Posts tagged ‘bear stearns’

Sleep With The Dogs, Wake Up With Fleas

JP Morgan finds itself under the government microscope for having heartlessly... cooperated with the government four years ago

The U.S. Department of Justice and New York Attorney General Eric Schneiderman teamed up last week to sue J.P. Morgan in a headline-grabbing case alleging the fraudulent sale of mortgage-backed securities.

One notable detail: J.P. Morgan didn't sell the securities. The seller was Bear Stearns—yes, the same Bear Stearns that the government persuaded Morgan to buy in 2008. And, yes, the same government that is now participating in the lawsuit against Morgan to answer for stuff Bear did before the government got Morgan to buy it....

As for the federal government's role, it's helpful to recall some recent history: In the mid-2000s, Bear Stearns became—outside of Fannie Mae and Freddie Mac—perhaps the most reckless financial firm in the housing market. Bear was the smallest of the major Wall Street investment banks. But instead of allowing market punishment for Bear and its creditors when it was headed to bankruptcy, the feds decided the country could not survive a Bear failure. So they orchestrated a sale to J.P. Morgan and provided $29 billion in taxpayer financing to make it happen.

The principal author of the Bear deal was Timothy Geithner, who was then the president of the Federal Reserve Bank of New York and is now the Secretary of the Treasury. Until this week, we didn't think the Bear intervention could look any worse.

Somewhere there was a legal department fail here - I can't ever, ever imagine buying a company with Bear's reputation that was sinking into bankruptcy without doing either via an asset sale or letting the mess wash through Chapter 7 so there could be an old bank / new bank split.  But Bank of America made exactly the same mistake at roughly the same time with Countrywide, so it must have appeared at the time that the government largess here (or the government pressure) was too much to ignore.

Why Is No One From MF Global in Jail?

Whether crimes were involved in the failures of Enron, Lehman, & Bear Stearns is still being debated.  All three essentially died in the same way (borrowing short and investing long, with a liquidity crisis emerging when questions about the quality of their long-term investments caused them not to be able to roll over their short term debt).  Just making bad business decisions isn't illegal (or shouldn't be), but there are questions at all three whether management lied to (essentially defrauded) investors by hiding emerging problems and risks.

All that being said, MF Global strikes me as an order of magnitude worse.  They had roughly the same problem - they were unable to make what can be thought of as margin calls on leveraged investments that were going bad.  However, before they went bankrupt, it is pretty clear that they stole over a billion dollars of their customers' money.  Now, in criticizing Wall Street, people are pretty sloppy in over-using the word "stole."  But in this case it applies.  Everyone agrees that customer brokerage accounts are sacrosanct.  No matter what other fraud was or was not committed in these other cases, nothing remotely similar occurred in these other bankruptcies.

A few folks are talking civil actions against MF Global, but why isn't anyone up for criminal charges?  Someone, probably Corzine, committed a crime far worse than anything Jeff Skilling or Ken Lay were even accused of, much less convicted.   This happens time and again in the financial system.  People whine that we don't have enough regulations, but the most fundamental laws we have in place already are not enforced.

The Great Bailout

Peter Tchir via Zero Hedge

The AIG moment was the first time that the US threw any pretense of real capitalism out the window.  Bear Stearns at least was done by JPM with government help.  Fannie and Freddie were taken over, but they were always quasi government entities.  It was AIG that was truly special.  The government didn't even attempt to see if the banks had managed their exposures at all.  The government didn't even care if they had.  They panicked and saved the banks from their own folly - they didn't give capitalism a chance.  The US has never truly recovered from that.  The entire system looks to government support more and more.  Since AIG the Fed has been running at least one massive easing program or another constantly.  The government is lurching from spending program to spending program to keep the economy churning.

At the first signs of weakness we beg for the FED or ECB or the government to do something big and fast.  The European credit crisis seemed a final chance to put some capitalism back into capitalism.  To allow dumb decisions to pay the price for failure.  To reward the institutions that had properly navigated through the risks.  There was even a brief moment when it looked like Germany would do that - would force those who failed to pay the price and support those who had taken the best steps.  But now with Dexia bailed out and some super SIV on the way, it looks like we are once again heading down a path of not allowing failure - in fact we are once again rewarding failure and living beyond your means.  It isn't communism, but it certainly doesn't fit any classic definition of capitalism.

Double Standard

Jeff Skilling of Enron essentially sits in jail for being too publicly optimistic about his company's prospects in the face of a liquidity crisis  (despite popular perceptions, he was not convicted for accounting issues associated with off balance sheet entities).

I didn't follow the trial that closely, but my sense is that Skilling denied this charge.  But even if he had admitted it, it strikes me that he would have had an interesting case in his favor.  US securities law takes as an absolute core principle that relevant information must always be disclosed quickly and completely to both shareholders and potential shareholders alike.  It presumes that total openness is the best way to serve shareholders.

But in a short-term liquidity crisis, openness is the kiss of death.  As we have seen over the last 6 months, the merest hint that a liquidity crisis may exist at a company creates a real crisis, even if one did not exist before.  Liquidity crises are crises of confidence among short-term lenders, and the only way to fight such a crisis is to build confidence.  So what happens if the best way to serve shareholders is to keep silent about problems?  What if the best way to fulfill one's fiduciary responsibility to maintaining shareholder value is to be overly rosy in one's pronouncements during difficult times?

Fast forward to the Bear Stearn failure last year, from the Economist:

As recently as March 12th, Alan Schwartz, the chief executive of Bear Stearns, issued a statement responding to rumours that it was in trouble, saying that "we don't see any pressure on our liquidity, let alone a liquidity crisis." Two days later, only an emergency credit line arranged by the Federal Reserve was keeping the investment bank alive. (Meanwhile, as its share price tumbled on rumours of trouble on March 17th, Lehman Brothers issued a statement confirming that its "liquidity is very strong.")

And now, we hear that the Federal Government urged Bank of America's Kenneth Lewis to do exactly what Lay and Skilling were convicted of.

Federal Reserve Chairman Ben Bernanke and then-Treasury Department chief Henry Paulson pressured Bank of America Corp. to not discuss its increasingly troubled plan to buy Merrill Lynch & Co. -- a deal that later triggered a government bailout of BofA -- according to testimony by Kenneth Lewis, the bank's chief executive.

Mr. Lewis, testifying under oath before New York's attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant. As part of his testimony, a transcript of which was reviewed by The Wall Street Journal, Mr. Lewis said the government wanted him to keep quiet while the two sides negotiated government funding to help BofA absorb Merrill and its huge losses.

Federal Reserve Chairman Ben Bernanke and then-Treasury Department chief Henry Paulson pressured Bank of America Corp. to not discuss its increasingly troubled plan to buy Merrill Lynch & Co. -- a deal that later triggered a government bailout of BofA -- according to testimony by Kenneth Lewis, the bank's chief executive.

Mr. Lewis, testifying under oath before New York's attorney general in February, told prosecutors that he believed Messrs. Paulson and Bernanke were instructing him to keep silent about deepening financial difficulties at Merrill, the struggling brokerage giant. As part of his testimony, a transcript of which was reviewed by The Wall Street Journal, Mr. Lewis said the government wanted him to keep quiet while the two sides negotiated government funding to help BofA absorb Merrill and its huge losses.

Many observers found it odd when Skilling was convicted of giving false information to shareholders but not for insider trading.  The implication, then, was that Skilling was guilty of lying to shareholders but not for personal gain.  Why then, people asked, did he do it?  It is becoming increasingly clear that putting on a happy face during an impending liquidity crisis is the only responsible approach for a leader to take.  Whether he goes to jail for it or gets rewarded by the Feds for it comes down to, what?  PR?

Update: In fact, one can argue that the Enron situation is more honorable than the BofA situation.  Enron management was trying to protect the value of Enron shareholders.  In the case of BofA, the feds demanded that BofA management hide information in order to complete a transaction that BofA shareholders might rightly oppose.

Republicans to Receive Bailout from Congress

Congressional Democrats announced today that they had agreed to a bailout plan for Republicans after last week's devastating election results.  While exact details are unavailable, sources tell us that the Republicans will be given 4 seats in the Senate and 15 in the House.  Nancy Pelosi said in a statement today: "We've established pretty clearly over the last several months that failed strategies and management should not necessarily have to result in losses in market share, particularly for well-connected Washington insiders."

Asked for comment, Democratic strategist James Carville was giddy.  "This is brilliant.  It really doesn't give up anything of substance to the Republicans.  But it will sap the energy from the Republican Party for making any substantial changes, and make it more likely they will continue the failed strategies that led to this most recent loss.  After their recent failures, the Republicans were on the verge of being forced to reinvent their whole organization.  This bailout should reduce the likelihood of that substantially."

When asked if bailouts of AIG, General Motors, Ford, Chrysler, Freddie Mac, Fannie Mae, and Bear Stearns wouldn't similarly reduce the urgency to change failed approaches, Carville answered "no comment."

Wa' Happen?

I know that most non-financial folks, including myself, have their head spinning after this past few weeks' doings on Wall Street.  Doug Diamond and Anil Kashyap have a pretty good layman's roundup on Fannie/Freddie, Lehman, and AIG.  My sense is that their Lehman explanation also applies to Bear Stearns as well.  Here is just one small piece of a much longer article:

The Fannie and Freddie situation was a result of their unique roles
in the economy. They had been set up to support the housing market.
They helped guarantee mortgages (provided they met certain standards),
and were able to fund these guarantees by issuing their own debt, which
was in turn tacitly backed by the government. The government guarantees
allowed Fannie and Freddie to take on far more debt than a normal
company. In principle, they were also supposed to use the government
guarantee to reduce the mortgage cost to the homeowners, but the Fed
and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits
and squeeze the private sector out of the "conforming" mortgage market.
Regardless, many firms and foreign governments considered the debt of
Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly. 

Fannie and Freddie were weakly supervised and strayed from the core
mission. They began using their subsidized financing to buy
mortgage-backed securities which were backed by pools of mortgages that
did not meet their usual standards. Over the last year, it became clear
that their thin capital was not enough to cover the losses on these subprime
mortgages. The massive amount of diffusely held debt would have caused
collapses everywhere if it was defaulted upon; so the Treasury
announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government
would wipe out shareholders if it carried through with the guarantee),
no self-interested investor was willing to supply more equity to help
buffer the losses. Hence, the Treasury ended up taking them over.

Lehman's demise came when it could not even keep borrowing. Lehman
was rolling over at least $100 billion a month to finance its
investments in real estate, bonds, stocks, and financial assets. When
it is hard for lenders to monitor their investments and borrowers can
rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment
bank, it could transform its risk characteristics very easily by using
derivatives and by churning its trading portfolio. So for Lehman (and
all investment banks), the short-term financing is not an accident; it
is inevitable.

Why did the financing dry up? For months, short-sellers were
convinced that Lehman's real-estate losses were bigger than it had
acknowledged. As more bad news about the real estate market emerged,
including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman's costs of borrowing rose and its share price fell. With an
impending downgrade to its credit rating looming, legal restrictions
were going to prevent certain firms from continuing to lend to Lehman.
Other counterparties
that might have been able to lend, even if Lehman's credit rating was
impaired, simply decided that the chance of default in the near future
was too high, partly because they feared that future credit conditions
would get even tighter and force Lehman and others to default at that
time.

A.I.G. had to raise money because it had written $57 billion of insurance contracts whose payouts depended on the losses incurred on subprime real-estate related investments.
While its core insurance businesses and other subsidiaries (such as its
large aircraft-leasing operation) were doing fine, these contracts,
called credit default swaps (C.D.S.'s), were hemorrhaging.   

Furthermore, the possibility of further losses loomed if the housing
market continued to deteriorate. The credit-rating agencies looking at
the potential losses downgraded A.I.G.'s debt on Monday. With its lower
credit ratings, A.I.G.'s insurance contracts required A.I.G. to
demonstrate that it had collateral to service the contracts; estimates
suggested that it needed roughly $15 billion in immediate collateral.

A second problem A.I.G. faced is that if it failed to post the
collateral, it would be considered to have defaulted on the C.D.S.'s.
Were A.I.G. to default on C.D.S.'s, some other A.I.G. contracts (tied
to losses on other financial securities) contain clauses saying that
its other contractual partners could insist on prepayment of their
claims. These cross-default clauses are present so that resources from
one part of the business do not get diverted to plug a hole in another
part. A.I.G. had another $380 billion of these other insurance
contracts outstanding. No private investors were willing to step into
this situation and loan A.I.G. the money it needed to post the
collateral.

In the scramble to make good on the C.D.S.'s, A.I.G.'s ability to
service its own debt would come into question. A.I.G. had $160 billion
in bonds that were held all over the world: nowhere near as widely as
the Fannie and Freddie bonds, but still dispersed widely.

In addition, other large financial firms "” including Pacific
Investment Management Company (Pimco), the largest bond-investment fund
in the world "” had guaranteed A.I.G.'s bonds by writing C.D.S.
contracts.

Given the huge size of the contracts and the number of parties
intertwined, the Federal Reserve decided that a default by A.I.G. would
wreak havoc on the financial system and cause contagious failures.
There was an immediate need to get A.I.G. the collateral to honor its
contracts, so the Fed loaned A.I.G. $85 billion.

Update:  Travis has an awesome post with his own FAQ about what is going on.  Here is a taste:

Lots of financially naive folks think that we can remove all risk,
inflation, etc. by only ever trading apples for chickens on the barrel
head, and doing away with paper money (so that all money is gold) and
doing away fractional reserve banking, so that when I deposit one gold
coin in the bank, the bank can then take that actual physical gold coin
and loan it to someone else. It turns out that the friction involved in
doing things this way is so huge that the effect would make The Road
Warrior look like a children's bedtime story. You want to borrow money
to buy a car? The bank can't just loan money that's been deposited in
someone else's checking account - the bank has to get that person to
sign a note saying "yes, I understand that this money is on deposit
until that dude buying the card pays the bank back IN FULL". And the
lender, if he wants his money out ahead of time, is SOL. And even then,
there can be a flood, and your car gets totaled, and you get
Legionaire's disease, and you can't make the payments.

or this:

Now, for the next complication, let's also imagine that there are
300 million other people watching all of this, thinking "How bad is
this? Should I go down to the gun store, stock up on .223 and 12 gauge
shells, then stop by the veterinarians to see how much antibiotics I
can cadge before heading to the hills" ?

And the Feds really don't want 300 million armed folks heading
for the national forests, so they first try to tell everyone who owns a
bicycle "Hey, the value of your bike didn't really drop! It's still
worth $9!".

But no one wants to believe that.

So then they go to the guy who's writing insurance policies on
the value of bikes and they say "if you got $100 million, would that
calm things down a bit?".

Bear Stearns & Enron

I wondered if folks would find my analogy from Bear Stearns to Enron I posted the other day stretched. 

Because Enron's demise came in exactly this sort of liquidity crisis,
and the situations are nearly entirely parallel, all the way up to and
including the CEO telling the world all is well just days before the
failure.  But no one understood Enron's business, so its failure seemed
"out of the blue" and therefore was attributed by many to fraud,
lacking any other ready explanation.   In the case of Bear Stearns, the
public was educated in advance as to the problems in their portfolio
(with mortgage loans) such that the liquidity crisis was less of a
surprise and, having ready source of blame (subprime loans) no one has
felt the need to apply the fraud tag.

Apparently, the Economist sees the same connection (via a reader):

For many people, the mere fact of Enron's collapse is evidence that
Mr Skilling and his old mentor and boss, Ken Lay, who died between his
conviction and sentencing, presided over a fraudulent house of cards.
Yet Mr Skilling has always argued that Enron's collapse largely
resulted from a loss of trust in the firm by its financial-market
counterparties, who engaged in the equivalent of a bank run. Certainly,
the amounts of money involved in the specific frauds identified at
Enron were small compared to the amount of shareholder value that was
ultimately destroyed when it plunged into bankruptcy.

Yet recent events in the financial markets add some weight to Mr
Skilling's story"”though nobody is (yet) alleging the sort of fraudulent
behaviour on Wall Street that apparently took place at Enron. The
hastily arranged purchase of Bear Stearns by JP Morgan Chase is the
result of exactly such a bank run on the bank, as Bear's counterparties
lost faith in it. This has seen the destruction of most of its roughly
$20-billion market capitalisation since January 2007. By comparison,
$65 billion was wiped out at Enron, and $190 billion at Citigroup since
May 2007, as the credit crunch turned into a crisis in capitalism.

Mr Skilling's defence team unearthed another apparent inconsistency
in Mr Fastow's testimony that resonates with today's events. As Enron
entered its death spiral, Mr Lay held a meeting to reassure employees
that the firm was still in good shape, and that its "liquidity was
strong". The composite suggested that Mr Fastow "felt [Mr Lay's
comment] was an overstatement" stemming from Mr Lay's need to "increase
public confidence" in the firm.

The original FBI notes say that Mr Fastow thought the comment
"fair". The jury found Mr Lay guilty of fraud at least partly because
it believed the government's allegations that Mr Lay knew such bullish
statements were false when he made them.

As recently as March 12th, Alan Schwartz, the chief executive of
Bear Stearns, issued a statement responding to rumours that it was in
trouble, saying that "we don't see any pressure on our liquidity, let
alone a liquidity crisis." Two days later, only an emergency credit
line arranged by the Federal Reserve was keeping the investment bank
alive. (Meanwhile, as its share price tumbled on rumours of trouble on
March 17th, Lehman Brothers issued a statement confirming that its
"liquidity is very strong.")

Although it can do nothing for Mr Lay, the fate of Bear Stearns
illustrates how fast quickly a firm's prospects can go from promising
to non-existent when counterparties lose confidence in it. The rapid
loss of market value so soon after a bullish comment from a chief
executive may, judging by one reading of Enron's experience, get
prosecutorial juices going, should the financial crisis get so bad that
the public demands locking up some prominent Wall Streeters.

The article also includes more details of exculpatory evidence that was withheld from the Skilling team and will very likely lead to a new trial.  The Enron prosecution team has not had a very good record in appeals court scrutiny of their actions at trial:

For what it is worth, prosecutors have had a tougher time in the
appeals court with Enron-related cases than in the initial jury trials.
Convictions have been overturned in a case relating to Nigerian barges
that Enron sold to Merrill Lynch. The conviction of the chief financial
officer of Enron Broadband has also been vacated, after two trials. So,
too, was the decision to convict Enron's auditor, Arthur Andersen
(albeit too late to save the venerable firm from liquidation).

Bear Stearns Roundup

My friend Scott, who actually worked for Bear Stearns years ago, sent me one of the more down to earth explanations of a liquidity trap that I have heard of late.  Imagine that you had a mortgage on your house for 50% of its current value.  Then suppose that in this alternate mortgage world, you had to renew your mortgage every week.  Most of the time, you are fine -- you still have good income and solid underlying asset values, so you get renewed with a rubber stamp.  But suppose something happens - say 9/11.  What happens if your renewal comes up on 9/12?  It is very likely that in the chaos and uncertainty of such a time, you might have trouble getting renewed.  Your income is still fine, and your asset values are fine, but you just can't get anyone to renew your loan, because they are not renewing anyone's loan until they figure out what the hell is going on in the world.

Clearly there are some very bad assets lurking on company books, as companies are still coming to terms with just how lax mortgage lending had become.  But in this context, one can argue that JP Morgan got a screaming deal, particularly with the US Government bending over and cover most of the riskiest assets.  Sigh, yet another government bailout of an institution "too big to fail."  Just once I would like to test the "too big to fail" proposition.   Why can't all those bankers take 100% losses like Enron investors or Arthur Anderson partners.  Are they really too big to fail or too politically connected to fail?

Anyway, Hit and Run has a good roundup of opinion.

Update:  I don't want to imply that everyone gets off without cost here.  The Bear Stearns investors have taken a nearly total loss - $2 a share represents a price more than 98% below where it was a year or two ago.    What I don't understand is that having bought Bear's equity for essentially zero, why an additional $30 billion guarantee was needed from the government.

Highly Leveraged Financial Companies Sometimes Fail

Bear Stearns is being bought for a price that is barely indistinguishable from zero:

Just four days after Bear Stearns Chief Executive Alan Schwartz assured
Wall Street that his company was not in trouble, he was forced on
Sunday to sell the investment bank to competitor JPMorgan Chase for a
bargain-basement price of $2 a share, or $236.2 million.

The stunning last-minute buyout was aimed at averting a Bear Stearns
bankruptcy and a spreading crisis of confidence in the global financial
system sparked by the collapse in the subprime mortgage market. Bear
Stearns was the most exposed to risky bets on the loans; it is now the
first major bank to be undone by that market's collapse.

This is what happens to a highly leveraged company when there is a liquidity crisis.  Fears about the company's health caused most lenders to withhold short term capital, which then in turn brought those fears to reality. 

While I suspect that we may find a lot of stupid blunders (at least in hindsight) and poor decisions, my sense is that this has nothing to do with fraud of any sort.  Which raises some interesting questions about Enron.  Because Enron's demise came in exactly this sort of liquidity crisis, and the situations are nearly entirely parallel, all the way up to and including the CEO telling the world all is well just days before the failure.  But no one understood Enron's business, so its failure seemed "out of the blue" and therefore was attributed by many to fraud, lacking any other ready explanation.   In the case of Bear Stearns, the public was educated in advance as to the problems in their portfolio (with mortgage loans) such that the liquidity crisis was less of a surprise and, having ready source of blame (subprime loans) no one has felt the need to apply the fraud tag.  (It also did not help that Lay and Skilling kept a higher profile than Schwartz at Bear Stearns, so that they were an easier target for vilification. 

I never really had the time to fully understand all the charges against Skilling at Enron (though I do think he deserves a new trial) but I always thought that it was unfair to try to ring either Skilling or Lay up for fraud because they were out trumpeting the health of the company shortly before its collapse.  Because it is clear from the Bear Sterns collapse that liquidity crises have everything to do with confidence, and you could see the Bear Stearns CEO out there in the last few days trying to boost confidence.  Was that fraud?  Or was that his very legitimate duty and obligation given his fiduciary responsibility to shareholders?   Why is Schwartz at Bear Stearns fighting for shareholders when he is trying to build confidence in the company in a liquidity crisis but Lay and Skilling at Enron defrauding shareholders when they were doing exactly the same thing?