Cioffi's Hero-to-Villain Hedge Funds Masked Bear Peril in CDOs
By Yalman Onaran and Jody Shenn
July 3 (Bloomberg) -- The two hedge funds that Ralph Cioffi managed were so hot that some investors had to call a friend at his firm, Bear Stearns Cos., to get his attention. Cioffi's employer and associates, dazzled by 40 consecutive months without a loss for one of the funds, invested at least $35 million of their own money with him.
Cioffi was so successful that colleagues insisted that his eight-figure compensation placed him among the highest-paid employees in 2006. Bear Stearns officials and Cioffi declined to comment.
Now everyone from the cigar-smoking Chief Executive Officer James ``Jimmy'' Cayne to the hundreds of institutions advised by Bear Stearns are staggered by the opposite bets Cioffi made on mortgage-backed bonds and collateralized debt obligations, or CDOs, that unraveled his funds during the last two weeks of June.
For the 51-year-old Cioffi, a quiet boy raised in a Vermont town 310 miles (500 kilometers) from the Madison Avenue headquarters of the fifth-largest securities firm, ``it takes one mistake to change your image,'' said Ryan Foster, a fixed- income fund manager at New York-based AllianceBernstein Holding LP.
Cioffi, whose reputation now depends on his ability to complete the $1.6 billion bailout of his High Grade Structured Credit Strategies Fund, is ``known as a very respectable investment manager, as someone who knows what he's doing,'' said Foster, responsible for $19 billion invested with AllianceBernstein, the third-largest publicly traded asset manager in the U.S.
Prices Nosedive
There's a lot more at stake than the career of another careening star on Wall Street or the Bear Stearns share price, which is down 12 percent this year and underperforming its peers in the securities industry and the Standard & Poor's 500 Index.
Bear Stearns is among the Wall Street firms that benefited from burgeoning sales of CDOs -- which repackage bonds, loans and other assets into new securities. CDO sales reached $503 billion last year, a fivefold increase in three years.
Prices of CDOs backed by subprime mortgage bonds nosedived as defaults by the least creditworthy borrowers surged in 2007. Bankers call the bottom sections of a CDO, the ones most vulnerable to losses from bad debt, the equity tranches. They also refer to them as toxic waste because as more borrowers default on loans, these investments would be the first to take losses, according to an exclusive 2,360-word report published June 1 by Bloomberg News.
The fallout from errant trading of CDOs is a growing concern for hedge funds, or private pools of capital that allow managers to participate substantially in the gains of the money invested, like Cioffi's, as well as for pension funds, such as the California Public Employees' Retirement System, that have invested in CDOs, seeking higher returns. Although Cioffi had mainly invested in the top tranches of the CDOs, his funds weren't spared from the market's tailspin.
Fit the Mold
Founded in 1923, Bear Stearns is known on Wall Street as a conservative firm that doesn't take unnecessary risks. It is run by the 73-year-old Cayne, a champion on the U.S. national bridge team. The firm is so tightly knit that few of the 15,120 employees defect; it favors smart, hard workers, no matter what college they attended.
Cayne, in an interview with the New York Times published June 29, said Bear Stearns suffered a ``body blow of massive proportion'' and that he was angry that the firm's reputation had been ``trashed.'' He also said his own reputation had been damaged and that he didn't plan to step down, the newspaper reported.
Cioffi, who was born on Jan. 5, 1956, and who grew up in South Burlington, Vermont, a city of 16,500 that borders Lake Champlain, fit the Bear Stearns mold. He went to Rice Memorial High School and St. Michael's College, both Catholic schools, three miles down the road from each other in the neighboring towns of South Burlington and Colchester.
Bodybuilding
He was a running back, fullback and offensive guard on the Rice football team and worked at bodybuilding at St. Michael's. To high school friends and a college professor, Cioffi was quiet, not very outspoken, and a very good student. He was an A student in math and economics in high school, a Rice official said. At St. Michael's, Cioffi studied business administration and graduated with honors in 1978.
Daryl Meunier, his football teammate for four years, said Cioffi didn't hang out with the partying crowd, took part in few extra-curricular activities and got along with everyone.
``A fun and personable fellow who seemed upbeat and happy most of the time,'' said Meunier, who now works for International Business Machines Corp.
`Honest' and `Capable'
Marc vanderHeyden is the president of St. Michael's, a liberal arts school with 2,000 undergraduates, and has met Cioffi numerous times in New York and South Burlington for fundraising efforts. He said that while ``family is everything'' for Cioffi, he works ``25 hours a day'' and is aware of the small amount of time he spends with his wife and four children at their home in suburban New Jersey.
Cioffi won close relationships with some of the largest institutional investors, like big pension funds, ``because he's such an honest and capable person,'' said Thomas Pearce, who worked with Cioffi at Bear Stearns for more than 11 years.
``This is a guy who goes out of his way to help people,'' said Pearce, now managing partner at Vertical Capital LLC, a New York-based asset manager overseeing $13 billion. ``He's not some Wall Street hedge fund guy who is full of himself. This is a guy who's a family man, a good father, with lots of integrity, and you can't find people inside or outside of the business who disliked him.'' He declined to discuss Cioffi's funds.
Cioffi joined Bear Stearns in 1985, selling so-called structured products such as bonds backed by mortgages or other loans. His career would also take him outside Bear Stearns's specialty of home-loan assets and into securities linked to company credit.
Structured Finance
He was a pioneer in several areas of structured finance, one of Wall Street's fastest-growing businesses over the past decade, and was responsible for the first offerings of several complex financial products used widely today. One example: principal protected notes, which are mostly backed by mortgages or corporate debt and also make use of non-risky assets to guarantee that investors will get at least their principal back.
Before transferring to the asset management side in 2003, Cioffi was the head of structured credit products. The first fund he started was the High Grade Structured Credit Strategies Fund, which earned investors 46.8 percent between October 2003 and March 2007, according to documents sent to investors.
Cioffi established a second fund, the High Grade Structured Credit Strategies Enhanced Leverage Fund, in August 2006 because of demand from investors who couldn't get into his first fund.
Borrowing
The enhanced fund returned about 7 percent in its first six months and then started losing money in February 2007. By June, the fund was down more than 20 percent this year, and Cioffi's first fund had fallen by about half that amount.
The losses wouldn't have been so bad except that Cioffi's investment strategy included liberal use of leverage, or borrowed money, that could be pulled.
Cioffi, who knew such investments well, was bearish on mortgages to borrowers with bad credit or high debt amid a surge in defaults, according to a person familiar with his investment strategy. While his funds had mostly bought high-rated home-loan bonds and high-rated pieces of CDOs, at some point this year they also started to use so-called ABX contracts to bet on defaults of low-rated pieces of subprime bonds.
Such strategies aren't unusual among risk takers looking to exploit cracks in the proficiencies of rating firms or other investors. In part, Cioffi blames the actions of Wall Street firms and other CDO underwriters for at least a temporary derailing of his tactics, according to the person familiar with his work, who spoke on condition that he not be named.
Dumping CDOs
According to that person:
Cioffi was convinced that the securities firms loaded up on new CDOs in late 2006 and early this year, expecting to sell them later when investor appetite improved. By the spring, after dozens of home lenders failed and the subprime mortgage market imploded, the Wall Street securities firms and other CDO underwriters started dumping collateralized debt, pushing their prices lower.
At the same time, those firms ended derivative bets on defaults of subprime-mortgage bonds used as hedges for the CDO holdings, pushing the values of those contracts also lower. That ruined both sides of Cioffi's trade, at least temporarily. Investors in his funds were upset, and they began asking for their money back.
In mid-June, as lenders to Cioffi's funds pressured him to come up with cash under the threat that they would move to seize fund assets, Cioffi's mood varied hour by hour. Throughout the period, he rarely saw his wife and children, and at times described what he was going through as a ``roller-coast ride,'' the person familiar with his work said.
Snowball Effect
Cioffi insisted he could still protect his reputation as a manager of investors' money, said the person. Yet the widespread media coverage of his funds' problems, which the person said Cioffi considered as often based on false rumors and misunderstandings, wasn't helping.
Now, with Bear Stearns hiring Jeffrey Lane, 65, from Lehman Brothers Holdings Inc. to run its asset-management division and assigning Thomas Marano, 45 and its top mortgage trader, to lead the $1.6 billion bailout, Cioffi may not be able to continue at Bear Stearns.
In a community where you're only as good as your last trade, Cioffi's sudden misfortune won't get a lot of sympathy, said AllianceBernstein's Foster. ``A few bad bets and there you go. This is the name of the game unfortunately.'' |
