Bears Behaving Badly

A Primer on How Bears Stalk Their Prey

In 2003, all was well in the forest. The markets were strong. There was a housing boom. There were lots and lots of picnic baskets. But some Bears wanted more. Not happy with their lot in the forest, these Bears set up a fund to take advantage of the booming US housing market. They called it the Bear Stearns High-Grade Structured Credit Strategies (Overseas) Ltd. (High Grade Overseas Fund). Now these were highly regarded Bears of great skill and industry, and they used their sterling reputation to convince investors that this new fund would be both incredibly safe and incredibly lucrative. Its targeted credit quality was 90% AAA and AA-. the safest tranches of Collateralized Debt Obligations (CDOs). Now, I don't know about you, but if a bear tells me that he's creating a new fund that invests in only the safest tranches of CDOs, then I'm probably on board. After all, this Bear must be pretty remarkable. Most Bears can't even read, let alone create new investment vehicles. Other people must have felt similarly. They sank more than $1 billion into the High Grade Overseas Fund.

Unfortunately, the Bears who ran this fund assembled and leveraged tranches of CDOs in such a fashion that unreasonably magnified their aggregate exposure to risky components of those tranches and structured investments in such a way that their aggregate embedded leverage – sometimes 30x - far exceeded what was disclosed to investors. These tranches, while individually favorably rated at AAA to AA-, were assembled in such a way that dramatically increased risk. Fast forward to 2006, and the Bears found themselves in trouble. Investor confidence was plumetting. Everyone knew the market was headed for a correction, possibly a recession. Meanwhile, these Bears had a dramatically overvalued fund, and could not risk a slew of investor redemptions, which would have exposed the funds true lack of liquidity. So what did they do? They created ANOTHER fund. Only this time, it was the High Grade Enhanced Overseas fund. This fund was safer. This fund could weather the market downturn. This fund was new and improved. This fund was... yes.. . enhanced! The ostensible goal: get investors to convert from the original Overseas Fund to the Enhanced Fund. And my. how the money did flow. Another $500 million. Clever Bears. They were still afloat.

These Bears were crafty. They had complete control over the reported Net Asset Value of the Overseas Funds, which were perceived by investors as never having a losing quarter from inception until the summer of 2007. What happened in the summer of 2007, you ask? Read on.

As there was no public market price for a portion of the Overseas Funds’ assets, the investment manager would generally value the Funds’ assets himself. This process is necessarily subjective, but should have involved numerous safeguards, including: a variety of rigorous computer models; communication with brokers and third parties who have had actual instances of buying or selling like securities; and periodical reevaluations of the firm’s model to reflect changing market conditions. But you know Bears. They sometimes behave badly and disregard fiduciary duties. Well, these were some bad Bears. They marked the price at whatever they saw fit. Their models never accounted for dramatic - and negative - changes in CDO values worldwide during late 2006 and early 2007. On paper, the Overseas Funds were booming. On paper, these Bears assured investors that the Overseas Funds only contained 6.1% of sub-prime mortgage investments. In reality, the Bears were losing money faster than they could count it. In reality, embedded sub-prime exposure was dramatically higher than the percentage reported.

Now some people might say, "Trusting a Bear? Are you crazy?" These Bears anticipated such a reaction. So they hired an accounting firm, Deloitte & Touche. And what did Deloitte say? They said - to paraphrase - "Calm down everyone. I know these Bears. They're good Bears. They run a clean operation. We've given them clean audit opinions. Nothing to fear here. Not from such well-respected Bears." And on the saga went. With Deloitte assuring investors of the veracity of its fiscal reporting methods, these Bears were able to stay in business. But I think the Bears were worried. They knew someone - perhaps that forest ranger who was always chasing Yogi - was on their trail. They panicked.

The Bears started using the Overseas Funds as dumping grounds for some of the most toxic investments on the Bear books. The Tahoma Squared CDO offering, for example. Very risky business. But the Asset Management Bears saw dollar signs. They had arranged and managed the CDO. They might as well collect one set of fees there... then sell that debt to.. you guessed it... the Enhanced Overseas Fund! From February 2007 through May 2007, the Bears caused the Overseas Funds to purchase some incredibly risky debt. The Bears are managing a risky offering and can't find a buyer.... they can just sell it to the Funds!

But Bear misconduct leaves big footprints. So what do Bears do when they think they're about to get in big, big trouble? They form a new spin-off that - on the surface - seems like it has nothing to do with any of the Bears. And they call that spin-off Everquest Financial, Ltd. And they sell Everquest all that crappy debt they had previously dumped into the Overseas Funds. And Everquest says, to paraphrase, "Thank you! You are such generous Bears! Yes, please! Sell us more of those super risky sub-prime tranches of CDOs. Oh, you generous Bears! Here, have a 16-million share stake in our company and $148 million." Wait a second! The manager of the Overseas Funds - Mr. Ralph Cioffi - was also the co-CEO of Everquest! Oh my! Was he having this conversation with himself, doing one character in his Bear voice and another character in his Everquest voice? And, if so, what does an Everquest even sound like? Apparently, according to the leading scholars on Everquests, an Everquest sounds... you guessed it... EXACTLY LIKE A BEAR! Oh bother.

I'm sure you can all guess what happened next. Everyone in the forest, including BusinessWeek, started asking some tough questions about this ursine scheme. What was Everquest? It was just a bunch of Bears engaged in a pathetic attempt to cover-up their misconduct. Weren't there clear conflicts of interest everywhere? This smelled like fraud. This looked like breach of fiduciary duty. And whatever happened to all the picnic baskets!??!? As the scandal blew up, the Bears kept talking. If you back any Bear into a corner, and he feels too weak to bite off your head or punch you in the face, he'll probably start talking real fast. He'll probably say things like.. "Who could have ever expected such a calamity! Oh, this is a disaster! Oh, we'll fire some Bears and make it all ok. We're good Bears, really. We'll get rid of the bad Bears who did this! Oh no, that previously reported 1% loss for April 2007.. well.. there have been some slight revisions... it's really a 6% loss... no.. check that... ummm... 10%... no... no.. wait... 19%. Nothing left to see here folks. We're finished. We're just going to get a court-ordered liquidation down in the Cayman Islands.... and since we have a bunch of Bears and Bear friends on the Bear Board.. we can basically do whatever we want...."

And then, the big bad Bears got sued by the Funds' newly appointed liquidators, who are represented by those Bear-hating lawyers at Reed Smith. But apparently, these aren't just your average Bears. They have some friends with deep pockets who appear willing to bail them out, indemnify them, and shoulder the cost of what will no doubt be some very ugly litigation. At last check, the public are up in arms about the prospect of having these dangerous Bears in the federal court in Manhattan. And I, for one, can't blame them. These are some bad news Bears, and if I were a judge, I sure as hell wouldn't want them in my courtroom.

- Jonathan Pollard

Jonathan Pollard also writes for the Hedge Fund Law Report. To subscribe to the HFLR, please email editor@hflawreport.com.