Risk taker refused to be risk maker

A throwback to a bygone era, Bear Stearns still operated as a cigar-chomping, suspender-wearing culture where taking risks was rewarded.

But there were some things that even that risk taker were too much to Bear. It was one of the few that took a Stearn stand against the temptations to which Goldman Sachs strayed.

The WSJ Deal Journal blog excerpted some interesting bits from Gregory Zuckerman's 2009 book, “The Greatest Trade Ever: The Behind-The-Scenes Story of How John Paulson Defied Wall Street and Made Financial History”:

Paulson and Pellegrini were eager to find ways to expand their wager against risky mortgages; accumulating it in the market sometimes proved a slow process. So they made appointments with bankers at Bear Stearns, Deutsche Bank, Goldman Sachs, and other firms to ask if they would create CDOs that Paulson & Co. could essentially bet against.

Paulson and his team were open with the banks they met with to propose the idea.

“We want to ramp it up,” Pellegrini told a group of Bear Stearns bankers, explaining his idea.

However, at least one banker smelled trouble and rejected the idea. Paulson didn’t come out and say it, but the banker suspected that Paulson would push for combustible mortgages and debt to go into any CDO, making it more likely that it would go up in flames. Some of those likely to buy the CDO slices were endowments and pension plans, not just deep-pocketed hedge funds, adding to the wariness.

Scott Eichel, a senior Bear Stearns trader, was among those at the in vestment bank who sat through a meeting with Paulson but later turned down the idea. He worried that Paulson would want especially ugly mortgages for the CDOs, like a bettor asking a football owner to bench a
star quarterback to improve the odds of his wager against the team. Either way, he felt it would look improper.

“On the one hand, we’d be selling the deals” to investors, without telling them that a bearish hedge fund was the impetus for the transaction, Eichel told a colleague; on the other, Bear Stearns would be helping Paulson wager against the deals.

“We had three meetings with John, we were working on a trade together,” says Eichel. “He had a bearish view and was very open about what he wanted to do, he was more up front than most of them.

“But it didn’t pass the ethics standards; it was a reputation issue, and it didn’t pass our moral compass. We didn’t think we should sell deals that someone was shorting on the other side,” Eichel says.

Other bankers, including those at Deutsche Bank and Goldman Sachs, didn’t see anything wrong with Paulson’s request and agreed to work with his team.

One of the biggest losers, however, wasn’t any investor on the other side. It was the very bank that worked with Paulson on many of the deals: Deutsche Bank. The big bank had failed to sell all of the CDO deals it constructed at Paulson’s behest and was stuck with chunks of toxic mortgages, suffering about $500 million of losses from these customized transactions, according to a senior executive of the German bank.