Monday, June 16, 2008

Bear Stearns Hedge Fund Managers Face Criminal Charges

After a yearlong investigation, federal prosecutors are preparing to file criminal charges against Ralph Cioffi and Matthew Tannin, managers of two Bear Stearns hedge funds that imploded last year.

Cioffi and Tannin, former Bear Stearns managers, managed two high-profile bond portfolios for the securities firm's asset-management unit. The federal investigation focused on whether the managers deliberately misled investors by telling them the funds will perform well when they were privately telling colleagues that the funds may not survive the volatility in the mortgage market. Cioffi and Tannin could be charged with securities fraud as soon as next week and that indictment would be the first criminal charges against Wall Street executives borne out of the worldwide credit crisis that began last year.

The collapse of the two Bear Stearns hedge funds cost investors $1.6 billion and helped mark the start of the credit crisis. Weeks before the funds' meltdown in June 2007, Cioffi and Tannin were still painting a rosy picture for investors. The funds' implosion raises questions about Bear Stearns' managerial oversight and risk controls. Bear Stearns' large mortgage portfolio and over-reliance on short-term funding also spelled its downfall when clients panicked and pulled their money out, triggering its collapse and a shotgun marriage with J.P. Morgan.

Cioffi and Tannin's funds, the High-Grade Structured Credit Strategies Fund and its riskier sister fund, used large amounts of borrowed cash and securities to invest in pools of bonds backed by low-end sub-prime mortgages. Cioffi, a former mortgage salesman, was highly regarded by investors and investor money poured in when the funds were created in 2006, some of it from sophisticated professional investors and corporate titans.

As the sub-prime mortgage market began to come to a head in February 2007, Cioffi still told investors at a conference late that month that a meltdown in the sector was "unlikely to occur." But in March, Cioffi sought and received permission from Bear Stearns' compliance officials to move $2 million of the $6 million he had personally invested in the riskier hedge fund into a separate internal fund called Structured Risk Partners. Cioffi explained that the transfer 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.

In emails with colleagues in April 2007, Cioffi expressed concerns about the credit markets and how a downturn might affect his investors. Yet, according to the transcripts of an April 25th call with fund investors, Cioffi said he was "cautiously optimistic" about his and Tannin's ability to hedge their portfolio. Cioffi said "the market will stabilize" and he and Tannin had a plan to get the funds back on track and the funds had enough cash on hand. Tannin echoed Cioffi's reassurances and advised investors not to be alarmed by the news. "We're quite comfortable with where we sit," said Tannin.

In May, Cioffi and Tannin began selling billions worth in bonds to raise cash for the struggling funds. Bad news leaked out and some investors rushed to get their money back. But the Cioffi and Tannin didn't have enough cash to repay investors and meet margin calls so they refused the redemption requests. That was like adding hot oil to water.

By late June, Cioffi and Tannin had given up on the riskier sister fund and left it to die. Bear Stearns agreed to lend up to $3.2 billion in an effort to save the less risky High Grade fund but eventually only lent half of that amount which the fund never fully repaid. On July 31, the funds filed for bankruptcy protection in a New York federal court.

Neither side of the investigation has commented but Cioffi has told people that he and Tannin denies misleading anyone and they were grappling with the volatile mortgage markets just as the rest of the financial world was.

Federal prosecutors have not hinted at bringing broader charges against Bear Stearns (now part of J.P. Morgan Chase) or its executives. However, Cioffi and Tannin's indictment over the two hedge funds could bear down on other companies and executives now under investigation for alleged criminal missteps related to the mortgage-market meltdown. For example, UBS AG, Countrywide and American Home Mortgage Investment are all being investigated for some type of securities, loan or accounting fraud.

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