The rise and fall of Jimmy Cayne (cont.)

The two had their differences. As New York City's finances collapsed in 1975, Cayne saw an opportunity to make a killing. The city was teetering on the edge of bankruptcy, and one of his clients wanted to sell some of his New York City bonds, but no one wanted to buy them. Cayne decided that Bear Stearns should make the market. All it would take was $5 million and some guts. He took the idea to Greenberg, then the firm's second-most-senior partner. Greenberg shot it down. "It's too racy," Greenberg told him. Cayne decided to go over Greenberg's head to the boss, Cy Lewis - an action that would likely be a career-ender at any other Wall Street firm. With Lewis's endorsement, Cayne bought the bonds and was able to find buyers for them at small brokerages around the city for prices higher than he paid.

"Greenberg never had the balls to take him on," Cayne said of Ace's relationship with Lewis. But in 1978, after Lewis suffered a fatal stroke at his retirement party, Greenberg did become the firm's senior partner. Cayne, however, was not the kind of guy to wait for the Grim Reaper to clear a path for him to the corner office. In 1978, Cayne maneuvered his way onto the firm's powerful executive committee, and not long after the firm went public in 1985, he became the sole president. By the early '90s he felt it was time to trump his onetime mentor. "He lost the ultimate power, I guess, in 1993," Cayne said of Greenberg. "I had the executive committee and the board completely on my side." In his estimation he and his loyalists were also responsible for 70% of the firm's profits. That year Cayne became CEO, and in 2001 he added the title of chairman of the board. Atypically, Greenberg stayed on the Bear board, and continued to show up at the office every day filling his seats on the executive committee, the risk committee, and the trading floor. Cayne chalked it up to the unusual "synergy" that existed between them. Still, he alone referred to Greenberg as "Alan," while everyone else called him "Ace"; Cayne billed those who used the nickname in his presence $100.

While Bear Stearns under Cayne became a far larger firm in terms of employees, revenue, and profitability, the basic business model-which had worked so well for so many years-remained unchanged. Those tried-and-true businesses - trading, mortgage underwriting, prime brokerage, private-client services - received the bulk of the firm's capital and management attention. Investment banking and asset management remained small and relatively undercapitalized. As a result Bear Stearns was never a major player in equity underwriting or M&A or in the accumulation of assets under management. The firm also never diversified, despite numerous opportunities. For instance, when Bear had the chance to buy asset manager Neuberger & Berman in 2001 for around $1 billion less than it eventually sold for, Cayne declined. Lehman Brothers then scooped up the respected money manager and its $64 billion of assets under management - now $277 billion-for $2.6 billion in 2003. "Acquisitions weren't my forte," he says. "The devil you know, that sort of thing. Yeah. I'm not saying I'm right. I was wrong about Neuberger Berman."

There was, however, one business that acted like rocket fuel for the firm's balance sheet - debt securitization. When persistently low interest rates during the middle years of this decade caused an explosion of debt issuance - whether to back mortgages, credit card receivables, or leveraged buyouts - Bear's debt-focused securitization businesses boomed. As the firm's stock price zoomed, Cayne looked like a hero to his investors. "They're a wealth-creation machine," explained Bruce Sherman, the CEO of Private Capital Management, then Bear's largest shareholder, at the end of 2006. "Jimmy's leadership over the past decade has been central to that."

Cayne's first inkling that something was terribly wrong at Bear Stearns came in the weeks before the firm announced, on June 22, 2007, that it was willing to invest up to $3.2 billion to try to rescue one of its two highly leveraged mortgage-related hedge funds, run by Ralph Cioffi (chee-OFF-ee). The hedge funds - and everything else at the firm except for investment banking, private-client services (the brokers), and operations - reported to Warren Spector, ostensibly the second-ranking executive at Bear and its rising star. (Alan Schwartz was head of investment banking and, like Spector, a member of the executive committee.)

Spector, then 49, was a bridge player too. Growing up in Chevy Chase, Md., he took a year's sabbatical from Bethesda-Chevy Chase High School after his sophomore year to play bridge full-time. In 1976 the American Contract Bridge League named him the Scholastic King of Bridge. That fall, after graduating from high school, he matriculated at Princeton but after a semester moved on to Maryland's St. John's College. After receiving his MBA from the University of Chicago, he went to work at Bear Stearns in 1983 because the firm would allow him to start on a trading desk immediately rather than work as an analyst. Cayne thought Spector was a brilliant trader but also "an elitist with his own people" - in other words, a perfect personality, in his estimation, for an early appointment to the executive committee. Cayne made that move in 1992, when Spector was just 34.

In the beginning the firm's hedge funds were winners for Spector. In the winter of 2003 he staked Cioffi - a 22-year Bear employee who had worked as an institutional bond salesman - to $10 million of the firm's money to start a hedge fund. Even though Cioffi had never managed money before, he did well enough with his grubstake that the firm decided to set up the first fund-the High Grade fund - in October 2003. All went well - 40 months straight of positive returns. But in 2006, returns started falling, and redemption requests increased. In August 2006 the second hedge fund - the Enhanced fund - was set up to take bigger risks, using even more leverage. Many of the investors in the High Grade fund moved their money to the Enhanced fund on Cioffi's recommendation. Both of the funds, which ended up with about $1.6 billion of investors' money, were housed in Bear Stearns Asset Management (BSAM), which reported to Spector.

By June 2007, as the funds' performance had been deteriorating for a few months, their short-term lenders, among them Merrill Lynch (MER, Fortune 500) and J.P. Morgan (JPM, Fortune 500), became increasingly concerned about the value of their collateral - all those mortgaged-backed securities Cioffi had invested in. They wanted Cioffi to put up more collateral or, better yet, give them their money back. Sensing an impending crisis, Cioffi hired the Blackstone Group (BX) to advise him on a way to keep the creditors and investors at bay. They decided that Cioffi and his bosses at BSAM should hold a series of meetings with the creditors, urging them to sit tight and allow Cioffi to attempt an orderly liquidation of the funds' assets. But that was like yelling "Fire!" in a crowded theater.

Merrill ran for the exit. In the previous weeks the firm had repeated its demands that Cioffi put up more collateral, but Cioffi refused. Then, on June 15, the day after a creditors meeting, Merrill seized $850 million worth of the collateral. Other lenders soon followed Merrill's lead. The strategy of asking for more time had failed. (A year after the funds' collapse, Cioffi and a colleague were indicted on nine counts of conspiracy, securities fraud, and wire fraud for allegedly misleading investors about the condition of the two funds.)

Initially Cayne was not focused on the problem. He viewed his role as Bear's CEO as similar to that of Joe Torre in his Yankee heyday: He was managing a team of superstars, and he expected Spector to handle the problems in the hedge funds.

From July 18 to 29, Cayne participated in the elite Spingold KnockOut event at the North American Bridge Championship in Nashville. His team made it to the 16th round. Spector was also there-taking his first vacation of the year. But given the hedge fund mess, Spector's presence in Nashville irked Cayne no end. When Cayne returned to Bear's 47-story office tower in Midtown Manhattan on July 30, he convened a meeting of the 20 most senior executives at the firm to come up with a strategy for dealing with Cioffi's hedge funds. Before going into the meeting Cayne asked Steve Begleiter, the firm's head of strategy, how much money Bear had invested in the funds. Cayne thought the amount was $20 million. Begleiter told him the firm actually had $45 million invested. Cayne wanted to know where the other $25 million had come from, but Begleiter said he did not know. "So, we walk in," Cayne recalled. "I said, 'Before we discuss what we're going to do, does anybody know about the $25 million that was put into the funds at the last minute?' Spector: 'I did. I fucked up.' Now, there's silence. People were expecting me to say, 'Are you fucking crazy? You yourself authorized putting $25 million into the hedge funds?' Well, I didn't, and I didn't say anything for like 30 seconds."

Cayne felt the firm had two options: to shut the funds down and stiff the lenders and investors, or become the lender itself and risk the deluge that would follow. He contended that it was better to damage the firm's reputation than its balance sheet. Greenberg, according to Cayne, disagreed. (Both Greenberg and Spector declined to comment for this article.)

NEXT: The rise and fall of Jimmy Cayne (cont.)

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