved capturing the interest rate differential between short-term repo market rates and those available on long-term CDOs. Essentially, the HGF would borrow at the shortest end of the yield curve and invest at the long end. As a second source of value, the HGF would exploit what Cioffi judged to be a pricing anomaly. Asset-backed securities, especially those backed by mortgages, could secure high credit ratings from the rating agencies. Yet, such CDOs were often “priced” to carry interest yields that resembled A or BBB rated corporate securities. The HGF was designed to capture this pricing anomaly for its investors.

Cioffi’s strategy was exposed to several risks. First was the risk that interest rates might rise, causing HGF’s long-term holdings to drop in price. In its most acute form, interest rates might rise to the point where HGF funding costs rose above its interest income. Cioffi judged that U.S. monetary policy was pointed toward a period of low short-term rates. Should Federal Reserve policy change, however, he would have to be nimble enough to spot the change early and hedge rising rates. Cioffi’s second risk was that the creditworthiness of CDOs “carried” by HGF might deteriorate. Should this happen, the prices of the Fund’s securities would decline. To hedge this risk, Cioffi promised investors his Fund would buy only AAA or AA rated CDOs.

One last risk element involved the way Wall Street reports financial results. Banks are required to use “Mark-to-Market” (MtM) accounting. This means that securities carried on their balance sheets are repriced to reflect market changes since the prior reporting date. Gains and losses are then reflected in reported net income. Philosophically this approach aims for greater transparency, i.e., allowing investors to see whether the “bets” are in the black or “under water.” It does, however, suggest that income has been gained or lost when in fact the underlying securities have not been sold. It can also involve ticklish and complex valuation issues when particular securities are not widely traded. Trouble can then be signaled to investors based on a few trades or revised assumptions used in valuation models. Whether such signals accurately reflected fundamentals was often debated. Like other hedge funds, HGF would report its results using MtM.

Things started out promisingly for HGF. The Fund showed positive results for 40 straight months and generated a 50% cumulative return.⁶ In line with other Hedge Funds, BSAM kept 20% of the Fund’s profits plus annual fees equal to 2% of the assets under management. HGF proved a star revenue generator, accounting for 75% of BSAM’s total revenues in 2004–05.⁷

Mortgage Market Trends and HGF Disclosure

In 1994 approximately 64% of American households owned their home. This figure had been stable for decades. Over the next ten years government policy worked to up this figure. The Clinton administration took an aggressive approach towards mortgage lender discriminatory practices. Under the Community Reinvestment Act (CRA), banks were rated on how much lending they did in low-income areas. Low CRA scores were strongly considered when a bank sought government approvals for mergers or branch openings. The two giant government mortgage agencies, Fannie Mae and Freddie Mac, were encouraged to become involved in securitizing packages of subprime mortgages. The first such securitization, a $385 million subprime loan package, was underwritten by Bear Stearns and First Union in October 1997.⁸

These government policies were extended during the Bush administration. The 2003 Dream Down Payment Initiative provided money to pay closing costs and down payments for first time low-income buyers.⁹ Tax policies improved the shielding of capital gains generated by home sales. No attempt was made to rein in subprime activity at Fannie Mae and Freddie Mac, even though there were visible signs that lending standards were deteriorating.

Prior to these initiatives, lenders expected loan applicants to provide a minimum 20% cash down payment, demonstrate the ability to fund their mortgage payment using no more than 30% of monthly salary, and evidence positive personal net worth. The house would be appraised to demonstrate a market value at least 15% higher than the mortgage.

Once the government began encouraging aggressive mortgage lending, these standards dropped—first to a 3% down payment, then zero down payments. Eventually some lenders offered a “103” mortgage, where closing costs were paid by the lender and rolled into the loan amount. The quality of personal financial disclosure also suffered. Borrowers were encouraged to exaggerate their financial condition, or lenders didn’t bother asking. In a not exceptional example, one couple living on disability checks and holding no financial assets saw their $285 k loan application filed by MortgageIT with a report stating they had a monthly $5000 salary, $158 k in liquid assets and a net worth of $153 k. The mortgage was securitized and sold first to GMAC and later to Wells Fargo Home Mortgage.¹⁰

Securitization of mortgages strongly encouraged these practices. Loan originators operated with the sense that they would not have to live with the consequences of relaxed standards.

One factor which facilitated the securitization of mortgages was relaxed credit standards at the three rating agencies: Moody’s, Standard & Poor’s, and Fitch. Fixed income investors have long depended on these agencies to do detailed risk assessment. Yet, the agencies are paid for ratings by the debt issuer. This basic conflict of interest had historically been contained by the professionalism of the agencies. However, by the time of the mortgage securitization boom the agencies had become part of public companies. Management cultures changed and standards slipped. Increasingly, the agencies rated mortgage-backed CDOs as AAA or AA without inspecting the underlying loan collateral. Embarrassing evidence of management directing analysts to temper their investigations later surfaced in congressional hearings. At a time when mortgage underwriting standards were deteriorating, bond credit ratings also lost their integrity.

The government’s policies did succeed in raising the level of home ownership. By 2008, ownership had risen to 69% of households. This increased demand helped cause average U.S. housing prices to more than double. Rising prices helped sustain aggressive lending, keeping the origination/securitization pipeline flowing.

By 2006, cracks in the mortgage market had begun to show. Late in 2005, financial services analyst Meredith Whitney published a “flashing red light” report. Whitney focused on deteriorating mortgage credit standards; she noted that a massive number of recent borrowers now had loan-to-value ratios exceeding 90%. Should surging home prices stall, these owners could quickly find themselves “under water.” Whitney documented the stupendous growth of the subprime mortgage segment—it had grown 489% since 1996, from $90 billion to $530 billion, largely on the basis of loans to first-time borrowers. The report’s conclusion was prescient and devastating:

“We believe low equity positions in their homes, high revolving debt balances, and high commodity prices make for the ingredients of a credit implosion … lenders with exposure to this segment [subprime] will experience loss levels of great enough enormity to not only substantially erode profitability but which would impale capital positions … most important, we believe restricted liquidity … could begin a domino effect of corporate insolvencies similar to that witnessed post-1998.”¹¹

This was the background against which Cioffi and Tannin managed the HGF. Their response was to provide reassurance to their investors. The Fund’s investment philosophy was succinctly stated in each monthly performance report:

“The Fund’s investment philosophy is to generate total annual returns through ‘cash and carry’ transactions and capital market arbitrage. Typically 90% of the Fund’s gross assets are invested in AAA or AA structured finance assets.”¹²

This commitment to invest in top quality securities was buttressed by monthly disclosure of the investment portfolio’s mix. For example, for January 2006 the HGF indicated that 30% of assets were in asset-backed securities (ABS) and another 15.2% in subprime mortgage residential securities.

Such disclosure was at best a half truth. Cioffi and Tannin were less than candid in their description of the assets being held. For example, in July 2006 the HGF monthly statement reported 50.5% ABS and only 6% in subprime mortgage securities. Yet, in a January 2007 investor conference, under direct questioning about the composition of the ABS portfolio, Cioffi admitted that it contained subprime exposure. Later congressional testimony by Kyle Bass, managing partner of Hayman Capital, asserted that HGF’s ABS portfolio was comprised almost entirely of subprime mortgages. Later disclosures by HGF would confirm this view.¹³

HGF’s initial performance left little cause for complaint. Cumulative returns were reported to be 16.88% in 2004 and 9.46% for 2005.

Financial Control Issues at HGF

Organizationally, Bear Stearns consisted of an investment bank, a broker/dealer who traded securities, and BSAM. From its inception, Cioffi’s HGF did most of its trading with Bear Stearns’ broker/dealer. This made sense because of Cioffi’s relationship with the firm and because Bear Stearns was Wall Street’s leading originator/trader of mortgage-backed securities. Attachment 3 provides an overview of the Bear Stearns organization.

Because Bear Stearns was a related party, procedures were established to guard against conflicts of interest. HGF had to have independent directors on its Board. HGF trades with Bear Stearns also had to be approved by these directors prior to execution. Compliance with these rules was required by the Investment Advisers Act of 1940. In theory, an HGF failure to comply on even one trade could have serious legal consequences for BSAM.

Unfortunately, Cioffi’s managerial weaknesses followed him into managing hedge funds. HGF routinely failed to comply with the rules. For an extended period it failed to appoint independent directors. When these were in place, needed approvals were often obtained after the fact or not at all.

BSAM’s compliance staff became increasingly concerned about HGF’s control failures. In 2003, 18% of HGF’s trades with Bear Stearns were not properly approved. Despite repeated warnings from compliance, HGF’s performance only worsened. By 2006, violations had risen to 76% of trades. Ultimately, BSAM reported that HGF executed 2300 trades with Bear Stearns between 2003 and the end of 2006; of these, 47% were noncompliant.¹⁴

Finally, in September 2006 BSAM imposed a moratorium on all trading with HGF. This moratorium cut HGF off from its major source of liquidity. Not only could HGF no longer trade asset-backed securities with Bear Stearns, it no longer could “repo” securities with its sister firm. HGF was thus cut off from the firm which had the most natural incentive to buy a distressed asset or extend financing should HGF encounter difficulties. Finally, it meant that senior Bear Stearns traders, who used to keep an eye on what Cioffi and Tannin were buying, no longer bothered to look. Bear Stearns management became increasingly unaware of whether HGF’s risks were being managed or if its strategies matched what the Fund was telling its investors.¹⁵

The moratorium remained in effect indefinitely.

Cioffi and Tannin Respond to Growing Pressures

Cioffi and Tannin understood that loss of access to Bear Stearns seriously diminished the liquidity of their funds. They also knew that pressures were growing in the mortgage market. In an April 2006 call with a potential investor, Tannin noted that the market was especially worried about the current crop of subprime mortgages because of “looser underwriting standards, ‘no-doc’ loans, high loan-to-value ratios, and a large ‘dispersion’ in credit scores.”¹⁶

Faced with deteriorating asset quality and reduced liquidity, Cioffi and Tannin embarked upon a new course. This strategy involved launching new funds and attracting new lenders to fund large new securities purchases. Most of the new investments would be subprime mortgage-backed CDOs.

First up was the “Enhanced Leverage Fund.” On August 1, 2006, the HGF was split into two components. Some $560 M in assets, about 37% of the HGF, became the ELF. Cioffi and Tannin promised investors higher returns due to the use of more debt financing. ELF would invest primarily in CDOs, using substantially more leverage while investing in a higher percentage of the least risky securities. The net result would be higher returns with only “limited additional risk.”¹⁷

To secure the liquidity needed to pursue the ELF strategy, Tannin approached Barclays Bank for a $400 M credit line. Tannin told the bank that the new Fund would invest in “AA/AAA assets” having “very, very low volatility.” Thus the Fund would:

“concentrate the ultimate exposure in the highest rated (floating rate) kinds of assets [and] generate a prudent return for our investors which allows our portfolio managers and structuring team to concentrate on the areas in the market where there is the greatest liquidity and greatest value.”¹⁸

Barclays ultimately granted ELF the credit line. Later in 2006, Cioffi and Tannin formed another new fund, called Rampart, to which they sold $549 M of less liquid CDOs from the two existing funds. This transaction left HGF/ELF collectively with an equity position in Rampart and $149 M in cash. Cioffi and Tannin felt, with some justification, that they had taken meaningful steps to counteract the moratorium on trading with Bear Stearns.

Then, the subprime mortgage market began showing increasing distress, and mortgage-backed CDOs slipped in price. Securities previously priced at par were now selling for 97–98% of par. Cioffi and Tannin used much of their new liquidity to load up their Funds with new securities purchased at what they believed to be bargain prices. By February 2007, subprime mortgage assets represented some 60% of total HGF/ELF holdings.¹⁹

February 2007: ELF Performance Turns Negative

A series of hammer blows struck the subprime mortgage market in February 2007.

On February 7, New Century Financial Corporation announced that it was restating earnings for 2006. New Century was a large, publicly traded real estate investment trust and major mortgage lender. The restatement involved home mortgages bought back from borrowers. New Century cancelled its earnings call with analysts and watched its stock fall 37% to a 52 week low. On the same day, HSBC Holdings announced large new loan loss provisions for nonperforming mortgages.

On February 21, NovaStar Financial, another subprime mortgage lender, announced a surprise loss for 4Q 2006. NovaStar also warned that it might not be able to pay its dividend for the foreseeable future. Its stock fell 43%.²⁰

Three days later, Lew Ranieri, a legendary Salomon Brothers mortgage-backed trader, gave a Wall Street Journal interview warning about mortgage-related risks and global markets. Ranieri cited the growing volumes of subprime CDOs being sold to a “much less sophisticated community” in foreign markets. Noting that in 2006 some 40% of the subprime borrowers were not required to produce pay stubs or proof of net worth, Ranieri went on to say:

“We’re not really sure what the guy’s income is and … we’re not sure what the home is worth … So you can understand why some of us become a little nervous.”²¹

It was against this backdrop that Cioffi and Tannin considered the performance of their Funds for February. Of particular concern was the question of the “marks” to be assigned at month-end to securities held by the Funds. Given all the bad news since February 1, Cioffi and Tannin worried that Fund holdings might need to be marked down considerably. Such markdowns could more than offset the Funds’ interest income, producing a net loss. Attachment 4 provides a brief summary of Bear Stearns procedure for setting monthly price marks.

Matthew Tannin Considers His Response to Barclays Bank

On February 27, 2007, Barclays Bank demanded that Tannin provide them with written monthly performance statements for the ELF. At this point, half of their credit facility for the Fund remained undrawn and available.

As Tannin considered his response, he identified several options:

• Signal the possibility of an ELF loss in February, but try to persuade Barclays that this result was an aberration. Go on from there to argue that it represented a buying opportunity for the fund.
• Try to reassure Barclays and buy time to draw down the remaining facility cash. Use the cash to buy additional securities at cheap prices, betting on producing turnaround positive results in March.
• Try to line up replacement liquidity in case Barclays froze their facility. Perhaps Bear Stearns could be persuaded to lift its trading moratorium.
• Go into defensive mode. Sell securities to increase cash reserves. Move away from mortgage-backed securities to more traditional asset-backed CDOs.

Tannin thought that these options were not mutually exclusive. Elements of one might be combined with another. For example, they could try to reassure Barclays, draw down the credit facility, but then go into defensive mode. Or, ELF could line up replacement liquidity and still execute a CDO purchase program. The decision depended on whether current market turbulence was localized and temporary, and hence a buying opportunity.

While considering his options, Tannin took stock of the legal framework that governed hedge fund disclosure. Requirements were somewhat murkier than those pertaining to publicly traded securities. Still, Tannin knew that material misstatements could lead to legal actions against the Funds and a possible criminal indictment of fund managers. Attachment 5 discusses the disclosure laws pertinent to hedge funds.

Here Tannin remembered the e-mail he had sent Barclays on February 19. Among other comments, the note had declared:

“You will be happy to know that we are having our best month ever this February … Our hedges are working beautifully. We were up 1.6% in January and are up 2% so far in February.”²²

Taking all of this into account, Tannin began to draft his written reply to Barclays Bank.

Attachment 3

Author’s Note

This case introduces students to hedge funds, one of the major growth sectors on Wall Street. It also shows how acute risk taking, compliance/controls issues, and disclosure questions are never far removed from Wall Street’s periodic disasters.

Ralph Cioffi and Matthew Tannin’s hedge funds are also “carry funds.” This means they borrow short-term money and invest in higher yielding long-term instruments. This structure is inherently risky. It amounts to a bet that short-term rates will remain lower than long rates and that financing can continually be rolled over. Such funds periodically become popular when fund managers perceive that the Federal Reserve will keep rates low. Managers are also attracted to carry funds when spreads between different classes of securities “widen out.” Both factors were at work here.

Students will now confront the problems Cioffi and Tannin faced in March 2007. For one, slipping market prices are causing the funds to lose money for the first time. Most of the declines are in subprime mortgage instruments. Cioffi and Tannin’s second problem involves their having been “less than forthcoming” about the extent of the funds’ subprime holdings. Hedge fund disclosure rules are not as clear as for public companies. Still, the fund managers face credibility issues with their investors and lenders. One lender, Barclays, controls a vital line of credit. Barclays is now pressing for more information. What should Cioffi and Tannin say in response? Finally, the two funds are associated with BASM. In theory, the funds should be able to look to Bear Stearns for emergency support. Unfortunately, they have been “cut off” due to repeated failures to comply with control practices.

The two funds could be facing a quick death. This type of fund is not supposed to lose money. Should investors and lenders conclude it is likely to do so, the investors will “cash out” while lenders will not roll over their loans. Cioffi and Tannin could quickly face redemption demands they don’t have cash to meet. Students, confronting this potential, must try to find a way to reassure investors, persuade Barclays to maintain its credit line, and accomplish these things while “coming clean” about the funds’ subprime exposure. Finding a way to get Bear Stearns back in the game may prove critical.

This case is based on House of Cards, William D. Cohan’s excellent account of the Bear Stearns demise. Bear Stearns was the first banking failure of the financial crisis, falling into J.P. Morgan’s hands for a fire-sale price in March 2008. Cohan thus had a head start on other analysts of the crisis; his book came out in 2009. Subsequent accounts have corroborated his story.

The failure of Bear Stearns’ funds has since been called the financial crisis’ “canary in the mine.” It was the event that alerted investors to subprime’s risks; it also fed mistrust among debtors and creditors. From the Funds’ liquidation in July 2007 to Lehman’s bankruptcy in September 2008, the story unfolds like a slow motion train wreck. This case gives students the opportunity to rewind the story to the previous March and see if a more ethical path to a better outcome was available.