Dear Mr. Buffett_ What an Investor Learns 1,269 Miles From Wall Street Part 6

Ralph Cioffi left Bear Stearns by mutual agreement on November 28, 2007, at the age of 51. His compensation reportedly soared to eight figures during his BSAM days. The less-leveraged fund had positive returns for several years, and colleagues invested money with him after noting he was returning around 1 percent per month-more than 12 percent per year-in an interest rate environment in which 10-year Treasuries were yielding less than 5 percent. It was an old story: If it sounds too good to be true, it is.

Warren Spector did not last as long as Cioffi. Like Warren Buffett, Warren Spector and Jimmy Cayne are avid bridge players. On August 5, 2007, Spector became the highest ranking bridge player-one of the world's top 300 contract bridge players-to lose his job over the mortgage lending crisis. Bridge is a great comfort in your old age. If it distracts you from business, it can help you get there faster. Bridge is a great comfort in your old age. If it distracts you from business, it can help you get there faster. Spector had been the lead promoter for Bear Stearns to get into the hedge fund business, and Cayne held him responsible. Cayne's ire may also have been sparked by the fact that while the funds faltered in July, Spector was at a bridge tournament playing perfect hands of bridge and racking up 100 master points. Cayne played less well at the same bridge tournament, and apparently he thought Spector should have been closer to the hedge fund problem, even if Cayne himself did not feel compelled to fly back to New York. Spector had been the lead promoter for Bear Stearns to get into the hedge fund business, and Cayne held him responsible. Cayne's ire may also have been sparked by the fact that while the funds faltered in July, Spector was at a bridge tournament playing perfect hands of bridge and racking up 100 master points. Cayne played less well at the same bridge tournament, and apparently he thought Spector should have been closer to the hedge fund problem, even if Cayne himself did not feel compelled to fly back to New York.

Unlike Cayne, Spector had sold millions of shares of his Bear Stearns stock in 2004. Bloomberg Bloomberg reported that Spector, 51, earned $228 million in cash from 1992 to 2006, and got another $372 million when he cashed in most of his Bear Stearns shares. reported that Spector, 51, earned $228 million in cash from 1992 to 2006, and got another $372 million when he cashed in most of his Bear Stearns shares.42 Jimmy Cayne, 74, resigned in January of 2008, after serving 15 years as CEO. His Bear Stearns stock had been worth more than $975 million in January 2007 and was worth around half of that when he resigned in January 2008. Cayne did not liquidate until after JPMorgan's March 2008 takeover. The stock was worth only $61 million. Jimmy Cayne, 74, resigned in January of 2008, after serving 15 years as CEO. His Bear Stearns stock had been worth more than $975 million in January 2007 and was worth around half of that when he resigned in January 2008. Cayne did not liquidate until after JPMorgan's March 2008 takeover. The stock was worth only $61 million.

Cayne may feel lucky in comparison to Ralph Cioffi and Matthew Tannin, Ralph's cohead at BSAM. On June 18, 2008, they were indicted on allegations of securities fraud, among other charges .4344 Prosecutors focused on electronic exchanges between Tannin and Cioffi. The partners may have stumbled over the truth, picked themselves up, and hurried on. In late April, they saw a negative report prompting Tannin to write to Cioffi: "If the report was [sic] true, the entire subprime market was toast."45 Yet they did not seem to share those concerns with investors. Perhaps the partners gave themselves unwarranted rea.s.surance. Yet they did not seem to share those concerns with investors. Perhaps the partners gave themselves unwarranted rea.s.surance.

It reminded me of a bridge joke I sent Warren Buffett after our lunch. It was a partners.h.i.+p misunderstanding. My partner thought I knew what I was doing. It was a partners.h.i.+p misunderstanding. My partner thought I knew what I was doing.

Chapter 9.

Dead Man's Curve I evaluate the probable loss myself. I don't use a model.

-Warren Buffett to Janet Tavakoli, September 2005

Benjamin Graham was not a fan of market timing, in which investors try to forecast stock market prices (or oil spreads, interest rate spreads, or prices of CDOs). He was sure those who followed forecasting would "end up as a speculator with a speculator's financial results."1 Instead, Graham advocated buying a stock if it was trading below its fair value and selling when it was above its fair value after doing a fundamental a.n.a.lysis. He knew that his views were "not commonly accepted on Wall Street." Instead, Graham advocated buying a stock if it was trading below its fair value and selling when it was above its fair value after doing a fundamental a.n.a.lysis. He knew that his views were "not commonly accepted on Wall Street."2 Even after Warren Buffett achieved a successful track record following (and then modifying) Graham's principles, many on Wall Street still did not accept these views. Even after Warren Buffett achieved a successful track record following (and then modifying) Graham's principles, many on Wall Street still did not accept these views.

A recent example is the demise of Bear Stearns, which was preceded and partly triggered by the deaths of Peloton, a European-based hedge fund cofounded by Ron Beller, and one of the funds of the Carlyle Group, a Was.h.i.+ngton-connected private equity firm. At the time of its demise, Peloton's held long positions of the type that Bear Stearns's research group touted in February 2008.

Ron Beller first made big headlines in 2004 when Joyti De-Laurey, personal a.s.sistant at Goldman Sachs to his wife, Jennifer Moses, went on trial and was convicted of forging the Bellers' and Moses' signatures to filch funds from their personal accounts. Beller and his wife asked De-Laurey to work for them personally when they both left Goldman Sachs, but De-Laurey stayed to become the personal a.s.sistant of another Goldman Sachs partner, Scott Mead. She was also convicted of filching funds from him. De-Laurey reportedly took 4.4 million (around $8.75 million in 2008 dollars) from the collective accounts of Scott Mead, Jennifer Moses (Beller's wife) and Ron Beller. Neither of the Bellers noticed that De-Laurey had taken millions from their personal accounts for several months. Is it any wonder that during the trial De-Laurey referred to Mr. Beller as "an absolute diamond"?3 Yet, when Beller co-founded London-based Peloton in 2005, investors seemed eager to let him manage their money. Yet, when Beller co-founded London-based Peloton in 2005, investors seemed eager to let him manage their money.

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Ron Beller and Geoff Grant, another former Goldman Sachs partner, ran Peloton Partners, named after the vee-like bird formation adopted by endurance bicycle riders that lead the pack by taking advantage of drafting to reduce wind friction. In January 2008, Peloton Partners LLP was riding high. It had two funds, the $1.6 billion Peloton Multi-strategy fund, and the $2 billion Peloton ABS fund.4 The latter fund won The latter fund won Eurohedge Eurohedge's best new fixed-income fund of the year award, after reporting a stunning net net return of 87.6 percent for 2007.When the fund's returns were announced, some of the attendees at the awards ceremony "gasped." return of 87.6 percent for 2007.When the fund's returns were announced, some of the attendees at the awards ceremony "gasped."5 Shock and awe. Shock and awe. Beller and Grant were lauded as "hedgie heroes." Beller and Grant were lauded as "hedgie heroes."6 Within two months of receiving these accolades, Peloton's $2 billion ABS fund collapsed, and Peloton put its offices up for sale. Within two months of receiving these accolades, Peloton's $2 billion ABS fund collapsed, and Peloton put its offices up for sale.

Beller told potential investors that his strategy was to make bets on a variety of a.s.sets to make money from global economic trends. He made leveraged leveraged bets on these trends, and for that to work, he had to be on the right side of the trend. bets on these trends, and for that to work, he had to be on the right side of the trend.

Initially, the ABS Peloton fund took short positions in subprime mortgage backed securities making huge bets against the U.S. housing market as John Paulson had done very successfully. Since the prices of those securities plummeted in 2007, the short position had huge gains. But what would Peloton do for an encore? There had to be another big trade. If only Peloton Partners could pedal to where there was luck-there must be more money! After all, spread relations.h.i.+ps for AAA and AA rated products looked out of line with historical relations.h.i.+ps. The spread curve After all, spread relations.h.i.+ps for AAA and AA rated products looked out of line with historical relations.h.i.+ps. The spread curve should should revert back to historical levels, according to the market timer's nursery rhyme. So the fund also bet that the "highly rated" mortgage securities trading at more than 90 cents on the dollar would be protected by subordinated investors eventually paying back all of the princ.i.p.al, and he went long these a.s.sets. Like market timers before them, Peloton Partners ended up with speculator's results. A fundamental a.n.a.lysis of the type Graham had advocated suggested that those "highly rated" products were revert back to historical levels, according to the market timer's nursery rhyme. So the fund also bet that the "highly rated" mortgage securities trading at more than 90 cents on the dollar would be protected by subordinated investors eventually paying back all of the princ.i.p.al, and he went long these a.s.sets. Like market timers before them, Peloton Partners ended up with speculator's results. A fundamental a.n.a.lysis of the type Graham had advocated suggested that those "highly rated" products were overpriced overpriced and and overrated. overrated. The prices were not going to revert back to "historical" levels; the prices would drop to reflect a lower fair value based on imperfect (but highly negative) loan performance data combined with the illiquidity that uncertainty about one's imperfect data brings. This is a market timer's worst-case scenario. Peloton Partners lost $17 billion in "a matter of days." The prices were not going to revert back to "historical" levels; the prices would drop to reflect a lower fair value based on imperfect (but highly negative) loan performance data combined with the illiquidity that uncertainty about one's imperfect data brings. This is a market timer's worst-case scenario. Peloton Partners lost $17 billion in "a matter of days."7 The Peloton ABS fund used credit derivatives (it sold protection) to go long $6 billion of exposure to two ABX indexes (the 2006 AAA and 2006 AA rated ABX indexes). In all, it was long $15 billion on various mortgage-backed a.s.sets and only partially hedged with short positions. Peloton was said to have leveraged up four or five times, "normal for a credit fund."8 Leverage "averages" are misleading when the a.s.sets themselves are inherently very risky (mispriced in the opposite direction to your trade). When the price of the "highly rated" 2006 ABX indexes continued to drop, Peloton's 14 lenders, including UBS, Goldman and Lehman, asked the fund to come up with more money to top up its cash cus.h.i.+on. Peloton's ABX positions headed around Dead Man's Curve and the fund skidded off the edge of the cliff. Leverage "averages" are misleading when the a.s.sets themselves are inherently very risky (mispriced in the opposite direction to your trade). When the price of the "highly rated" 2006 ABX indexes continued to drop, Peloton's 14 lenders, including UBS, Goldman and Lehman, asked the fund to come up with more money to top up its cash cus.h.i.+on. Peloton's ABX positions headed around Dead Man's Curve and the fund skidded off the edge of the cliff.

Since Peloton liked bicycle a.n.a.logies, this simplified one may help explain its problem with leverage. Suppose Peloton's a.s.sets consist of a fleet of uninsured bikes originally worth $1 million purchased with $200,000 of its investors' money and $800,000 of money borrowed from an investment bank. The investment bank says that at all times, Peloton must keep a balance of pledged a.s.sets-any a.s.sets-against the $800 million loan of $1 million in value. The extra $200,000 is margin collateral for the loan, a cus.h.i.+on for the investment bank making it unlikely that the investment bank will lose money. Initially, Peloton pledges the entire $1 million fleet of bikes as collateral for the $800,000 loan with the investment bank. If Peloton damaged 5 percent of its bikes due to rough riding, the a.s.sets would only be worth $950,000, and the bank would ask Peloton for another $50,000 in collateral to maintain the cus.h.i.+on. This is known as a margin call. margin call. If Peloton has enough cash on hand there is no problem. But if Peloton does not have enough cash (or If Peloton has enough cash on hand there is no problem. But if Peloton does not have enough cash (or liquidity) liquidity) to meet the investment bank's demand, it will have to liquidate the a.s.sets-sell the bicycles and to meet the investment bank's demand, it will have to liquidate the a.s.sets-sell the bicycles and unwind unwind the position-to pay back the bank. Since the bikes are worth $950,000, the bank is paid its $800,000 in full, but the original investment of $200,000 is now only worth $150,000 for a 25 percent loss on the investors' original capital.That's the downside of leverage on fixed a.s.sets. the position-to pay back the bank. Since the bikes are worth $950,000, the bank is paid its $800,000 in full, but the original investment of $200,000 is now only worth $150,000 for a 25 percent loss on the investors' original capital.That's the downside of leverage on fixed a.s.sets.

Now suppose that 25 percent of Peloton's bikes round Dead Man's Curve and skid off a steep cliff. One quarter, or $250,000, of the value of the fleet disappears. Peloton loses the investors' entire original $200,000. More than that, if the bank repossesses the fleet and sells it-known as unwinding the position unwinding the position-it will not get back the full amount of the $800,000 since the $200,000 cash cus.h.i.+on the investors provided has been used up.The bank loses $50,000 and only gets back $750,000 of its original $800,000 loan. The investors lose 100 percent of their initial equity; the investors are wiped out. the investors are wiped out. But the investment bank, the creditor, loses 6.25 percent of the original princ.i.p.al on its loan. But the investment bank, the creditor, loses 6.25 percent of the original princ.i.p.al on its loan.

Bear Stearns's shareholders and creditors had Peloton's demise fresh in their minds when, a couple of weeks later, a confluence of events raised questions about Bear Stearns's solvency. If Peloton were an investment bank, shareholders would be wiped out, shareholders would be wiped out, and only the bond-holders and other creditors would recover some (or all) of the original amount of the debt.That is the power of leverage.When things are going your way, everyone is euphoric and gasping with delight. When things do not go your way, shareholders can be wiped out. The results can be dramatic and swift, and instead of gasping with delight, shareholders are gasping for air. and only the bond-holders and other creditors would recover some (or all) of the original amount of the debt.That is the power of leverage.When things are going your way, everyone is euphoric and gasping with delight. When things do not go your way, shareholders can be wiped out. The results can be dramatic and swift, and instead of gasping with delight, shareholders are gasping for air.

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Funds that leverage risky debt a.s.sets without sufficient liquidity are doomed to collapse. Yet, time and again, bankers extended credit lines to funds using fully priced tranches of collateralized debt obligations, turning a blind eye to the unwind potential.

When we first met, Warren explained that he evaluates the underlying collateral: its probability of default and its probable recovery value. He avoids leverage and looks for a risk premium payment to cover potential losses and more. Peloton was about as far away from Warren Buffett's philosophy as one can get.

Peloton's problem with making leveraged bets on fixed-income securities was that they had little or no upside, and the securities underlying the ABX index were overpriced when Peloton put on the trade even though they had already dropped from par to prices ranging from 90 to 95.The downward price swing was due to irreversible damage in the underlying collateral, and unlike a manufacturing company, there is no source of future earnings to make up for the lost cash.9 In January 2008, when Beller accepted his award, Peloton thought it had solid credit lines and thought its $750 million in cash was more than enough liquidity to meet margin calls. It was wrong. On February 25, 2008, the ABX index prices dropped and when Peloton tried to sell a.s.sets to meet margin calls, brokers wouldn't bid. At one point Beller, like the rocking horse winner, "collapsed on a couch in distress."10 On February 28, lenders seized the a.s.sets of the Peloton ABS fund. On February 28, lenders seized the a.s.sets of the Peloton ABS fund.

Beller, Grant, and a third partner had around $117 million11 of their own money plus the previous year's fees invested in the ABS fund; Beller's individual loss is said to be $60 million. Beller may not have learned his lesson. He reportedly believes that the Peloton ABS fund failed because the prices were only of their own money plus the previous year's fees invested in the ABS fund; Beller's individual loss is said to be $60 million. Beller may not have learned his lesson. He reportedly believes that the Peloton ABS fund failed because the prices were only temporarily temporarily depressed when his bankers made margin calls and pulled their credit lines. The reality is that the delinquencies of the loans backing the poorly structured a.s.sets in the home equity indexes ensure prices will not recover to the lofty levels at which Beller put on his trades. Peloton's long positions were partially hedged with short positions in lower quality mortgages. depressed when his bankers made margin calls and pulled their credit lines. The reality is that the delinquencies of the loans backing the poorly structured a.s.sets in the home equity indexes ensure prices will not recover to the lofty levels at which Beller put on his trades. Peloton's long positions were partially hedged with short positions in lower quality mortgages. 12 12 It seemed to me the damage to "higher rated" tranches had yet to be acknowledged by a market that was still in denial. Investors seemed to avoid fundamental a.n.a.lysis at the time Peloton put on its original trades. BlackRock Inc. and Man Group PLC among others also lost money on their investment in the fund. It seemed to me the damage to "higher rated" tranches had yet to be acknowledged by a market that was still in denial. Investors seemed to avoid fundamental a.n.a.lysis at the time Peloton put on its original trades. BlackRock Inc. and Man Group PLC among others also lost money on their investment in the fund.

The $1.6 billion Peloton Multi-strategy fund had contributed $500 million in investor money to launch the Peloton ABS fund. Investors' a.s.sets were frozen and Peloton Partners wound down the fund. It is estimated that within the month of February 2008, investors in the Multi-strategy fund lost half of their capital. Beller and Grant wrote a letter to investors during the last week of February 2008 bemoaning the fact that their creditors had "severely" tightened their terms "without regard to the creditworthiness or track record."13 In early March, a week after the Peloton ABS fund collapsed, Peloton Partners put its offices in London's Soho district on the market. In early March, a week after the Peloton ABS fund collapsed, Peloton Partners put its offices in London's Soho district on the market.

As Benjamin Graham observed, the market is not there to instruct you. The market isn't trying to teach you something when prices rise or fall (or when spreads widen or narrow) relative to where they were historically. You can stuff all of that information into a model (or your head) if you want to, but manipulating market numbers-if that is all you are doing-will not tell you anything about value. It is up to you to a.n.a.lyze the fundamental value and compare it with the market. Peloton Partners was not alone in skimping on fundamental a.n.a.lysis, but Peloton was not as well connected as the Carlyle Group, which had a fund of its own rounding Dead Man's Curve.

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Was.h.i.+ngton-based Carlyle Group is the world's second largest private equity firm, and the most well-connected. As of March 13, 2008, it managed $81 billion in 60 venture capital funds.14 Louis V. Gerstner Jr., former CEO of IBM, chairs the group founded by Dan D'Aniello, William E. Conway, also chairman of United Defense Industries; and David Rubenstein, former policy advisor to former President Jimmy Carter. The Carlyle Group's employees past and present include former President George H. W. Bush; his former Secretary of State James Baker (also President Ronald Reagan's Chief of Staff and later his Secretary of the Treasury); former Carlyle head (until 2003) Frank Carlucci, President Reagan's CIA director and defense secretary; former British Prime Minister John Major, Ken Kresa; former CEO of defense contractor Northrup Grumann; and Louis Giuliano, former CEO to military and oil electronics supplier ITT Industries. One of Carlyle's investors is Shafig bin Laden, one of Osama's many brothers. Shafig was one of the honored guests at a Was.h.i.+ngton-held Carlyle conference on September 11, 2001, the day his brother's Al Qaeda terrorists hijacked U.S. pa.s.senger airliners and piloted them into the Pentagon and the World Trade Center. Louis V. Gerstner Jr., former CEO of IBM, chairs the group founded by Dan D'Aniello, William E. Conway, also chairman of United Defense Industries; and David Rubenstein, former policy advisor to former President Jimmy Carter. The Carlyle Group's employees past and present include former President George H. W. Bush; his former Secretary of State James Baker (also President Ronald Reagan's Chief of Staff and later his Secretary of the Treasury); former Carlyle head (until 2003) Frank Carlucci, President Reagan's CIA director and defense secretary; former British Prime Minister John Major, Ken Kresa; former CEO of defense contractor Northrup Grumann; and Louis Giuliano, former CEO to military and oil electronics supplier ITT Industries. One of Carlyle's investors is Shafig bin Laden, one of Osama's many brothers. Shafig was one of the honored guests at a Was.h.i.+ngton-held Carlyle conference on September 11, 2001, the day his brother's Al Qaeda terrorists hijacked U.S. pa.s.senger airliners and piloted them into the Pentagon and the World Trade Center.1516 Carlyle Capital Corporation Ltd. (Carlyle Capital), one of the funds managed by the Carlyle Group, was troubled since July 2007, the day it launched its initial public offering.The fund was registered in the island of Guernsey in the United Kingdom, run out of New York, and its IPO listed and traded on the Amsterdam Stock Exchange.The IPO was scaled down and delayed due to a nervous market. It ultimately raised $345.5 million, $54.5 million under its initial target of $400 million. Carlyle Capital Corporation ominously chose CCC as its stock ticker. 17 17 Within two months the market would ask whether CCC stood for its stock ticker or a near-default credit rating. Within two months the market would ask whether CCC stood for its stock ticker or a near-default credit rating.

Like the doomed hedge funds managed by BSAM, Carlyle Capital financed its a.s.set purchases with repurchase agreements. It had around $940 million in investor capital backing $22.7 billion in leveraged borrowings. CCC was around 24 times leveraged, meaning that if the price of its a.s.sets dropped 4 percent, the initial investment of its investors would be wiped out if it were forced to liquidate a.s.sets.18 If the price dropped more than that, its creditors, including a number of U.S. investment banks, would also lose money. Given that there were questions about the quality of the mortgage loans backing AAA rated securities, and given the low prices revealed when the BSAM's bid lists circulated, a price drop of more than 4 percent was very likely. If the price dropped more than that, its creditors, including a number of U.S. investment banks, would also lose money. Given that there were questions about the quality of the mortgage loans backing AAA rated securities, and given the low prices revealed when the BSAM's bid lists circulated, a price drop of more than 4 percent was very likely.

By August 2007, the month the Fed indirectly bailed out Countrywide's a.s.set-backed commercial paper, the Carlyle Group provided CCC with a $100 million unsecured revolving credit facility to help meet margin calls. The value of CCC's investments in AAA U.S. government agency residential mortgage-backed securities, declined in value. At the end of February 2008, the Carlyle Group increased its credit line from $100 million to $150 million.19 Carlyle Capital reported a net profit for 2007 of $16.8 million while downward price pressure on its a.s.sets persisted. In early March 2008, CCC received a notice of default for failing to meet a margin call, and it announced that since August it had sold around $1 billion in a.s.sets in an attempt to decrease leverage and increase liquidity. On March 7, 2008, after CCC could not meet additional margin calls, trading in CCC shares was suspended. Carlyle Capital reported a net profit for 2007 of $16.8 million while downward price pressure on its a.s.sets persisted. In early March 2008, CCC received a notice of default for failing to meet a margin call, and it announced that since August it had sold around $1 billion in a.s.sets in an attempt to decrease leverage and increase liquidity. On March 7, 2008, after CCC could not meet additional margin calls, trading in CCC shares was suspended.20 JPMorgan Chase vice chairman James Lee Jr., warned a Carlyle Group founder, David Rubenstein, that unless it could line up a huge capital injection, the funds' collateral would be seized to satisfy its debts. The problem was that the only likely source of capital for the fund was the Carlyle Group itself. JPMorgan Chase was asking the Carlyle Group to bail out its hedge fund the way Bear Stearns had bailed out BSAM's doomed funds. If the Carlyle Group bailed out its fund the way Bear Stearns had bailed out the funds managed by BSAM, it could lose some of its own princ.i.p.al, and losses would probably eclipse its $16.7 million in profits reported for 2007. On the other hand, investment banks seizing collateral would use up much needed liquidity. If investment banks were forced to immediately liquidate Carlyle's billions in a.s.sets, they would take losses and drive market prices down even further. As of March 10, 2008, Carlyle Capital stared down the barrel of around $400 million in margin calls it couldn't meet, and it asked its lenders for a standstill agreement.21 Bear Stearns had its own liquidity problems that week as the market speculated on its exposures. Even the breaking Governor Spitzer pay-to-play s.e.x scandal could not upstage the March 10 Moody's Investors Service's downgrade of tranches of mortgage-backed debt issued by Bear Stearns Alt-A Trust. Bear Stearns was one of Carlyle Capital's creditors and now this. Bear Stearns was one of Carlyle Capital's creditors and now this. Throughout the day of March 10, rumors circulated that Bear Stearns was sinking fast from lack of liquidity and possibly even insolvency. Bear Stearns officially denied it, saying there was "no truth to the rumors of liquidity problems." Throughout the day of March 10, rumors circulated that Bear Stearns was sinking fast from lack of liquidity and possibly even insolvency. Bear Stearns officially denied it, saying there was "no truth to the rumors of liquidity problems."22 In reaction to the market's reaction, Moody's clarified that its ratings actions did not affect Bear Stearns' corporate ratings, which it viewed as stable. The rumors persisted. At the end of the day, Bear Stearns issued a press release quoting Alan Schwartz, then its president and CEO. "Bear Stearns' balance sheet, liquidity and capital," he said,"remain strong."23 On March 11, 2008, Bloomberg News Bloomberg News issued its article suggesting the rating agencies propped up AAA rated subprime residential home equity loan-backed bonds backing the ABX index. According to its a.n.a.lysis of S&P data, issued its article suggesting the rating agencies propped up AAA rated subprime residential home equity loan-backed bonds backing the ABX index. According to its a.n.a.lysis of S&P data, none none of the a.s.sets backing the index merited an AAA rating and it took only a short step for readers to realize that 90 percent of the bonds in the AAA index were not even investment grade. of the a.s.sets backing the index merited an AAA rating and it took only a short step for readers to realize that 90 percent of the bonds in the AAA index were not even investment grade.24 "Peloton," I told an investment banker, "was leveraged and "Peloton," I told an investment banker, "was leveraged and long long an ABX index, so the news suggests the depressed prices may not rebound and investment banks will take losses on those positions. Carlyle's CCC is an ABX index, so the news suggests the depressed prices may not rebound and investment banks will take losses on those positions. Carlyle's CCC is long long AAA agency a.s.sets, and it cannot meet its margin calls. No wonder they want the Carlyle Group to put up more collateral (margin)." AAA agency a.s.sets, and it cannot meet its margin calls. No wonder they want the Carlyle Group to put up more collateral (margin)."

The Carlyle Group was not alone. Anyone Anyone who was long would have to put up more collateral. Was John Paulson correct the previous summer when he hypothesized that, when Bear Stearns appealed to ISDA, it was trying to avoid making billions of dollars in payments on credit default swaps? who was long would have to put up more collateral. Was John Paulson correct the previous summer when he hypothesized that, when Bear Stearns appealed to ISDA, it was trying to avoid making billions of dollars in payments on credit default swaps?25 If so, the If so, the Bloomberg Bloomberg article was devastating news. At a minimum, Bear Stearns would have to come up with more collateral to back those trades and it might eventually have to make payments to cover defaults. article was devastating news. At a minimum, Bear Stearns would have to come up with more collateral to back those trades and it might eventually have to make payments to cover defaults.

The Federal Reserve Bank took unprecedented action that had the effect of being an indirect bailout for the Carlyle Group. It created a new Term Securities Lending Facility (TSLF). Instead of lending overnight it extended the term to 28 days to primary dealers and would accept "federal agency debt, federal agency residential mortgage-backed securities, and nonagency AAA and Aaa rated private label residential MBS." The program would start through weekly auctions beginning March 27, 2008, and the Fed would lend up to $200 billion of Treasury securities in exchange for the collateral.26 How soon can you stuff overrated AAA a.s.sets to the Fed so you don't have to show a loss on your balance sheet? How soon can you stuff overrated AAA a.s.sets to the Fed so you don't have to show a loss on your balance sheet?

Traditionally, the Fed freely provides liquidity to the U.S. banking system's securities arms including: Banc of America Securities LLC, HSBC Securities (USA) Inc., and J. P. Morgan Securities Inc. But the Fed had never before opened securities lending to all primary dealers including some foreign banks, U.S. brokers and investment banks: BNP Paribas Securities Corp, Barclays Capital Inc. Bear, Stearns & Co., Inc., Cantor Fitzgerald & Co., Countrywide Securities Corporation, Credit Suisse Securities (USA) LLC, Daiwa Securities America Inc., Deutsche Bank Securities Inc. Dresdner Kleinwort Wa.s.serstein Securities LLC., Goldman, Sachs & Co., Greenwich Capital Markets, Inc., Lehman Brothers Inc., Merrill Lynch Government Securities Inc., Mizuho Securities USA Inc., Morgan Stanley & Co. Incorporated, and UBS Securities LLC. Although the program would not begin until March 27 for primary dealers, banks should now be more willing to provide back-door financing for them in the meantime.

The Fed was supposed to protect banks banks not not nonbank investment banks and nonbank primary dealers. nonbank investment banks and nonbank primary dealers. Primary dealers included the worst actors in the subprime lending crisis. The Fed not only failed to speak out against the bad guys before or during the crisis, it had just announced it was bailing out some bad guys after-the-fact. Primary dealers included the worst actors in the subprime lending crisis. The Fed not only failed to speak out against the bad guys before or during the crisis, it had just announced it was bailing out some bad guys after-the-fact.

Similar to the terms of its August 2007 bailout of Countrywide's borrowing problems, the Fed would lend up to 28 days. The primary dealers had to pledge securities to secure the loans. The Fed announced it would accept mortgage-related a.s.sets having AAA ratings as well as other a.s.sets with any kind of nominal investment grade rating. The Fed proposed to "haircut," or discount those securities by 5 percent, but that would not be nearly enough to cover potential losses. The only condition was that the a.s.sets could not be on negative credit watch. Given how poorly the ratings agencies had "watched" up until then, it seems that the Fed will take in a.s.sets worth much less than a nominal price of 95 cents on the dollar. The prices on overrated mortgage-backed a.s.sets had proven to be wildly inflated. Did the Fed think no one would notice? In the coming weeks, the Bank of England would launch a bailout of its own and demand five to six times the discount five to six times the discount asked for by the Fed. asked for by the Fed.

I was against the Fed's actions. It was like watching a trailer for the Fed's version of a financial horror movie: 28 Days Later-four weeks after the Fed debases the dollar by exchanging treasuries for trash, the raging virus of inflation infects the planet. 28 Days Later-four weeks after the Fed debases the dollar by exchanging treasuries for trash, the raging virus of inflation infects the planet.

The Carlyle Group was off the hook; only investors in Carlyle Capital's fund would lose money. On March 13, 2008, Carlyle Capital announced the fund's collapse. It had failed to find financing and it had failed to negotiate the standstill agreement it sought. On March 13, 2008, Carlyle Capital announced it defaulted on about $16.6 billion $16.6 billion in loans. in loans.27 The Fed had conveniently provided Carlyle's creditors with a source of liquidity. Now Carlyle Capital's a.s.sets need never come under public scrutiny. Carlyle Capital said its a.s.sets were mostly agency AAA mortgage-backed paper, but the agencies had owned up to having AAA rated subprime-backed RMBS tranches, so what exactly backed Carlyle's investments? Carlyle Capital's $940 million fund went under and its creditors took approximately $22.7 billion in a.s.sets back on their balance sheets. Now they had to fund them (with a little help from the Fed). The Fed had conveniently provided Carlyle's creditors with a source of liquidity. Now Carlyle Capital's a.s.sets need never come under public scrutiny. Carlyle Capital said its a.s.sets were mostly agency AAA mortgage-backed paper, but the agencies had owned up to having AAA rated subprime-backed RMBS tranches, so what exactly backed Carlyle's investments? Carlyle Capital's $940 million fund went under and its creditors took approximately $22.7 billion in a.s.sets back on their balance sheets. Now they had to fund them (with a little help from the Fed).28293031 Some said the Carlyle Group took a hit to its reputation, but others disagree. One banker told me: "This shows how much clout the Carlyle Group really has." Some said the Carlyle Group took a hit to its reputation, but others disagree. One banker told me: "This shows how much clout the Carlyle Group really has."

As for the investors that lost money in the Carlyle Capital fund, David Rubenstein made a cryptic remark: "We will try to make this experience ultimately feel better than it does today."32 I do not recall ever before hearing a fund manager say anything like that to investors that lost money in a fund. I do not recall ever before hearing a fund manager say anything like that to investors that lost money in a fund. Don't worry, we'll make it up to you; we're connected, so you're connected. Don't worry, we'll make it up to you; we're connected, so you're connected.

Carlyle's creditors included Bear Stearns, Merrill Lynch & Co., Deutsche Bank AG, and Citigroup, Inc.33 Bear Stearns could not yet access the Fed's largesse, since the proposed borrowing plan for primary dealers was not yet in effect. One might be tempted to blame market rumors for Bear Stearns's demise, but there were plenty of troublesome facts to infer that anyone with exposure to Bear Stearns should consider reducing that exposure. Bear Stearns could not yet access the Fed's largesse, since the proposed borrowing plan for primary dealers was not yet in effect. One might be tempted to blame market rumors for Bear Stearns's demise, but there were plenty of troublesome facts to infer that anyone with exposure to Bear Stearns should consider reducing that exposure.

Benjamin Graham had warned of new conditions causing a nervous market to stampede, and creditors could infer they had reason to be nervous.

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Neither Moody's affirmation that Bear Stearns' rating was stable, nor the press release issued by Bear Stearns convinced the market that Bear Stearns had enough liquidity. The morning of March 11, Bear Stearns' CFO Sam Molinaro appeared on CNBC to flatly deny that Bear was having liquidity problems. Bear had used up its good will, an important source of Wall Street liquidity in a crisis. Carlyle had not yet announced its March 13 collapse but market watchers wondered: How much exposure did Bear Stearns have to Carlyle Capital? What about the money-losing credit derivatives (long exposure to subprime CDOs) trades that Paulson mentioned the previous year? What about the a.s.sets Bear Stearns took back on balance sheet from the two hedge funds in the summer of 2007-how were they doing? How much exposure did Bear Stearns have to Carlyle Capital? What about the money-losing credit derivatives (long exposure to subprime CDOs) trades that Paulson mentioned the previous year? What about the a.s.sets Bear Stearns took back on balance sheet from the two hedge funds in the summer of 2007-how were they doing? One could infer from publicly available information that these were reasonable questions, but Bear Stearns again created its own PR disaster by failing to antic.i.p.ate these concerns. One could infer from publicly available information that these were reasonable questions, but Bear Stearns again created its own PR disaster by failing to antic.i.p.ate these concerns.

Rumors circulated that highly leveraged Lehman Brothers was also having liquidity problems. Lehman informally denied it, and unlike Bear, Lehman still had many market supporters (Lehman would not declare bankruptcy until six months later).

On March 11, SEC Chairman c.o.x said he was comfortable that Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley had enough capital. Based on what, exactly? Based on what, exactly? "We are reviewing the adequacy of capital at the holding company level on a constant basis, daily in some cases." "We are reviewing the adequacy of capital at the holding company level on a constant basis, daily in some cases."34 This statement gave me no comfort. The SEC's failure to shut down investment banks' financial meth labs (Byzantine CDOs) made it as credible as a rating agency in my eyes. Given that investment banks priced tens of billions of dollars of a.s.sets using only managements' a.s.sumptions, and given their excessive leverage, This statement gave me no comfort. The SEC's failure to shut down investment banks' financial meth labs (Byzantine CDOs) made it as credible as a rating agency in my eyes. Given that investment banks priced tens of billions of dollars of a.s.sets using only managements' a.s.sumptions, and given their excessive leverage, no one no one should have been comfortable. should have been comfortable.

Earlier in the day, rumors spread that Goldman Sachs35 or CSFB or CSFB36 or both had sent an e-mail letter bomb to hedge fund clients saying that it would no longer take fees for intermediating Bear Stearns' derivatives transactions. Up until then, investment banks pocketed cash to stand in the middle of the hedge funds' derivative trades with Bear Stearns. In credit derivatives speak, sending an e-mail like that was as good as saying you expected Bear Stearns to lose its investment grade rating and possibly go bankrupt. Goldman later told or both had sent an e-mail letter bomb to hedge fund clients saying that it would no longer take fees for intermediating Bear Stearns' derivatives transactions. Up until then, investment banks pocketed cash to stand in the middle of the hedge funds' derivative trades with Bear Stearns. In credit derivatives speak, sending an e-mail like that was as good as saying you expected Bear Stearns to lose its investment grade rating and possibly go bankrupt. Goldman later told Fortune Fortune the e-mail did not say it would categorically refuse to sell credit protection on Bear Stearns. the e-mail did not say it would categorically refuse to sell credit protection on Bear Stearns.37 By the end of the day, on Tuesday, March 11, 2008, it seemed the entire credit derivatives market was reluctant to sell credit default protection on Bear Stearns. By the end of the day, on Tuesday, March 11, 2008, it seemed the entire credit derivatives market was reluctant to sell credit default protection on Bear Stearns.

That afternoon, I spoke with Jonathan Wald, CNBC's senior vice president of business news, saying there was a lot of turmoil. I mentioned that it looked as if there would be a large fund failure. I was referring to Carlyle Capital Corporation Ltd., but did not name it (it collapsed two days later). Wald said we might get together for coffee the following day, unless Eliot Spitzer resigned since the s.e.x scandal would cram his schedule. I responded,"In that case, we should schedule it another time." Spitzer was out of options.

On the morning of Wednesday, March 12, 2008, Alan Schwartz, then CEO of Bear Stearns for less than one fiscal quarter, was in Palm Beach, Florida. He gave an early morning interview to CNBC. Schwartz claimed he saw no liquidity pressure on Bear Stearns. He said the holding company had a liquidity cus.h.i.+on of $17 billion in cash, plus there were billions of dollars in cash and unpledged collateral at the subsidiaries. He smiled and I thought he looked relaxed. CNBC was not trying to be funny when, partway through Schwartz's interview, a female commentator broke in to announce that Eliot Spitzer would resign that day.38 Was Schwartz bluffing? It appeared to me he was. He said the previous week had been a "difficult time" in the mortgage market with rumors about problems at the government-sponsored ent.i.ties (Fannie Mae and Freddie Mac), funds (he did not mention Carlyle Capital Corporation by name) invested in "very high quality" mortgage instruments with high leverage that were having problems, and that people might "speculate" that Bear Stearns also had problems since it was a "significant" player in the mortgage market.39 The only part of Schwartz's spin that the market bought was his observation that in tough markets, there is a tendency to "Sell first and ask questions later." The only part of Schwartz's spin that the market bought was his observation that in tough markets, there is a tendency to "Sell first and ask questions later."40 While $17 billion sounds like a large number, if market prices moved down 5 percent-$17 billion and more could disappear faster than a car in Gone in 60 Seconds. Gone in 60 Seconds. For securitized lending, the market now asked for 3 percent more collateral for mortgage-backed bonds issued by Fannie Mae and Freddie Mac (Carlyle Capital-type a.s.sets); and was now asking for 30 percent collateral on Alt-A backed bonds. Jeffrey Rosenberg, head of credit strategy research for Bank of America, said this funding dried up and "that appears to have been Bear's problem." For securitized lending, the market now asked for 3 percent more collateral for mortgage-backed bonds issued by Fannie Mae and Freddie Mac (Carlyle Capital-type a.s.sets); and was now asking for 30 percent collateral on Alt-A backed bonds. Jeffrey Rosenberg, head of credit strategy research for Bank of America, said this funding dried up and "that appears to have been Bear's problem."41 In fact, the Fed's new lending program may have contributed to Bear Stearns's downfall. Banks took Carlyle Capital's a.s.sets knowing the Fed would soon provide liquidity for them, but the program was not yet in place, and Bear Stearns had fewer funding options than other banks.42 As one CEO of a boutique investment bank told me: "Bear Stearns had no friends." The Fed indirectly bailed out Carlyle's creditors-and saved the Carlyle Group from pressure to come up with bailout money-but now As one CEO of a boutique investment bank told me: "Bear Stearns had no friends." The Fed indirectly bailed out Carlyle's creditors-and saved the Carlyle Group from pressure to come up with bailout money-but now Bear Stearns Bear Stearns had a problem. had a problem.

Kevin O'Leary, the managing director of Boston's Tibbar Capital, was in St Bart's with other hedge fund managers. The hedge fund managers did not mess around. O'Leary said they felt Bear Stearns might be forced into bankruptcy, and it was not worth the risk of losing a part of their cash by leaving it tied up in margin accounts at Bear Stearns. They simply pushed the b.u.t.ton and boom boom, billions moved out of their trading accounts and into custodian accounts, so Bear Stearns was no longer able to borrow against these a.s.sets.43 That made quite a dent in Schwartz's cash and unpledged collateral at the subsidiaries. That made quite a dent in Schwartz's cash and unpledged collateral at the subsidiaries.44 The CEO of a small New York investment bank said he was concerned about his clearing account, given that Bear Stearns' sources of liquidity were turning their backs. He explored other alternatives. He was relieved after Jamie Dimon announced his bid for Bear Stearns a few days later and told me: "It doesn't get better than a guarantee from JPMorgan Chase and and the Fed." the Fed."

On Friday March 14, 2008, there was still hope for Bear Stearns; it was not yet dead. The Fed announced a stop-gap loan (Bear Stearns later found out it was only good for a day), but since its lending program was not yet operational, it agreed to accept collateral via JPMorgan Chase. It was odd. If JPMorgan Chase had confidence in Bear Stearns's collateral, it could have accepted the collateral itself (on a recourse basis) and made the loan to Bear Stearns. JPMorgan Chase has access to the Fed and could meet its own liquidity needs there.The announcement made it seem as if JPMorgan Chase did not trust the value of the a.s.sets. The market will price the a.s.sets, but you may not like the price. The market will price the a.s.sets, but you may not like the price.

That day, I discussed this move both Bloomberg Television and Canada's business news network, BNN. The market still questioned the survival of Bear Stearns, but Lehman Brothers was able to get financing. There seemed to be a view that "a firm is only as solvent as people think it is." I pointed out that is not true. If you are liquid, solvent, have a positive cash flow and you have no leverage-you do not have to borrow money-and it does not matter what the market thinks about you. If you are liquid, solvent, have a positive cash flow and you have no leverage-you do not have to borrow money-and it does not matter what the market thinks about you.

If you are solvent solvent but not liquid (you need cash but the value of your a.s.sets make you more than good for it) and you can but not liquid (you need cash but the value of your a.s.sets make you more than good for it) and you can prove prove you are solvent, you tend to get the you are solvent, you tend to get the liquidity, liquidity, since people will lend you money. But if you are highly leveraged, it only takes a small negative change in the perception of the value of your collateral for you to be in trouble. since people will lend you money. But if you are highly leveraged, it only takes a small negative change in the perception of the value of your collateral for you to be in trouble.

The investment banks were playing a very dangerous game, and they were losing that game. They could not prove they were solvent (if they were). No one trusted their own pricing, and there was no transparency.

If no one can figure out if an investment bank is solvent, short-term financing disappears. In fact, the investment bank itself may not know whether or not it is solvent. In fact, the investment bank itself may not know whether or not it is solvent.

If you lend a brother-in-law $100,000 for the down payment on a $1 million home, and the price of the home goes to $1.1 million, you might be willing to give him a short-term loan of $1,000 knowing he's temporarily short of cash, but he's good for it. If you know, however, that the price of all of the homes in his neighborhood are down to $900,000, you know he will be lucky to pay you any of the money you originally lent him.You might say no to an additional short-term loan of $1,000.

Warren Buffett and Charlie Munger avoid leverage so that they are not at the mercy of the manic depressive Mr. Market. By supplying investment banks with liquidity, the Fed introduced huge moral hazard. The Fed rewarded those who brought down the housing market.

I told Bloomberg Bloomberg: The $200 billion lending program "is really bad for the dollar; the Fed is now practicing junk economics."The Fed agreed to accept ersatz AAA rated paper in exchange for treasuries, and the rating agencies now had further incentive not to downgrade these securities. The problem is lack of trust in the underlying collateral. The problem goes right back to the mortgage market and leveraged corporate loans on investment banks' balance sheets. The Fed swept the problem under the rug by taking the collateral. "This is a bailout of the rich . . . You are worried about recession? You should be terrified about inflation. You should be terrified about inflation. Inflation is the great destroyer" The Fed is Inflation is the great destroyer" The Fed is counterfeiting counterfeiting dollars, but we call it debasing the currency because the Fed is behind it instead of gangsters. dollars, but we call it debasing the currency because the Fed is behind it instead of gangsters.45 Bruce Foerster, president of South Beach Capital Markets, told Bloomberg Television that the publicly traded large investment banks and commercial banks are a "national a.s.set."46 A commodity trader in Chicago heard Foerster's comments "Bear Stearns," he said, ". . . a 'national a.s.set' A commodity trader in Chicago heard Foerster's comments "Bear Stearns," he said, ". . . a 'national a.s.set' Gag Gag!"

I observed that large investment banks had failed before; for example, Drexel Burnham Lambert went bankrupt in the 1980s. In the 1990s GE made a quick sale of its troubled Kidder Peabody holdings to Paine Webber. Let it happen. Jim Rogers, head of Rogers Holdings, a.s.serts that a bear market cleans out the system, and it is good for capitalism and the markets. Bear Stearns was the fifth largest investment bank in the United States. If you believe the Fed's excuse that the whole system is so fragile that will fall apart if Bear Stearns goes under, what happens when one of the larger larger investment banks goes under? The Federal Reserve is using up its balance sheet. It will have no weapons in its a.r.s.enal for the next time. investment banks goes under? The Federal Reserve is using up its balance sheet. It will have no weapons in its a.r.s.enal for the next time.47 By the weekend, Bear Stearns was looking for a rescuer. Warren Buffett turned down a request to lead the rescue. He could not evaluate Bear Stearns in one weekend, and he didn't have enough capital.48 Alan Schwartz later told Jamie Dimon that Bear Stearns directors wanted a double-digit bid because there was a "psychological limit." Alan Schwartz later told Jamie Dimon that Bear Stearns directors wanted a double-digit bid because there was a "psychological limit."49 Warren studied under Graham, who would probably advise that emotional directors should not set a stock price any more than the emotional Mr. Market should set the price at which an investor buys or sells. A low price does not mean a company is trading at fair value, and Warren studied under Graham, who would probably advise that emotional directors should not set a stock price any more than the emotional Mr. Market should set the price at which an investor buys or sells. A low price does not mean a company is trading at fair value, and not even Warren Buffett can come up with a value on these hard-to-price a.s.sets in that period of time. not even Warren Buffett can come up with a value on these hard-to-price a.s.sets in that period of time.

JPMorgan Chase bought Bear Stearns with some a.s.sistance from the Federal Reserve. Now JPMorgan Chase has to decode Bear Stearns's $400 billionish balance sheet including mortgage backed securities valued at $56 billion.50 No matter how one spins this, JPMorgan Chase bought a pig in a poke, and it is not in the interest of the health of the financial system for banks to be forced to operate that way. No matter how one spins this, JPMorgan Chase bought a pig in a poke, and it is not in the interest of the health of the financial system for banks to be forced to operate that way.

Since Bear Stearns was so highly leveraged, the stock was probably worth zero, and it was unclear if all of the creditors of Bear Stearns would be paid in full. Those who later talked about the "value" of the Bear Stearn's headquarters building may not have realized that in bankruptcy, sales of all of Bear Stearns's a.s.sets-including the building-might not have covered its debts. Creditors would probably have had to write off bad debts, and there would be nothing leftover for shareholders. Even if every Bear Stearns investment banker hocked their jewelry and watches, it probably wouldn't be enough.That is the nature of leverage.

It would have looked bad if Jamie Dimon bid, say a penny a penny or a dollar for Bear Stearns's stock, so JPMorgan Chase bid $2. This was still probably $2 too high, but if it wanted to take control, Dimon had to possess the shares. Jamie Dimon told Congress: "We could not and would not have a.s.sumed the substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed. . . . We are acquiring some $360 billion of Bear Stearns a.s.sets and liabilities. The notion that Bear Stearns' riskiest a.s.sets have been placed in the $30 billion Fed facility is simply not true. And if there is ever a loss on the a.s.sets pledged to the Fed, the first $1 billion of that loss will be borne by JPMorgan alone." or a dollar for Bear Stearns's stock, so JPMorgan Chase bid $2. This was still probably $2 too high, but if it wanted to take control, Dimon had to possess the shares. Jamie Dimon told Congress: "We could not and would not have a.s.sumed the substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed. . . . We are acquiring some $360 billion of Bear Stearns a.s.sets and liabilities. The notion that Bear Stearns' riskiest a.s.sets have been placed in the $30 billion Fed facility is simply not true. And if there is ever a loss on the a.s.sets pledged to the Fed, the first $1 billion of that loss will be borne by JPMorgan alone."51 As part of the deal, the Federal Reserve agreed to take $30 billion of Bear Stearns's securities, and JPMorgan Chase put up only $1 billion as security (at 3.3 percent, this is less than the margin the Fed proposed for its lending program). However, if the price of the a.s.sets declined, JPMorgan Chase could walk away. Were the a.s.sets already overvalued? Who knows? As Dimon himself said: "Buying a house is not the same thing as buying a house on fire." As part of the deal, the Federal Reserve agreed to take $30 billion of Bear Stearns's securities, and JPMorgan Chase put up only $1 billion as security (at 3.3 percent, this is less than the margin the Fed proposed for its lending program). However, if the price of the a.s.sets declined, JPMorgan Chase could walk away. Were the a.s.sets already overvalued? Who knows? As Dimon himself said: "Buying a house is not the same thing as buying a house on fire."5253 The Fed did not provide the necessary transparency for anyone on the outside to offer an independent opinion. JPMorgan Chase may have paid $1 billion for the right to put potentially overvalued and deteriorating a.s.sets to the Fed. Within three months the Fed admitted that if it used market prices, JPMorgan Chase's $1 billion would be history and the Fed itself had a loss. The Fed did not provide the necessary transparency for anyone on the outside to offer an independent opinion. JPMorgan Chase may have paid $1 billion for the right to put potentially overvalued and deteriorating a.s.sets to the Fed. Within three months the Fed admitted that if it used market prices, JPMorgan Chase's $1 billion would be history and the Fed itself had a loss.54 The deal temporarily went sideways after JPMorgan Chase discovered it had inadvertently given away a valuable option for free. Buried in the 74-page agreement brokered and partially financed by the Fed was a clause putting JPMorgan on the hook to finance Bear Stearns's trades for a year, whether or not shareholders accepted the deal. In the end, JPMorgan Chase increased its bid from $2 per share to $10 per share (or $2.2 billion-not counting the $1 billion at risk that JPMorgan put up as collateral to the Fed) and the shareholders approved the deal. By the end of May 2008, Bear Stearns was no more.5556 [image]

Was the bailout necessary? It is convenient that supporters cannot prove their case, and I cannot prove mine, either. But I can hypothesize. If Bear Stearns failed, the banking system could have bid on Bear Stearns's derivatives books just as it did when Drexel went under. The system may have purchased cheaper a.s.sets if Bear Stearns had gone bankrupt. While temporarily painful, once the system trusted each other's prices, easier trading might have resumed. I am much more worried about the inflationary consequences of the balooning bailouts.

Was the purchase of Bear Stearns a good idea for JPMorgan Chase? The rushed weekend purchase of a highly leveraged company led to a costly mistake and is the same thing as buying a bag of mystery meat. JPMorgan Chase looked in the bag, and it is still trying to figure out what it is. It seems to me that JPMorgan Chase overpaid, and Jamie Dimon seemed a bit testy afterwards. When Vikram Pandit, Citigroup's CEO, asked a question about long-term guarantees during a conference call, Jamie said:"Stop being such a jerk."57 This is when I first realized that Jamie and I graduated from the same charm school. This is when I first realized that Jamie and I graduated from the same charm school.

When Dimon testified before Congress, he might have used more balanced candor about Bear Stearns. Specifically, it might have been better better for the financial system to let Bear Stearns fail. Within two months JPMorgan revised its estimates of merger-related costs 50 percent upward to $9 billion. Richard "d.i.c.k" Bove of Laden Burg Thalmann & Co. said that Bear Stearns would not add to JPMorgan's profits and Bear "should have gone bankrupt," noting it has a nice office building in Manhattan-"big deal." for the financial system to let Bear Stearns fail. Within two months JPMorgan revised its estimates of merger-related costs 50 percent upward to $9 billion. Richard "d.i.c.k" Bove of Laden Burg Thalmann & Co. said that Bear Stearns would not add to JPMorgan's profits and Bear "should have gone bankrupt," noting it has a nice office building in Manhattan-"big deal."58 On June 16, 2008, JPMorgan stated that Bear Stearns is worth more than the $10 per share it paid.59 But financial firms can trade at single digits during recessions. Salomon Brothers had a saying: "Our a.s.sets ride down the elevator at night," meaning the people that generate the fees, make the trades, and attract the But financial firms can trade at single digits during recessions. Salomon Brothers had a saying: "Our a.s.sets ride down the elevator at night," meaning the people that generate the fees, make the trades, and attract the customers. customers. Bear Stearns lost customers (in addition to employees). Given the opacity of investment banking products, there is no reason to accept JPMorgan's claim at face value. Suppose it were true that Bear Stearns was worth more than $10 per share (and I can fly).That is all the more reason the Fed should not bail out an investment bank. In bankruptcy, everyone has a chance to bid on the a.s.sets and the net result may net shareholders more. Bear Stearns lost customers (in addition to employees). Given the opacity of investment banking products, there is no reason to accept JPMorgan's claim at face value. Suppose it were true that Bear Stearns was worth more than $10 per share (and I can fly).That is all the more reason the Fed should not bail out an investment bank. In bankruptcy, everyone has a chance to bid on the a.s.sets and the net result may net shareholders more.

If, however, Bear Stearns' stock was worth zero, it still doesn't make sense to bail it out. Bear Stearns would go into bankruptcy and JPMorgan Chase could have cherry picked the a.s.sets and paid less. If Dimon were after Bear Stearns' employees, they would have been ripe for hire.

I find my theories more plausible than the Apocalypse Now Apocalypse Now story the Fed told to Congress, but now we will never know. story the Fed told to Congress, but now we will never know.

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Was Warren Buffett even tempted by Bear Stearns? I do not know for certain, but I have a point of view. On September 27, 2007, BusinessWeek's BusinessWeek's Matt Goldstein asked me if I had seen a Matt Goldstein asked me if I had seen a New York Times New York Times article suggesting that Warren Buffett was considering the purchase of a stake in Bear Stearns. The original article stated that "Mr. Buffett did not return telephone calls seeking a comment." article suggesting that Warren Buffett was considering the purchase of a stake in Bear Stearns. The original article stated that "Mr. Buffett did not return telephone calls seeking a comment."60 It did not surprise me; It did not surprise me; it is hard to talk and laugh at the same time. it is hard to talk and laugh at the same time. Goldstein was not suggesting I had a particular reason to know, it was just that everyone was talking about it. Many news outlets picked up the viral rumor and CNBC aired at least five segments that day on the rumor that Buffett was a potential buyer. Goldstein was not suggesting I had a particular reason to know, it was just that everyone was talking about it. Many news outlets picked up the viral rumor and CNBC aired at least five segments that day on the rumor that Buffett was a potential buyer.61 I told Goldstein that I had no way of k