Bear's dogs that didn't bark

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NEW YORK (Fortune) -- Government documents supporting the charges filed last week against two former Bear Stearns hedge fund stars paint a picture of an organization that had a hard time tackling problems head-on - a flaw that ultimately would prove fatal to the firm.

Bear Stearns, now part of JP Morgan Chase, was ultimately done in by a crisis of confidence among its clients, lenders and business partners. What sank the mortgage hedge funds run by Ralph Cioffi and Matthew Tannin was a series of poor investment decisions. But in both instances, the firm's management failed to act quickly enough to keep big problems from ballooning out of control.

The Justice Department indictment and the Securities and Exchange Commission complaint allege that Cioffi and Tannin systemically misled their investors about the funds' exposure to the riskiest sectors of the securitized product market. According to the SEC complaint, private placement memorandums in 2003 and 2006 assured investors that the majority of fund assets carried the highest ratings from Moody's and Standard & Poor's - in the triple-A and double-A-minus range.

Yet it appears that by 2006, Cioffi was leading the BSAM funds headlong into subprime mortgage bond management - to a degree that stunned even his alleged co-conspirator Tannin.

"Unbelievable. He is unable to restrain himself," wrote Tannin to an unnamed colleague in February 2007, discussing Cioffi's aggressive purchases of the riskiest and most opaque securitized bonds, according to the SEC complaint. Even as Cioffi and Tannin assured clients that only "6%-8%" of fund assets were in subprime mortgage securities, the fact was that they had massive indirect exposure to that segment of the market and an unusually high exposure to the risk of mortgage defaults.

That none of this was disclosed to investors is laid out in the government's narrative of the case. What remains unanswered is how, by all indications, Cioffi and Tannin were never called on it internally.

To be sure, the indictment makes clear that prosecutors believe Cioffi and Tannin misled their bosses as well as their investors. But what rival hedge fund managers are most baffled about is that throughout the months-long collapse of the High Grade funds, no one at Bear Stearns Asset Management appears to have asked how the funds got themselves into such a jam.

A spokesman for J.P. Morgan (JPM, Fortune 500) declined comment. Several messages to Andrew Merrill, the spokesman for both Cioffi and Tannin, were not returned. Both men have proclaimed their innocence, and their lawyers maintain the government is using them as scapegoats for the subprime debacle.

The indictment and complaint are remarkably free of indications that the firm's compliance officials or top mangers ever demanded Cioffi and Tannin explain how their funds, supposedly dedicated to the slow-and-steady approach to winning the investment race, had morphed into some of the largest subprime players on the Street. The one example of Bear Stearns oversight cited in the government's papers comes when Cioffi pushed, unsuccessfully, to have the monthly loss on one fund reported at a lower number than it actually was.

But in other instances, Cioffi and Tannin appear to have gone totally unsupervised. Consider the issue of hedging, or offsetting the risk of purchased investments - the core of hedge fund management. According to the SEC complaint, there wasn't a whole lot of it going on, contrary to what the funds' managers said.

"We have proper hedges in place," Cioffi assured investors in a January 2007 investor conference call. "We are short a significant amount of the sub-prime space." He also assured investors that if the markets continued to deteriorate, "We would do very well," according to the SEC complaint.

But at least one of the two BSAM hedge funds weren't really hedged at the time the subprime market began to crumble. In February 2007, the SEC complaint alleges, Cioffi "admitted in e-mails" that one fund - the Enhanced Leverage fund - "hadn't hedged substantial positions that it had recently entered into" - a misstep that resulted in the fund posting its first monthly loss.

The indictment and complaint don't accuse the managers of faking trades; their unhedged trades were there for numerous Bear lawyers, operations personnel and administrators to see, as was Cioffi's apparent lack of a significant short position in sub-prime securities.

The fact that key positions at the two BSAM hedge funds were apparently not hedged for nearly a month should have immediately triggered an alarm bell within BSAM's risk management or supervisory units. Similarly, an easily performed internal analysis of exposure to the even-then wobbly subprime mortgage markets would have called into question Cioffi's characterization of the funds' credit risks. Even the smallest of hedge funds have personnel assigned to monitor value-at-risk. A $1.5 billion fund would ordinarily be expected to have several layers of oversight, both human and computer-driven.

But the funds were big money makers for Bear Stearns - a firm whose previous attempts to build a money management franchise had been star crossed, with another mortgage-backed hedge fund it sponsored blowing up in 2004. So it is understandable that senior managers might have been deferential to Cioffi.

The lack of oversight seems to have allowed Cioffi and Tannin to keep money coming in the door even as market players were starting to worry about how the funds would handle a sharp downturn in the subprime mortgage markets. Take a suit filed last December by one of the funds' big lenders, Barclays (BCS) Capital. That suit alleges Tannin assured a Barclays salesman that the fund was up 4.3% for the month of February, when in reality its value had declined 0.1% in a preview of things to come. Tannin's alleged misrepresentations gave the English bank the comfort necessary to lend the fund an additional $100 million - money that would quickly go down the drain.

If Bear's response to the problems at the BSAM funds was inadequate, though, management would soon make much bigger, if similar, mistakes. Consider the way the firm botched a crisis of investor confidence that started in the second half of last year and culminated in March's Federal Reserve-brokered fire sale to JPMorgan.

Back in August 2007, just days after the hedge funds collapsed in a Cayman Islands bankruptcy filing, Bear Stearns held an investor conference call aimed at reversing the sharp decline of the firm's stock. James Cayne, who was then the firm's chief executive, opened the call by saying he believed in the firm and its employees and expected Bear to see its way through the credit market storm. But Cayne promptly undermined any belief in Bear's management by disappearing without explanation later in the call, suggesting even Bear's CEO couldn't be bothered to sit through the entire event.

Similarly, Bear execs handled the liquidity crisis that finally brought it down earlier this year with an almost blase lack of engagement. While rival financial firms were out raising billions of dollars in new capital, Bear sat on the sidelines, insisting it had plenty of cash. The firm's main capital-raising effort was a complicated deal with China's Citic -- a $1 billion stake swap that was never completed, in part because of Bear's deteriorating finances.

By March, debt markets were in a panic and Bear's customers and trading partners were fleeing. Yet CEO Alan Schwartz told CNBC, "We don't see any pressure on our liquidity, let alone a liquidity crisis." Four days later, the firm - facing a certain bankruptcy filing of its own if it didn't line up a partner - announced its sale to JPMorgan, nearly wiping out shareholders including the employees who owned nearly a third of the stock.