– Ross Thomas, Chinaman’s Chance, page 58

Are developers more credulous than other people? 

Ross Thomas: “They never took nobody who didn’t deserve it”

Ever since the bizarre story broke of the world’s biggest and longest-running Ponzi scheme, I’ve been agape at its audacity and searching for something to say.  Now I’ve found it, courtesy of a faith-chasm-leaping set of logical links from Christine Haughney of the New York Times:

Madoff Scandal Shaking Real Estate Industry

The real estate industry alone?  Or a lot of rich people in New York?

Almost no segment of New York City’s real estate industry [Or any other industry? – Ed.] was spared in the Madoff scandal, which may be history’s largest Ponzi scheme: commercial brokers large and small, little-known developers and prominent families like the Wilpons and Rechlers all lost money to Bernard L. Madoff, industry executives say.

The outsize impact on the industry may have resulted largely because Mr. Madoff (pronounced MAY-doff) –

Actually, it’s pronounced MADE-off, as in “made off with the money.”

– managed his funds much the way that real estate leaders have operated successfully for decades: He provided little information and demanded a lot of trust.

He made off with the money because due diligence as always being done by some other guy

That’s implausible to me, since the real estate people I do business with engage in extensive due diligence.  Indeed, my for-profit company is now conducting a complex and detailed due diligence investigation of a large acquisition. 

“You have a lot of wealthy people who made a lot of money on handshakes,” said Mark S. Weiss, a commercial real estate broker at Newmark Knight Frank, where several brokers had invested heavily with Mr. Madoff. There was “something about this person, pedigree and reputation that inspired trust,” he said.

In business, our working principle is that we listen to everything you tell us, and we believe it while you’re telling us, but then we immediately verify everything you said, and if we can’t verify it, we disbelieve it.

No offense, Jesus, but let me see your schedules

Yet the grand bluff – the big lie, as it’s sometimes called – can work, particularly among the very wealthy, for whom inquiry into backgrounds is gauche, or even worse, classless. 

Dr. Mueller said many patients were re-evaluating whether they can trust their business partners after Mr. Madoff’s betrayal.

“Madoff was considered a member of the family,” he said.

Neat, sweet, and … discreet

That’s how the self-styled Clark Rockefeller perpetuated his multi-decade con on the world, being someone he evidently was not.

It’s because we assume that someone who moves effortlessly, even arrogantly, within a rarefied universe must already have been vetted by some one of us. 

They met Mr. Madoff through contacts at country clubs in the tri-state area, he said.

“They knew him from golfing in the Hamptons. They knew him from the locker rooms,” Mr. Reisman said. “He was considered a wizard.”

Among the most wonderful characters invented by the incomparable Ross Thomas was Otherguy Overby, introduced in Chinaman’s Chance, who never took the rap – because it was always pinned on some other guy.

What ’s all but inconceivable to me is that all these savvy investors would have sat still for an ask-no-questions-tell-no-lies approach to due diligence.  What were they thinking?

The essence of business is conducting transactions with people whom one need not inherently trust.

It’s just business

Now many a real estate deal is going to come unwound:

Many developers had pledged their investments with Mr. Madoff as collateral for projects, and are now worried that their banks will call in their loans.

The bankers will.

The victims include executives at the global commercial brokerage CB Richard Ellis, most prominently Stephen Siegel, a major Bronx landlord who is chairman of worldwide operations at the brokerage and whose wife, Wendy, helped organize Saturday’s fund-raising dinner.

One who trusted and should not: Stephen Siegel

Brian S. Waterman, a principal at Newmark, also invested with Mr. Madoff.

Another victim: Waterman (at right)

Jerry Reisman, a lawyer based in Garden City, N.Y., said he was representing six commercial real estate investors and developers in the area who lost a total of $150 million to Mr. Madoff.  Mr. Reisman said his clients were especially concerned because they counted on Madoff investments to complete some of their real estate projects, pledging their investments as collateral for projects.

What were they thinking?  Was it all a suspension of healthy skepticism?

“Many of these developers, their resources are all with Madoff,” Mr. Reisman said.

There are widespread concerns that some developers will have trouble completing projects currently under construction. Edward Blumenfeld, who runs Blumenfeld Development Group, had invested heavily with Mr. Madoff and considered him a friend. Gary Lewi, a spokesman for Mr. Blumenfeld, said he still planned to complete a shopping complex in East Harlem that is to include a Target and a Costco, as well as several other projects where construction is “in the ground.”

Edward Blumenfeld, the developer of East River Plaza, above, invested heavily with Mr. Madoff and considered him a friend.

Other real estate developers are finding that their charitable giving has been wiped out by Mr. Madoff. Leonard Litwin, one of the city’s largest apartment landlords and head of Glenwood Management, had nearly all of his charitable foundation’s investments managed by Mr. Madoff.

I wonder if Mr. Madoff’s aura of wealth dulled their sensibilities.  Yet when I was selling a controlling interest in Recap to some British investors who are now my bosses, we did extensive due diligence on the buyers, just to satisfy ourselves as to who they were.  And we were the sellers, the ones receiving cash.

In any con game, the essential rule is watch who gives whom the money.

As beautifully expressed in David Mamet’s play and film, House of Games:

Mike: It’s called a confidence game. Why? Because you give me your confidence? No. Because I give you mine.

“It’s called a confidence game.”

Here Mr. Madoff made the fantastic transformation of becoming so accepted that everyone assumed that some other guy had done the diligence on him:

Gary Jacob, executive vice president of Glenwood, said Mr. Litwin had never met Mr. Madoff but had invested with him on the advice of a friend.  

My ‘friend’ did the due diligence ..

All right, who did the due diligence!?!?

Some members of the real estate industry are receiving the news with a mix of schadenfreude and sadness for their peers. Jeffrey R. Gural, chairman of Newmark Knight Frank, the brokerage firm, said Mr. Madoff had turned his family down as investors about eight years ago because they would not invest at least $20 million. For years, he said, colleagues introduced to Mr. Madoff through relatives or country club friends had sung his praises.

There is the con man’s genius – you’re too small, you’re not worth my trouble.

Dr. Margaret Ford: You took my money.
Mike: How naughty of me.

“You took me under false pretenses.”

“Well, that’s just what happened, isn’t it?”

Those on the inside became Mr. Madoff’s best salesmen, doing his next marks’ diligence for them:

“People used to brag how they were getting these great returns when everybody else was struggling,” he said. “They thought Bernie Madoff was a genius, and anybody who didn’t give them their money was a fool.”

A reputation for genius has its uses – you can bluster and people interpret it as part of your charm.

Maybe you’re good enough to let me take your money

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[Continued from yesterday's Part 1.]

Symbols of fidelity and chastity abound

Yesterday’s post covered the basics of the JP Morgan Chase/ Bear Stearns shotgun wedding, and the sudden discovery that JP Morgan had paid over the dowry before the vows were exchanged.  Thus, as reported in The New York Times, Morgan had to boost its price, and that set off a chain reaction of renegotiations:

JPMorgan was also in negotiations with the Fed on Sunday to assume the first $1 billion in losses on Bear assets before the Fed’s $30 billion cushion kicks in. However, the Fed may now be seeking to raise that number.

‘Right,’ we can imagine the Fed saying.  ‘You’re using our credit to buy Bear Stearns on the cheap, and in your haste to get it, you overlooked an elementary precaution, the extrication from which has caused you to quintuple the price.’

As CNN put it:

Also complicating matters for a rival bidder is the Fed. Regulators have gone out on a limb, politically, to make this deal happen, including a $30 billion guarantee to help finance it. The New York Times reported earlier Monday that the Fed wasn’t happy with a higher price for Bear Stearns stockholders because it wanted to avoid being seen as having bailed out equity holders with taxpayer money.

Continues the Fed, in our imagined scene, ‘Look, you morons, we just put our necks right on the chopping block, and you’re the private beneficiary, and you just did something so monumentally blockheaded?  Do you realize that in backing you, who at this instant look like idiots, we look like idiots too?‘

‘We’ll fix it,” says Mr. Dimon, grimly.

To placate regulators, JPMorgan agreed to take on the first $1 billion of losses from Bear Stearns’ bond portfolio – a move that likely eased Fed worries. 
 

It’s a fundamental principle of good hard-debt lending that the originator takes first loss – because the originator or sponsor has more knowledge before the event, and more control after it.  The $1 billion of cushion not only makes the Fed’s position way safer, it effectively doubles JP Morgan’s exposure, because the stock purchase will cost about $1.18 billion.
 

‘There’s a silver lining, sir,’ says the imagined Wachtell lawyer, wringing his bristle-board binder in his hands.’
 

Honest, it’s clearing up
 

It also presents another hurdle for potential bidders.
 

‘You mean,’ replies Mr. Dimon, ‘that nobody else will make a One-L mistake and get their asses in a sling like we just did?’
 

The Fed, in a statement, said it would set up a limited liability company to control $30 billion worth of Bear Stearns assets. Those assets, in turn, will be pledged as collateral for the Fed’s guarantee, now valued at $29 billion.
 

‘All right,’ says Mr. Dimon when he is no longer apoplectic – and he being a very shrewd and experienced trader, that probably took him all of ten seconds – ‘you had damn well better make certain that we are not getting whipsawed again, do you hear me?‘
 

I’m really not happy right now
 

What’s more, the structure of the revised merger agreement suggests it’s unlikely that JPMorgan would sweeten the pot yet again. The new pact calls for JPMorgan to buy 95 million Bear Stearns shares at $10 apiece within two weeks. That will give JPMorgan a nearly 40% stake in Bear before shareholders vote on the deal. 
 

If it’s still a bargain at $10 a share, if you’re still on the hook for 100% of Bear’s trades, why stop at 39.5%?
 

In an unusual move, Bear’s board was seeking to authorize the sale of 39.5% of the firm to JPMorgan in an effort to move closer to majority shareholder approval. Under state law in Delaware, where the companies are incorporated, a company can sell up to 40% without shareholder approval.
 

‘Forty percent, sir,’ says the by-now-thoroughly-miserable lawyer, ‘is as much as we can get without going to the shareholders.’
 

Mr. Dimon glares at him.  ‘A third of whom are Bear employees who already hate us, and another 10% of which is a rogue British billionaire.’
 

[Joe] Lewis, the billionaire currency trader, […] is Bear’s second-biggest shareholder. Lewis had called the deal “derisory” and, in a regulatory filing last week, vowed that he and other members of his group would “take whatever action that they deem necessary and appropriate to protect the value of their investment in the shares.”
 

‘Then get the directors’ votes as well!’
 

If Bear’s board sells JPMorgan 39.5% of the firm, as it was attempting to do on Sunday night, that would leave JPMorgan needing only slightly more than 10.5% of shareholder support to complete the transaction. And the individuals on Bear’s board, who were supportive of the deal on Sunday night, own a total of about 5% of outstanding shares.
 

We’ll tie your billion to that cowcatcher out front, got it?
 

The $1 billion first-loss guarantee, the 39.5% + 5.0%, and the sidelining of management, all add up to a likely closure:
 

Bear’s directors have agreed to vote in favor of the deal as well, throwing cold water on the notion that Jimmy Cayne, the bank’s chairman and former CEO, might put together a rival bid.
 

‘Now, sir, you need to speak to the markets.  Statesmanlike, sir, that’s the ticket.’
 

“We believe the amended terms are fair to all sides and reflect the value and risks of the Bear Stearns franchise,” Dimon said in Monday’s press release, “and bring more certainty for our respective shareholders, clients, and the marketplace.”
 

Or maybe not. Some investors are betting that we haven’t heard the last from Lewis. Bear Stearns shares doubled in heavy trading Monday, to $12 each, showing that some on Wall Street believe even the revised deal isn’t high enough.
 

I love markets because they’re so cynical, they put Michael Corleone to shame.  Having gouged JP Morgan Chase for a 5x on its bid, and a 10x on its exposure, they’re betting it will go to 11:
 

So what accounts for the 20% premium that Bear Stearns shares were fetching midday Monday? Perhaps traders have observed that speculating on a better buyout price worked once – so why not try it again?
 

“Who knows exactly what it is that’s causing it,” Paul Hickey at Bespoke Investment Group in Harrison, N.Y. says. But there are signs that sanity is slowly returning. After last week’s huge gains, Hickey says, Monday’s trading in Bear stock is at least “closer to what you’d expect.” 
 

Personally, I think it’ll close at $10.  Not everybody in Bear has to sell, and those who stay in may be betting that the post-Morgan Bear will roar again.  Some people will sell:
 

Further adding to the mix is the hefty short position in Bear Stearns, which Hickey estimated at 20% as of Monday morning. Investors who have been betting the shares would fall will be inclined to buy the stock Monday to close out those trades now that it’s clear what the stock might be worth.
 

Out of all this roller-coaster ride, who loses and who wins?  
 

Losers are holders of Bear common stock – the largest chunk of whom are Bear’s employees.
 

Winners include JP Morgan/ Chase – probably – because even $10 a share looks like a fire-sale bargain relative to Bear’s price as recently as three months ago.  Tort lawyers are likely winners too, as the collapse of Bear’s share price, and the very nasty negotiations over the last few days, will offer a fertile documentary and communication trail to uncover, imagine, or impute impropriety.  
 

Interested bystanders are all of us taxpayers, and beyond us, the global economy.
 

Am I about to get free of this web?

My spidey-sense is starting to tingle that we’re at the bottom of the credit gridlock.  As I posted on Monday, Ben Bernanke’s Big Bet on Value may do its job of both backstopping the capital markets and also creating a value point under which liquidity will once again flow.
 

Be one with the wave

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[Editor's note: we interrupt the multi-part post on water and sanitation for breaking news regarding the Bear Stearns/ JP Morgan Chase shotgun marriage, which is too delicious to ignore and too timely to defer.  We'll return to water later in the week.]

Although it’s only tangentially related to housing, I have to post about the recent ultra-intense marriage between JP Morgan/ Chase and Bear Stearns, with the Federal Reserve acting as matchmaker and a large shotgun cradled easily in its arm.  The story’s full of its revealing flashes about the nature of our current credit gridlock, and insights hardball market negotiations.

One of us is just an interested third party

What ate the Bear?

Lack of cash ate the Bear.

Out of cash?  Out of cash?

When you’re running an engine hot, you need enough crankcase oil to lubricate that furiously rotating and cycling machinery.  If you run dry, the block seizes, the car crashes.

Good only for being a boat anchor

For a bank, the crankcase oil is cash liquidity.  Having net equity is secondary; you can’t make payroll with accounts receivable, accrued income, or non-cash assets held in inventory. 

A little cash infusion keeps it lubricated

Late last week, Bear’s temperature gauge shot up past critical, so Bear had to find a better-capitalized suitor.

Who ate the Bear?

With the Federal Reserve’s active matchmaking, it hastily found an eligible groom in JP Morgan/ Chase, so a deal was swiftly struck.  Perhaps too swiftly, for as reported in The New York Times, Bear’s shareholders balked – ingrates! – believing they were being exploited in their hour of need:

Two bucks a share!!?

Inside Bear, the vitriol over that bargain-basement price was palpable last week. Bear employees own more than a third of Bear’s stock, and many longtime employees faced the prospect of losing all their savings. On Monday, some were seen crying in the hallways of the firm’s Midtown Manhattan headquarters.

My grandfather worked twenty-five some-odd years for the Saturday Evening Post, and when it went under, there went a quarter-century’s pension.  Out of his small financial tragedy, and millions like it, came ERISA — The Employee Retirement Income Security Act, which mandated properly funding pensions.  The market then shifted, covering the pension in investable cash but offering incentive compensation in the form of restricted stock.  Employers like this because not only were the shares or options non-cash, they also could be vested over several future years, in effect creating a large cumulative penalty for leaving the firm.  Conversely – and this may be an unintended benefit – having employees as principal owners gives them a veto and a voice, and they used both:

One employee started a Web site to rally opposition to the deal. Some employees said they talked back to their new supervisors from JPMorgan, which commandeered desks and conference rooms after being given operational control of the firm last week.

Before its recent meltdown, [Bear's shares] were trading at about $67 two weeks ago and as high as $170 a year ago.

Even measured by measured implosions, that’s an extraordinary price collapse.  Most people, without even looking at the books, would conclude that price is too low, driven by lack of liquidity and market panic.

Even after JPMorgan announced that it would acquire Bear for $2 a share, investors bid up the stock to close at $5.96 on Friday in anticipation that a better deal would be reached.

A condemned man is curiously liberated to threaten to take others with him, and in those high-pressure days, Bear’s shareholders made such threats:

Some of Bear’s largest shareholders have even considered voting down the deal to send the firm into bankruptcy protection, where they speculate they might get more than $2 a share from creditors.

Bankruptcy’s a strange netherworld of litigation goo and disorienting financial logic, but there’s one lodestar to pursue – nobody in a bankruptcy gets more than he deserves.  Bankruptcy exists to protect the unsecured creditors and common shareholders by calling a halt to any fire-sale trading and compelling the markets to give a company time to recover its financial wits. 

A few months in Chapter 11 will clear my head

The British billionaire financier Joe Lewis, the firm’s largest shareholder, who had invested $1.26 billion in Bear over the last year at an average price of about $104, said in a filing with the Securities and Exchange Commission that he would seek to block the deal by taking “whatever action” necessary and would “encourage” the firm and “third parties to consider other strategic transactions.”

If I owned 12,100,000 or so shares, I’d fight about the difference between $2 and something higher.  Wouldn’t you?

I invested in this firm in 1898, sir, and by gad I’ll fight your price

It’s not as though the $2 per share price had been established through calm reflection:

[It was] a tumultuous week on Wall Street and in Washington because of the near collapse of Bear and the hastily devised deal to save it.

While the initial agreement appeared to have defused the financial crisis of confidence that undid Bear, the initial terms of the deal — and the government’s controversial role in reaching them — drew criticism from those who say the takeover amounts to a government bailout of Bear, a firm at the center of the mortgage meltdown.

Like the proverbial shotgun marriage, this one was arranged from outside:

As part of the original deal, the Fed guaranteed to take on $30 billion of Bear’s most toxic assets.

It reads like a Regency novel: the spendthrift maiden had run up debts all around town, and her glowering father would stand surety for them, provided the wild young lady got herself respectably married.  Enter the modest sober suitor:

The central bank also directed JPMorgan to pay no more than $2 a share for Bear to assure that it would not appear that the Bear shareholders were being rescued, according to people involved in the negotiations.

Assuming this is right, the Fed told Bear that it couldn’t pay anything more than a de minimis price because doing so would look bad.  (I’m parodying only slightly – the risks of moral hazard are real.)

A spokesman for the Federal Reserve would not comment on the central bank’s involvement in the negotiations and denied that it had directed the original sale price.

Well, they would deny, wouldn’t they?  I doubt we’ll ever know.

“Follow the money”

JP Morgan/ Chase, the Fortinbras of this particular tragedy, began its new venture by playing the reluctant heir:

Last week, in an impassioned speech to Bear’s employees seeking their support, Mr. Dimon said: “No one on Wall Street could have anticipated this. I feel terrible sometimes when people think we took advantage. I don’t think we could possibly know what you all are feeling, but I hope that you give JPMorgan a chance.”

We’ll give you a chance, all right

Even as it was soothing an angry mob of employees, JP Morgan/ Chase sought frantically to get the bride to the altar and the vows exchanged:

As it began to look more possible late last week that the deal might be struck down, Mr. Dimon became increasingly desperate in recent days. He offered certain employees cash and stock incentives to stay on and made calls to his rival chief executives on Wall Street — John J. Mack at Morgan Stanley and John A. Thain at Merrill Lynch, among them — pleading with them not to recruit Bear employees during the transition.

There’s very little point in buying a going concern if all the people who make it go are gone.

Mr. Dimon had became convinced that the deal was in jeopardy after spending much of last week taking angry calls from Bear’s largest shareholders, including Mr. Lewis, these people said.

Yes, your call is very important to us

Yes, I will be personally responsible for your happiness

Moreover, Mr. Dimon, who had indignantly told associates that he would “send Bear back into bankruptcy” if the deal was struck down, was persuaded by his advisers that he had less leverage than he thought, according to people briefed on the conversation. Such vindictive behavior, they told him, would turn into a legal and public relations nightmare.

There was also, if the reports are true, another reason [hat tip: Volokh Conspiracy], one a whole lot more dangerous than bad public relations:

JPMorgan and Bear were prompted to renegotiate after shareholders began threatening to block the deal and it emerged that several “mistakes” were included in the original, hastily written contract, according to people involved in the talks.

I didn’t get to be chief executive by forgiving mistakes

‘Mistakes,’ we can hear Mr. Dimon repeating with an ominous purr in his voice.  ‘What kind of mistakes?’

One sentence was “inadvertently included,” according to a person briefed on the talks, which requires JPMorgan to guarantee Bear’s trades even if shareholders voted down the deal.

Ooo, I really wouldn’t want to be the lawyer who had to tell Mr. Dimon that, for it violates one of the absolute bedrock principles of trading: simultaneity of exchange.

The essence of a trade is simultaneity: I give you what you want, you give me what I want, at the same instant.  In formal transactions we do this with escrow agents.  In informal or illicit transactions, they do it while pointing guns at each other.

I guarantee your trades, you guarantee you’ll sell, right?

Here, if the story is correct, either JP Morgan or its lawyers blew it big time.  Bear went in to this transaction reluctantly, with the prize being access to liquidity and a guarantee of its business lines. 

A major aim of a new agreement would be to provide assurances to investors who trade with Bear that it will continue to be open for business. Even with JPMorgan’s original agreement in place last week, some of Bear’s largest customers would not trade with it, still nervous that the deal might unravel.

True enough, but if you are being paid to rescue someone, make sure you’re paid before you do the rescue.  JP Morgan had done the good deed without getting that necessary signature.

‘Do you mean to tell me,’ we can imagine Mr. Dimon’s voice rising, ‘ that we’ve given them what they wanted before they close?  Before they’ve even made a binding COMMITMENT?’

If you don’t close, I’m going to have a vulture eat your entrails for all eternity

That provision could allow Bear’s shareholders to seek a higher bid while still forcing JPMorgan to honor its guarantee, these people said.

When the error was discovered, James Dimon, JPMorgan’s chief executive, who was described by one participant as “apoplectic,” began calling his lawyers at Wachtell, Lipton, Rosen & Katz to seek a way to have the sentence modified, these people said.

‘Sir,’ we imagine the sweating lawyer replying in a strangled voice rising to a squeak,’ would you relax your grip on my testicles?’

Finger pointing over the mistakes in the contracts began as bankers blamed the lawyers and vice versa.

Now squeeze!  Squeeze hard!

Finger pointing will be the least of Wachtell Lipton’s worries.  If these reports are true, they will be lucky to get out of this deal for zero fee and a release, because immediately thereafter, the renegotiation happened fast and furious

JPMorgan Chase was in talks on Sunday night for a deal that would quintuple its offer for Bear Stearns, the beleaguered investment bank, in an effort to pacify angry Bear shareholders, according to people involved in the negotiations.

Under the terms being discussed, JPMorgan would pay $10 a share in stock for Bear, up from its initial offer of $2 a share — a figure that represented a mere one-fifteenth of Bear’s going market price.

Ten bucks a pop still looks like a bargain compared to $67, but it looks a whole lot less like pillage than did the original $2 a share.

Just a friendly little discussion of asset values, that’s all

If the price is increased, however, some critics could have more ammunition to complain that taxpayers are helping to bail out a Wall Street firm that should be responsible for its own risky behavior. That is one reason the Fed was hesitant on Sunday night to approve the transaction at $10 a share, people briefed on the talks said.

Agree, however, the Fed did.  As CNN reported Monday:

JPMorgan Chase (JPM, Fortune 500) agreed Monday to quintuple the value of its all-stock offer for Bear Stearns, to $10 a share. The revamped agreement, valued at $1.18 billion, comes just a week after JPMorgan agreed to buy the cash-strapped brokerage firm with backing from the Federal Reserve. The deal staved off a probable Bear Stearns bankruptcy that threatened to swamp the financial sector with a new wave of uncertainty.

This wasn’t the only agreement made Monday:

You see my argument?

[Continued tomorrow in Part 2.]

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