Corporate & Securities Law

"End of Wall Street" Series - A 'Leading Question'...

By Brett D. Sherman

Q: Mr. Cayne - Between you and me, would you keep your respective millions

in a bank if you weren't totally confident that your money was safe?

A: Puffs Cigar. Flicks ashes. Shrugs shoulders.

***

WHEN YOU ARE HOLDING OTHER PEOPLE'S MONEY - YOU CAN'T BLAME THEM FOR WITHDRAWING IT NOW AND ASKING QUESTIONS LATER...

    More than any other business, financial institutions are vulnerable to crises of confidence. Former investment bank Bear Stearns had a substantial prime brokerage unit. In simple terms, this means that other financial institutions - primarily hedge funds - essentially used Bear Stearns like you and I would use our local bank. Bear was custodian of billions of dollars for these prime brokerage clients. And it was these customers who were behind the much talked about "run on the bank" that ate up Bear's liquidity and forced it into the arms of JP Morgan.

To paraphrase the Corleone men, 'it isn't personal, its only business.'  The "run" on Bear Stearns (i.e., hedge funds and other prime brokerage clients pulling their assets out of Bear the week of March 10, 2008) was not only justified, but fund managers would have been incredibly stupid / grossly negligent to be leave their assets with the troubled investment bank.  

There is no way that customers of Bear Stearns could afford to gamble millions and millions of dollars on the possibility that Bear would live happily ever after. It wouldn't have been good risk management, know what I mean Mr. Cayne?  How 'bout you Mr. Schwartz?

When one's money may be in jeopardy because of legitimate questions about the stability of the custodian, the only prudent thing to do, the only smart thing to do, the only thing that makes any sense at all, is to get your cash out of Dodge.  And this bit of wisdom holds true whether the threat is as bad as you thought it was or not.

   Imagine you are sleeping on the sofa on the first floor of your house (you live alone).  The tv is on, and you could swear that, between snores, you heard the newscaster give your address and announce that there is a raging fire on the second floor.  Suddenly you are awake.  You may have dreamed the whole thing.  Then again, the news is on the tv.  Maybe the second floor is on fire.  Maybe not.  You have some options: You can go back to sleep and hope you aren't engulfed in flames or suffer from smoke inhalation, or you can get up and see if your house is burning down.  

You are so tired. You really want to sink back into the depression your body made on the sofa.  Then again, you hadn't planned on dying for quite a few years yet.  What to do?

Obviously, there is no choice.  You go back to sl.. Umm, you get up and check every single square inch of your home for any sign of fire.  You don't go back to sleep and hope everything is alright in the morning.

Some people seem to value money more than life itself.  No judgments here (unless you are or were a Wall Street senior executive or board member).  Regardless, most of us work hard to make enough money to support our families, our lifestyles, our golfing habits, and even our love for the game of bridge (I am not referring to you Jimmy Cayne - you didn't work that hard).  

If we common folk have a fairly good reason to suspect that our savings may be in jeopardy by keeping our money with, say, Bernie Madoff (pretend it is 2007), then most of us would demand our money back from Mr. Madoff and sons even if we did not know for sure that the threat is as serious as we fear.  None of us want to lose our wealth because of another's incompetent or criminal conduct.

Now, when doubts arise about the viability of a major financial institution like Bear Stearns, there is almost always a legitimate and serious problem (or problems) at the heart of the matter.  Any issue substantial enough to jeopardize confidence in an investment bank by investors, creditors, counter-parties, and customers is, by definition, serious. In March 2008, that is the situation Bear Stearns faced.

At any financial institution, it is the CEO's job - the CEO's responsibility - to prevent serious problems.  By serious, I mean the kind of problems that can undermine confidence in your company.  This is just the fact of the matter.  And, like it or not Mr. Cayne and Mr. Schwartz, the responsibility is warranted.  Wall Street Chief Executives regularly earn (or earned) eight figure bonuses. Its a bear, guys, but with that kind of pay comes some serious accountability.   

Yes, there was a run on Bear Stearns.  And it happened because practically everyone lost confidence in the former powerhouse investment bank.  However, the crisis of confidence grew out of serious problems that Bear Stearns created.  The Bear's wounds were self-inflicted.  

Some examples?  Certainly.  

For starters, the company had a distinctly undiverse business structure. Bear Stearns was far too dependent on its fixed income business and lacked sufficient fallback revenues after the market for mortgage-backed securities (MBS) collapsed. 

Lacking reliable replacement streams of revenue was bad enough, but Bear Stearns had also overloaded its securites portfolio with, you guessed it, toxic MBS. Bear Stearns drank its own cool-aide, and creditors eventually decided that the worthless MBS were not acceptable collateral. 

To complete the trifecta, Bear Stearns was buried beneath a mountain of debt.  Bear was the most leveraged firm on Wall Street, at close to 35:1.  In other words, the firm borrowed money to finance more than 95% of its investment activity. Bear Stearns also depended on borrowing more than $50 billion each day in the overnight repo market to fund daily operating expenses. There was no question that the investment bank was in trouble, as it had been since at least August 2007.

There was, by the way, a deepening credit crisis already ongoing by the week of March 10, 2008. Carlyle Capital's large MBS hedge fund had just collapsed, banks were writing down the value of Alt-A mortgage-backed securities and CDOs left and right (Bear held a lot of Alt-A MBS) and, on March 10, a major credit rating agency downgraded a CDO stocked with Alt-A MBS that Bear Stearns had securitized and sold.

In sum, there were innumerable reasons for the financial universe to lose confidence in Bear Stearns. There was no act of God, no perfect storm, no (as Jimmy Cayne has said) hurricane.  There was a poorly run investment bank that took tremendous risks and ultimately got burned. Bear's customers were right to pull their money. 

Bear Stearns was steaming through icy waters and hit an iceberg. Its customers had no responsibility to stay on board to see if the foundering boat could be salvaged.  The institutions that pulled their money from Bear Stearns did the responsible thing for their own clients. They couldn't risk the possibility that the millions of dollars and other assets they had on deposit with Bear Stearns would go down with the ship.   

Full post as published by Wall Street Law Blog on June 04, 2009 (boomark / email).