Bear Stearns' Subprime IPO

Everquest Financial is going public with risky mortgage bets purchased from its underwriter’s hedge funds

by Matthew Goldstein

Never underestimate the ability of a Wall Street investment firm to find a new way to pawn off risky assets onto retail investors. The latest example? The initial public offering for Everquest Financial.

Everquest is a fledgling financial-services company that has been buying up equity interests in risky bonds backed by subprime mortgages from hedge funds managed by Bear Stearns (BSC)—one of Wall Street's biggest underwriters of mortgage-backed securities and other exotic mortgage-related bonds. The deal appears to be an unprecedented attempt by a Wall Street house to dump its mortgage bets.

The sales pitch for the IPO, which Bear Stearns is also underwriting, is that Everquest will "provide attractive risk-adjusted returns" to shareholders by investing in collateralized debt obligations (CDOs)—a sophisticated bond that's made up of pieces of lots of other asset-backed bonds. The nine-month-old company expects to produce reliable earnings from the quarterly cash flows generated by the underlying "financial assets" in the 19 CDOs it either owns outright or has a majority equity interest in. Everquest's portfolio of CDOs is valued at about $720 million, of which nearly two-thirds were purchased last fall from hedge funds managed by Bear Stearns Asset Management, a subsidiary of the Wall Street firm.

But Everquest's portfolio could be a time bomb. A "substantial majority" of the CDOs are backed by mortgages to home buyers with risky credit histories, according to its filing with the Securities & Exchange Commission.

Trouble is, the subprime market has imploded this year with scores of home lenders going out of business and home foreclosures on the rise. There's fear on Wall Street that pain in the subprime housing market will undermine some of the bonds and CDOs backed by these mortgages—especially as the level of home loan defaults rises.

The Everquest filing notes this possibility, saying: "Subprime mortgages have experienced increased default rates in recent periods. A deterioration in the assets collateralizing the asset-backed securities held by our CDOs could negatively affect the cash flows."

No Arm's Length Transaction

The prospectus for every IPO contains a lengthy section entitled "risk factors." The purpose of this section is to make it difficult for investors to sue a company. It alerts them to all the things that could go wrong with a company's business model. Often much of what appears in the "risk factors" section is boilerplate stuff about the perils of operating in a competitive market, or a company's slim operating history.

But the risk factors section of the Everquest IPO—spread out over 21 pages—would give even the most high-stakes gambler reason to pause. That's especially so in light of the close relationship between Everquest and Bear Stearns.

The filing notes that most of the CDOs were bought from hedge funds managed by Bear Stearns and based on valuations established, in part, by Bear Stearns. The filing concedes that the transaction, in which Bear Stearns hedge funds received 16 million shares in the soon-to-be public company and $149 million in cash, was "not negotiated at arm's length."

That's not to say Everquest got a raw deal in buying up these CDOs from Bear Stearns. But the lack of a give-and-take negotiating process in assembling Everquest's investment portfolio is an indication of just how beholden the company is to the interests of Bear Stearns.

In fact, Everquest, which is based in New York but incorporated in the Cayman Islands, intends to operate with a minimum of employees. Other than an independently hired chief financial officer, Everquest mainly will rely on employees from Bear Stearns Asset Management to oversee the business.

Some Proceeds Will Pay Down Debt

Also running the show will be employees from Stone Tower Capital, a partner in the venture. Ralph Cioffi, a Bear Stearns senior managing director, will serve as co-chief executive, along with Michael Levitt, chairman of Stone Tower, a New York hedge fund. In fact, Everquest and Stone Tower have the same mailing address on West 57th Street in Manhattan.

Everquest also has a $200 million line of credit from Citigroup (C), from which it borrowed to pay for some of the CDO purchases. Some of the proceeds from the IPO will be used to pay down the line of credit.

The company isn't saying how many shares will be sold in the offering or who will do the selling. Presumably, some of the 16 million shares obtained by the Bear Stearns hedge fund will be included in the deal. Additionally, Bear Stearns itself purchased 1 million shares. The stock has yet to price.

Janet Tavakoli, a Chicago financial consultant who specializes in advising clients on asset-backed investments, isn't impressed with the Everquest offering. "There is a huge moral hazard with Bear providing the assumptions for valuing the CDO equity," says Tavakoli. "Bear Stearns Asset Management is very good at surveillance, so if it is trying to get CDO equity off of its balance sheet, incur the costs of securitization, and sell the risk without arm's length valuation, why would a customer want to buy it on that basis?" Bear Stearns declined to comment for this story.

The Everquest filing could be just the start of things to come for the CDO market, which has grown exponentially in recent years, largely because of the demand for bonds backed by mortgages. Last year about $158 billion in CDOs were sold, up from just $14 billion in 1996. In April, Highland Financial Partners, a CDO manager, filed for an IPO. If Bear Stearns can find buyers for Everquest shares, it's likely that other Wall Street banks with big exposure to the subprime market may follow its lead.

Matthew Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.