Managers of Failed Bear Hedge Funds May Face Criminal Indictments (And Why Not Bear?)

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.

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  1. Steve

    I assume Cayne’s withered hand wouldn’t sign the JPM deal without a sub rosa guarantee from the SEC and Justice about his future, and Dimond wouldn’t sign without assurances that the firm would escape indictment. Cioffi will probably be indicted for marketing his funds to unqualified investors after the Everquest IPO was withdrawn, but whatever happens to him I expect his defense will introduce information that SEC, Treasury and the Fed would prefer to keep under wraps. These indictments reek of selective enforcement.

  2. Yves Smith


    Ah, I had forgotten about Everquest, good point, but again, Cioffi didn’t go out and do this like a cowboy. As I am sure you know, you can’t go off and do an offering without going through certain hoops (oh, and using whoever the firm’s designated counsel is for the offering documents). The idea that he would be held personally liable (worse, criminally liable) for actions done in accordance with firm procedures is just wild.

    Now I’m not saying there might not be good reason to move to that standard, just as CEOs and CFOs are now held accountable for the accuracy of financial statements, But you can’t impose that sort of standard retroactively.

    Or maybe (hey hey) the Brooklyn attorney’s office is after bigger fish and will use Cioffi and Tannin to go after Bear, just as they use lower level Mafiosi to bring down the bigger ones. The Brooklyn DA’s office has no particular loyalty to the securities industry.

  3. Richard Kline

    So Yves, I think and hope that you’ve hit the nerve in the last paragraph of your comment, that this is an Enron situation where the appendage caught in the crack is squeezed to get _testimony on record_ about who and how the Cioffi et. al. reported upchannel to BSC. The case against Bear might be weak unless somebody turns songbird, but there has to be an indictment to ‘enliven the memory’ of the little peckers. No agreement at the top involving Cayne, Dimon, and the Fed can get those who lost money in BSC’s captive hedges to shut up, and the prosecutors may have to keep after this whether they like it or not. Now, if Dimon and JPM _pay the complainants to go away_, then perhaps all this will be dropped; I guess Jamie D. isn’t paying enough until an indictment got handed up: now, he and the counterparties know how to price the deal. : )

  4. Anonymous

    You have to wonder whether an Obama or McCain administration will be more vigorous in going after malfeasance on Wall Street. It may be that it would be a McCain administration since he is certainly less bourgeois than Obama.

  5. Anonymous

    In a string of collusion, there are many players that should be in prison and I see no reason to stop with Bernanke and Paulson in playing God bailing out these crooks that broke the law; in for a penny in for a pound! Let them all hang! There was no way that The Fed should have stepped in to help those criminals evade justice…

  6. Lune


    I hope you’re right, and that this is just a play to start building the case against the bigger fish. That was my first take as well. After all, I bet they’ll be able to find numerous relatively minor SEC infractions in the way that some of these funds were marketed, and if they can use that pressure to establish a trail of communication and coordination with the higher-ups who were desperately trying to wall of their hedge funds from the rest of their enterprise, then the door will be wide open.

    That said, I won’t get my hopes up. Enron is one matter. They only had the President and VP in their pocket. Wall St has just about the entire financial regulatory apparatus licking its boots.

  7. Anonymous

    At issue is whether the Federal Reserve intentionally misled investors by presenting a rosy picture of the economy 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….

    Early on in the meltdown of the firms, the Federal Reserve had tried to take the position that they were independent entities and therefore could sink or swim on their own. The Federal Reserve was forced to relent, and my view at the time was that it was due to the rest of world 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 the Federal Reserve be as sponsor of the firms?).

  8. Anonymous

    Brooklyn DA are state prosecutors and have nothing to do with the potential indictments. These indictments are being handled by the US Attorney’s Eastern District office (located in Brooklyn). Since the Justice Dept under Bush has been turned into a cesspool of politics it is certainly plausible that Bush and the Treasury have leaned on them to ensure the selective enforcement that some in the comments above allege may take place.

  9. Yves Smith

    Apologies for the slip in nomenclature. I recognize this is not a state law matter.

    But having said that, Cioffi seems a very weird choice for selective enforcement for the reasons raised earlier.

  10. Ken Houghton

    Never forget Everquest, especially if you’re looking for criminal activities.

    Cioffi (1) started the fund, (2) ran the fund, and (3) pulled his own monies out of it at the same time he kept others from doing so.

    If you’re looking for an individual indictment, that’s the lowest-hanging fruit you can find.

  11. Anonymous

    Rough analysis: You and 999 others purchased homes appraised at $160,000 and took out mortgages with a broker/bank promising to pay $150,000. The broker/bank sold your mortgage and the 999 similar mortgages to Bear Stearns (or F-Mae, or F-Mac, or Indymac, or …).

    BS put the 1000 mortgages in the “High-Grade Structured Credit Strategies Enhanced Fund“ with a face value of $150 million with a 6% return.

    BS sold 150 million shares in its fund, face valued at $1.00 per share, to investors for, say, $1.20/share with an annual return for investors of 4.5%.

    (Aside: June 19, 2008: two BS fund managers, Ralph Cioffi, 52, and Matthew Tannin, 46, were arrested by FBI agents at their homes in Tenafly, New Jersey and Manhattan, and charged with nine counts of securities, mail, and wire fraud.)

    Investors paid $180 million for all the shares in the BS fund. BS pocketed $30 million profit and hoped to pocket the interest differential on the fund‘s face value.

    It turned out that lenders over-appraised houses and exaggerated borrowers’ ability to pay in order to facilitate loans. If a professional banker tells me my home is worth $160,000 and that I can afford the payments, who am I to argue?

    Along came JP Morgan Chase. Egged on by the federal government, JPM Chase bought what remained of BS, including the mortgage fund, for 10 cents on the dollar.

    JPM, having purchased BS’s assets, owns your mortgage for which it paid 10 cents on the dollar or $15,000. But, you and the other 999 borrowers each still owe $150,000.

    Financial experts (who have a large stake in keeping us befuddled) explain that JPM Chase took on a big risk and many of the mortgages in the fund may go to foreclosure. They say that the fund JPM bought from BS may only be worth 10 cents on the dollar. So, to insure that the entire fund does not go belly up, everyone must pay their original mortgages.

    This, of course, is bunk. Assume 50% of the mortgages in the fund go to foreclosure. This is wildly improbable given the current rate of foreclosures, but we’ll argue from JPM’s point of view to be conservative. The remaining 50%, the “good” mortgages in the fund, are still worth $75 million which is $55 million more than JPM paid for the entire fund. And, JPM still owns the 500 houses on which they will foreclose.

    Again, assume worst case that the foreclosed on houses are worth only half their original appraised value; one-half of $160,000 equals $80,000. JPM sells the 500 foreclosure homes at fire sale prices and pockets an additional $40 million.

    So, even in the face of a financial cataclysm, JPM obtains $115 million in exchange for its $20 million investment. Every person from the original mortgage broker/banker, managers at BS, and managers at JPM has pocketed huge bundles of money. You, on the other hand, remain fully on the hook for your mortgage obligation.

    If JPM said to all 1000 homeowners, “Pay us principle only on your mortgage”, quite possibly none of the 1000 would default. In that case, the homeowner still has a place to live and JPM pulls in $150 million. Not a bad return on a $20 million investment.

    But, giving homeowners a break, even though JPM would still make $130 million, would set an ugly precedent. We can “forgive” or write-off the bad debts of institutions because of market risk, but we will never forgive even a portion of a consumer’s debt.

    Homeowners’ tax money will bail out some of these institutions, their taxes will go up because corporate taxes went down or were refunded, thousands of financial con men made large money off the mortgages, some financial managers may go to jail for fraud, and your home remains at risk for foreclosure. Is this a scam?

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