naked capitalism

The Wall Street Journal reports that criminal charges against the managers of the failed Bear Stearns hedge funds, Ralph Cioffi and Matthew Tannin, are imminent. The Journal also indicates there are no charges pending against Bear Stearns or any other Bear executives.

Pray tell, why not?

The funds were clearly under the supervision of Bear Stearns; the Journal story reports that Cioffi had to get approval from Bear’s compliance department to move $2 of the $6 million he had invested in the riskier of the two funds he managed into an internal Bear fund. The funds were located in the Bear headquarters building and used Bear’s risk management systems.

Early on in the meltdown of the funds, Bear had tried to take the position that they were independent entities and therefore could sink or swim on their own. Bear was forced to relent, and my view at the time was that it was due to the rest of Wall Street having considerable leverage (literally, the other firms could cut repo lines or take other punitive action) rather that out of a consideration of legal niceties (exactly how responsible should Bear be as sponsor of the funds?).

Had I not read about Cioffi’s little chat with compliance, I could have accepted the view that the funds were independent enough in legal structure and operation as to get Bear off the hook. But that interaction says that Cioffi thought that Bear had oversight of the fund (and if Bear didn’t, the compliance officer should have dismissed the inquiry rather than giving approval). Similarly, the story also indicates the funds were NOT independent, but part of Bear’s asset management operation. These all say the firm had a duty to supervise. Unless it is established that Cioffi and Tannin willfully misled the firm, it ought to be Bear, not these individuals, that is in the dock.

From the Journal:

The former Bear Stearns managers, Ralph Cioffi and Matthew Tannin, managed two high-profile bond portfolios for the securities firm’s asset-management unit. They could be charged with securities fraud within the next week, says one of the people familiar with the matter, though evidence could emerge that would change that.

At issue is whether the managers intentionally misled investors by presenting a rosy picture of the funds at a time when they were privately communicating with colleagues about their worries over how the investment vehicles would ride out weakness in the mortgage market….

But in February 2007, the feverish activity in the subprime-mortgage market began to slow, and securities tied to the mortgages swooned. Still, Mr. Cioffi and a number of his colleagues remained upbeat…

On Feb. 27, 2007, a warning signal came from a closely watched slice of the ABX, an index that tracks subprime-mortgage securities. The indicator slid to a low of 63 from well north of 90 at the beginning of the year…

In March, the ABX recovered some ground. That’s when Mr. Cioffi, who had worked at Bear Stearns for 22 years, sought and received permission from the firm’s compliance officials to move $2 million of the $6 million he personally had invested in the riskier hedge fund into a separate internal fund called Structured Risk Partners…

It is unclear what Mr. Cioffi’s expectations for the mortgage market were at the time. During the investigation, he has said that a shift of that size would have had no material impact on his substantial net worth at the time. He told colleagues that it was an effort to use money gained from his investment in the High-Grade fund to give a boost to a neighboring hedge fund at the firm. To bring charges, prosecutors would have to allege that Messrs. Cioffi and Tannin deliberately misled investors.

In April 2007, Mr. Cioffi exchanged emails with colleagues in which he expressed concerns about the credit markets, and wondered how a downturn might affect his investors, according to people familiar with the matter. In an April 25 call with fund investors, however, he sounded an upbeat note, telling participants he was “cautiously optimistic” about his and Mr. Tannin’s ability to hedge their portfolio.

“The market will stabilize,” Mr. Cioffi said, adding: “We have a plan in place that will get the funds back on track to generate positive returns,” according to a review of the transcript of the call. The two funds had solid financing from lenders, he said, and “significant” cash on hand. It is unclear how much money the funds actually had at the time. Mr. Tannin echoed Mr. Cioffi’s reassurances, counseling investors not to be alarmed by “articles daily about how the world is coming to an end.” He added, “We’re quite comfortable with where we sit.”

The swoon wasn’t reported to investors until early June, partly because of the standard delays in calculating monthly returns. But in May, the fund managers began selling billions of dollars in bonds to raise cash for the struggling funds. As the bad news leaked out, some investor rushed for the exits, demanding that Messrs. Cioffi and Tannin return their money.

But the fund managers didn’t have enough cash handy to repay investors and meet “margin calls” — demands from lenders for additional cash or collateral — so they refused the redemption requests. This created further investor anxiety.

By late June, the riskier fund, which faced unmet margin calls and notices of default, essentially was left to die. To salvage the less-risky High-Grade fund, Bear Stearns officials agreed to lend it as much as $3.2 billion to meet its immediate needs. (Bear Stearns ultimately lent just half that; the loan was never fully repaid.) On July 31, the funds filed for bankruptcy protection in a New York federal court.

Now I may be giving Cioffi far too much credit; it’s quite possible that prosecutors have a damning e-mail or witness recollection of a phone conversation to back their charges.

However, it isn’t just common for traders to hold on to an outdated view when markets undergo a sea change. I first saw this in 1984. I was part of a team tasked to figure out why the biggest Treasury operation in London had gone from money-spinning to loss-making.

The root cause was actually pretty simple, although the remedies were not as obvious. The senior managers, and in particular, the highly regarded, highly connected FX trading desk, had grown up in a weak dollar environment. The dollar had, as a result of Volcker’s tough monetary policies, suddenly become a strong currency. The traders’ reflexes were dead wrong.

Never attribute to malice that which can be explained by incompetence. Although the details may prove otherwise, I find it plausible that Cioffi and Tannin were slow to recognize that subprime was terminal, and Bear did an incompetent job of supervising them. And if that’s the case, it’s Bear, and not the two managers, who should be the focus of the investigation.