In part, the vagaries of the prime brokerage business, where hedge funds park capital with a prime broker in exchange for broker services, further exacerbated conditions at Bear Stearns. The lucrative business of facilitating trades for hedge funds became a millstone for Bear in 2008: As the firm’s problems became public, many of its prime brokerage clients—Jim Simon’s Renaissance Technology, Citadel Investment Group, and PIMCO—sought to protect themselves from a messy collapse, pulling their capital out of the firm. Each departing client depleted the company’s capital base; each led to more Wall Street rumors of a possible bankruptcy. Each rumor prompted more prime brokerage clients to pull capital, and so on.1 Plummeting almost 90 percent, Bear Stearns’ liquidity pool went from $18.1 billion on March 10, 2008, to $2 billion by March 13, 2008. It was evidence of how quickly fortunes can change on Wall Street, especially at highly leveraged firms.
“A lot of people, it seemed, wanted to protect themselves from the possibility of rumors being true and act later to learn the facts,” Bear Stearns President and Chief Executive Alan Schwartz said in a March 14, 2008, conference call.
Was it a self-fulfilling prophecy? Funds fled Bear because they feared it might become insolvent; hedge funds shorting Bear Stearns’ stock passed along rumors that others were doing as much. Others bet on credit default swaps linked to the company, and were none too shy about e-mailing negative analysis to their peers and colleagues.
Is that what did Bear Stearns in?
Hardly.
Bear was a highly leveraged firm that bought lots and lots of bad assets with mostly borrowed money. The assets these products were based on—namely, subprime and Alt-A mortgages—were going bad at an increasingly rapid pace. It was readily apparent to the analysts and short sellers who crunched the numbers that Bear Stearns’ days were numbered.
That was the factor Wall Street CEOs like Dick Fuld, Hank Paulson, and Jimmy Cayne failed to consider: When you are a bank, your existence depends on the confidence of your clients, investors, and counterparties. “A company is only as solvent as the perception of its solvency,” said noted analyst Meredith Whitney, formerly of CIBC Oppenheimer.
Anything you do that puts that perception at risk is extremely dangerous. If you want to run lots of leverage and push the envelope, well, then, you’d better hope nothing else goes wrong. At 35:1 leverage, you do not leave a lot of room for error. If your business model is highly dependent upon access to cheap capital, what happens when that access to liquidity disappears?
Which raises this question: Why aren’t there ever runs on semiconductor firms or software companies? Why don’t the integrated oil companies or railroads suffer from similar bear raids? The short answer is their business model does not depend on a belief system—of solvency, liquidity, deleveraging, or risk management. All these firms have to do is not go bankrupt.
If you run a major investment bank, however, you also have to make sure you don’t appear to be remotely close to going bankrupt. You needed a bigger margin of safety. Such is the fate of those who depend on the confidence of others.
Bear was perhaps the most colorful example, but it wasn’t only a crisis of confidence that did in the investment banks; it was a crisis of competence.
And yet, somehow, the investment bank CEOs all failed to realize this. It is inexcusable that this much leverage was applied to firms that relied on others’ favorable belief in their solvency. It was unconscionable these firms had been purposefully put into a risk-taking position in extremis. That the CEOs blamed short sellers and rumors—but tried to exonerate their own horrific actions—serves only to emphasize not only their own failures, but their lack of comprehension of what they themselves had done to their firms. It was their own incompetent stewardship that purposefully and unknowingly placed these firms at such grave danger of destruction.
Imagine a patient being treated for a particularly aggressive form of cancer. The chemotherapy makes the patient’s hair fall out, so he buys himself a Yankee baseball cap to wear. Unfortunately, the cancer is too far progressed, and patient succumbs to the illness. If you were the management of Bear Stearns, you would blame the Yankees for the death of this patient.
Bear’s failure contained harbingers of what other management teams would soon do also:• Executives kept an upbeat public persona in the face of corporate disaster. “We don’t see any pressure on our liquidity, let alone a liquidity crisis,” Schwartz said on March 12, 2008. Four days later, when JPMorgan Chase announced its takeover of Bear for about $2 per share, he said: “The past week has been an incredibly difficult time for Bear Stearns. This transaction represents the best outcome for all of our constituencies based upon the current circumstances.”
• Executives failed to raise capital, or raised too little: “At least six efforts to raise billions of dollars—including selling a stake to leveraged-buyout titan Kohlberg Kravis Roberts & Co.—fizzled as either Bear Stearns or the suitors turned skittish,” the Wall Street Journal reported. Lehman Brothers, most notably, failed to heed this warning.
• Executives failed to see the folly of their ways. Former CEO James Cayne said Bear “ran into a hurricane,” which is a variation of the “act of God” and “100-year flood” excuses used by many a floundering CEO. There are reasons why buildings are made to withstand hurricanes and/or people buy hurricane insurance. CEOs reaping huge salaries can’t take all the credit for the good times and then blame so-called acts of God when things go bad—as they inevitably do.
Schwartz was in many ways the fall guy for the failures of his predecessor, Jimmy Cayne, who famously spent much of 2007 and 2008 playing golf and bridge. Infamously, the Wall Street Journal reported Cayne also favored marijuana.2 As Bear careened toward disaster, Schwartz got burned for Cayne’s fiddling.
An investment banker by training, Schwartz was admittedly not an expert in the complex mortgage-backed securities that were crippling the firm. That was the purview of co-president Warren Spector. In the years leading up to Bear’s fall, Cayne had reportedly given Spector free rein to run that side of the business (and it was a big side at Bear). Spector became the fall guy after those internal hedge funds blew up in the summer of 2007, and he was unceremoniously fired shortly thereafter.
When the crisis intensified in late 2007 and on into early 2008, Bear was being run by one executive who was in over his head, and another who had figuratively (and possibly literally) checked out. The Wall Street Journal reported that “repeated warnings from experienced traders, including 59-year Bear Stearns veteran Alan ‘Ace’ Greenberg, to unload mortgages went unheeded.” Schwartz, most notably, “didn’t want to unload tens of billions of dollars’ worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.”3 Any experienced trader will tell you to “cut your losers short and let your winners run.” That the corner office at Bear failed to grasp this is telling.
After Bear’s bailout, the question of who might be next was on all of Wall Street’s minds. What other overleveraged firm might also be in trouble?
The obvious answer was Lehman Brothers. Just two months after Bear’s demise, hedge fund manager David Einhorn explained at the Ira Sohn Investment Research Conference, an annual charity event, why he believed Lehman Brothers was the next candidate for problems. Einhorn questioned Lehman’s accounting, its Level 3 (“mark-to-make-believe”) assets, and its solvency. There were suggestions the firm was being evasive in terms of hard numbers for its liabilities.4
Why was Lehman Brothers allowed to fail when Bear Stearns was rescued? Why the nonbailout? Lehman was both older and larger than Bear Stearns. It had 25,000 employees at its peak, and the two firms were involved in similar businesses.
Unfortunately for Lehman, it seemed as if the team of Paulson and Bernanke were desperately hoping to avoid moral hazard. Bear was a one-off, they noted. Referring to the Fed’s funding of JPMorgan Chase’s takeover of Bear, Ben Bernanke said: “That was an extraordinary thing to do. I thoug
ht about it long and hard.... I hope this is a rare event. I hope this is something we never have to do again.”5
Rare? Hardly. History would repeat itself again and again as the year unfolded.
After Bear’s implosion, Lehman’s management considered their options. Its senior team—longtime, entrenched employees—were contemplating raising capital. Unfortunately, their loyalty and closeness to the company prevented them from fully grasping the firm’s dire circumstances—at least, not until it was too late. Selling a few billion dollars in preferred stock was the plan. By engineering JPMorgan’s takeover of Bear Stearns, the Fed may have lulled Lehman’s executives into a false sense of bravado regarding the urgency of their need to raise capital. Similarly, Lehman’s prime brokerage clients kept more funds with the struggling firm than they surely would have if they had seriously thought the Fed would let Lehman go under.6
In April 2008, less than a month after Bear Stearns’ demise, Lehman’s annual meeting took place. CEO Richard Fuld was pugnacious, and seemed not at all worried about the situation. He was rumored to have told Lehman Brothers employees: “I will hurt the shorts, and that is my goal.”
Talk about your misplaced efforts. Six months later, Lehman Brothers filed the biggest bankruptcy in American history. (Full disclosure: My firm was one of the shorts that was decidedly unhurt by Fuld’s efforts.)
Warren Buffett made an offer to Lehman, one that turned out to be more generous than the offer later accepted by Goldman Sachs.7 As noted in our discussion of moral hazard, one can surmise Lehman’s rejection of Buffett’s bid was the last straw as far as the Fed and Treasury were concerned. If they were unwilling to help themselves, went the thinking, then we’ll be damned if we’ll write another $30 billion check.
With Buffett spurned and an irritated Fed and Treasury, there were fewer and fewer options. Potential suitors kicked the tires at Lehman, but there were simply too many toxic assets on the books to attract a serious buyer.
Once Lehman filed for bankruptcy, Barclays scooped up most of the U.S. and U.K. operations—without any troubling bad paper to worry about. Neuberger Berman’s management—who had sold to Lehman Brothers a decade earlier—bought the wealth management unit post bankruptcy. They essentially bought themselves back. Nomura Securities took over Lehman’s Asian operations.
After 158 years, Lehman Brothers was no more.
The Terrible Lessons of Bear Stearns
Bear Stearns was rescued, but Lehman Brothers was forced to declare bankruptcy. Why?
These are the terrible lessons of Bear Stearns:• Go big: Don’t risk just your company; risk the entire world of finance. Modest incompetence is insufficient—if you destroy merely your own company, you won’t get rescued. You have to threaten to bring down the entire global financial system. The fear and disruption caused by a Bear collapse were why it was saved. (AIG had the right idea about size.)
• If you can’t go big, go first: Had Lehman collapsed before Bear, then the same fear and loathing over the impact to the system might have worked to its advantage. But the Fed having been through this once before, the sting was somewhat lessened—especially for an apparently less interconnected firm like Lehman (in the dot-com days, this was called “first mover advantage”).
• Threaten your counterparties: Bear Stearns had about $9 trillion in its derivatives book, of which 40 percent was held by JPMorgan. Some people have argued that the Bear bailout was actually a preemptive rescue of JPMorgan. That points to another good strategy, if your goal is a bailout—risk bringing down someone much bigger than yourself.
• Risk an important part of the economy: If your book of derivatives is limited to some obscure and irrelevant portion of the economy, you will not get saved. In contrast, AIG’s $40 trillion in credit default swaps (CDSs) might threaten much of the financial system. Mortgages are important, credit cards and auto loans less so—but securitized widget inventory is completely unimportant. To use a dirty word, Lehman’s exposure was “contained”—Bear’s and AIG’s were not.
• Incompetence is more tolerable than arrogance: Play bridge. Roll up a fattie. Work on your handicap. All these acts of foolishness generate a tsk-tsk from the powers that be. But this bumbling also led to a $29 billion assist for the purchase of the company. Pride, hubris, and a lack of humility create far worse results. Reject a legitimate bid from Warren Buffett and you’re really screwed.
• Balance sheets matter: You can focus on the media, complain about short sellers, and obsess about PR, but these are the hallmarks of a failing strategy—and a grand waste of time. Why? Insolvency. When everything is said and done, all that really matters is the firm’s balance sheet. Lehman’s liabilities exceeded its assets, and that meant no one wanted to buy the firm. Merrill Lynch got a lot of the junk off of its books, and was taken over at a 70 percent premium to its recent closing price. And Credit Suisse, which dumped much of its bad paper many quarters ago, remains in a better position than most of its peers.
• Unintended consequences lurk everywhere: When the Fed opened up the liquidity spigots via its alphabet soup of lending facilities, the fear was of the inflationary impacts. But the bigger issue should have been complacency. The Dick Fulds of the world said after Bear that these new facilities “put the liquidity issue to rest.” Lehman got complacent once liquidity was no longer an issue—and failed to act more quickly to resolve its capital needs.
Unfortunately, these are the terrible moral hazard lessons of 2008—via Bear Stearns, Lehman Brothers, Fannie Mae, Freddie Mac, and AIG.
Chapter 16
Dot-Com Penis Envy
What you do speaks so loud that I cannot hear what you say.
—Ralph Waldo Emerson
What took down the grand financial icons of Wall Street?
Why did a veritable conga line of storied names and legendary firms follow Bear Stearns and go the way of the dodo?
There are no hard-and-fast answers, but if you will indulge me, I have a theory. It may surprise and even shock you, given the stunning irresponsibility involved. But it is the only explanation that makes any logical sense, from either an economic perspective or a behavioral one.
No, it wasn’t a conspiracy of short sellers. Mark-to-market accounting rules had nothing to do with it. And in the recent era of radical deregulation, you can be sure that excess supervision and regulatory compliance were not the root cause.
The question before us is simply this: Why did these profitable, well-run companies insist on embracing ever greater amounts of risk? What was it that compelled formerly conservative, low-risk business models to throw caution to the winds, and shoot the moon?
The most cogent explanation is tied to misplaced incentives and the overcompensation of senior executives, especially the C-level execs. Much of it can be traced back to the glory days of the tech boom.
I call it the “dot-com stock option penis envy” theory of financial mismanagement.
Got a better theory? I’m all ears. But before you dismiss this one, let’s try it on for size:
In the bull market boom of 1982 to 2000, employees at Silicon Valley start-ups received huge pools of stock options. These were wildly risky companies whose potentials for success were quite slim. Indeed, the typical start-up eventually fails via conception or execution. Once the venture capitalist money is exhausted, it is on to the next start-up. Those few who made it really hit the big time: first Intel, then Microsoft, then Cisco, Apple, Dell, Oracle, AOL, and EMC. Each of these firms’ founders became billionaires, and many of their early hires became multimillionaires.
That alone wasn’t what did it. These were storied names, famously started in garages and dorm rooms. It wasn’t even the second wave of technology firms that went public that caused the problem. Netscape, Rambus, Microstrategy, Global Crossing, Research in Motion, Yahoo!, and others all grew rapidly, had enormous revenue, and were real businesses (well, maybe not Netscape, but the others did).
I suspect it was the thi
rd wave of technology initial public offerings (IPOs)—whisper-thin business models, zero profitability—that really got under the bankers’ skin. These were the merest wisps of companies, put together over the course of a semester or two by college kids. The bankers watched as companies like WebMD, CMGI, eToys, Investor Village, Excite, and InfoSpace went public, creating vast paper wealth; perhaps Pets.com was the last straw. When the pubescent founders/CEOs/dudes-in-chief became billionaires after their IPOs, one can only imagine what the bank executives thought.
I’d bet the East Coast CEOs turned green with envy. The big investment houses, banks, and insurers saw this from 3,000 miles away—and started losing their minds. It was going on right in the backyards of West Coast banks like Washington Mutual and IndyMac and Countrywide Financial. They witnessed this, and it got to be too much for their dopamine-addled brains. Soon they were scheming to get some of that sweet stock option lucre for themselves. They created a system of incentives that gave themselves huge stock options bonuses. Sauce for the goose is sauce for the gander indeed.
Unfortunately, there were two major flaws in the plan. When technology creates what has become known as “the killer app”—the hockey stick portion of growth—it catches a wave. These were new product lines, groundbreaking ecosystems, vast changes in consumer habits. E-mail! Mobile phones! Online retail! iPods! Game-changing booms like these were most likely to come from technology. The companies that developed these were awesome wealth producers. As these products became widely adopted, a natural sweet spot for cashing in stock options was created.
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