Bear puts more skin in the game

Two factors that Cioffi and Tannin could not have foreseen were starting to cripple their funds. Investors spooked by the January and February returns put in redemption orders for well over $100 million. With less new money flooding into Cioffi's funds and BSAM being forced to sell assets out of the funds, the small esoteric market became less liquid. The second factor was the creation in January 2007 of an index - known as the ABX index - that for the first time allowed investors to bet on the performance of the subprime mortgage market in much the way an S&P index fund allows them to bet on the direction of the stock market as a whole. The ABX was an index of securities backed by home loans issued to borrowers with weak credit.

"In previous times, if the market sold off, no one really knew how much," Friedman explained. "Now you had a published index that people could observe. More importantly, it was the only real thing they could short as a hedge. As a result, the index got driven lower and lower as people looked for a way to hedge, going far lower than the underlying bonds. Potential buyers then demanded to buy bonds at the levels that the index suggested they should trade [at] when in fact no one was willing to sell there. So you had a period of time when, for example, the index would trade at 90 but the underlying bonds traded - when they traded - at 95. Hence, there would be no trades."

On May 1, despite mounting redemption notices, Bear's co-president Warren Spector invested an additional $25 million into the fund, bringing the firm's total stake to more than $500 million in hedge funds and other seed capital opportunities. Spector made the additional investment without taking a thorough look at the analytics and without consulting with his boss Jimmy Cayne - a decision he would come to regret even though it was within his authority to do so.

Next: Goldman questions Bear's marks

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.