'The subprime market is toast'

After 40 months of positive returns, the sudden and sharp decline in the two hedge funds was new territory for Cioffi and Tannin. They struggled mightily to figure out what to do. On April 18, one of Cioffi's investors, who had $57 million invested, informed him that he was considering redeeming his money. Cioffi told the investor that the portfolio managers had $8 million of their own money invested, one-third of their liquid net worth. He neglected to tell the investor that he had taken $2 million of his own money out and invested it in his other hedge fund.

On April 22, Tannin wrote Cioffi an e-mail from his personal Gmail account to Cioffi's wife's personal Hotmail account with the subject line "Things to Think about - Parts I and II."

He wrote at times with great emotion and about his personal feelings, which may have accounted for his decision not to write the e-mail on the Bear Stearns system. Tannin, a philosophy major, was certainly waxing philosophical in the correspondence. "We have spent our time well - and time is the ONLY thing in this life which one can't ever get back." He said he was feeling "pretty damn good" about what was happening at the funds because he had no doubt "I've done the best possible job that I could have done. Mistakes, yep, I've made them - but they do not bother me as much as they did years ago.... So - f*** it - all one can do is their best - and I have done this."

He went on to wonder whether the funds should be closed or significantly restructured. The argument for closing the funds was based on the market and on a complex internal April 19, CDO report, which was a new analysis that Tannin had recently perused. "If we believe the [new CDO report] is ANYWHERE CLOSE to accurate, I think we should close the funds now. The reason for this is that if [the CDO report] is correct, then the entire subprime market is toast," wrote Tannin. "If AAA bonds are systematically downgraded, then there is simply no way for us to make money - ever."

On April 25, Cioffi and Tannin held a conference call for the funds' investors, who were getting skittish. Cioffi and Tannin's performance was Oscar-worthy. Cioffi kicked the discussion off with a review of the first-quarter performance at both funds. The High-Grade Fund was down a cumulative 0.34% in the first quarter, with the loss coming in March after a positive January and February; the Enhanced Leverage Fund had lost 4.74% year to date, with much of the loss coming in March. "At this point in time, the [Enhanced] fund has significant amounts of liquidity," Cioffi said. He then predicted returns of 14% for the year in the Enhanced Leverage Fund and 11% for the year in the High-Grade Fund.

A charitable view of Cioffi's predictions for the funds' 2008 performance would be that he was badly mistaken; another view would be that he deliberately misled investors to keep them from seeking a stampede of redemptions, which would spell the end of the funds and of Cioffi's lavish lifestyle.

Next: Bear puts more skin in the game

Excerpted from House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan, to be published in March, 2009 by Doubleday Books, a division of Random House, Inc. Copyright 2009 by William D. Cohan.