Dear Mr. Buffett: What an Investor Learns 1,269 Miles From Wall Street

by Janet M. Tavakoli

  The Fed was supposed to protect banks not nonbank investment banks and nonbank primary dealers. Primary dealers included the worst actors in the subprime lending crisis. The Fed not only failed to speak out against the bad guys before or during the crisis, it had just announced it was bailing out some bad guys after-the-fact.

  Similar to the terms of its August 2007 bailout of Countrywide’s borrowing problems, the Fed would lend up to 28 days. The primary dealers had to pledge securities to secure the loans. The Fed announced it would accept mortgage-related assets having AAA ratings as well as other assets with any kind of nominal investment grade rating. The Fed proposed to “haircut,” or discount those securities by 5 percent, but that would not be nearly enough to cover potential losses. The only condition was that the assets could not be on negative credit watch. Given how poorly the ratings agencies had “watched” up until then, it seems that the Fed will take in assets worth much less than a nominal price of 95 cents on the dollar. The prices on overrated mortgage-backed assets had proven to be wildly inflated. Did the Fed think no one would notice? In the coming weeks, the Bank of England would launch a bailout of its own and demand five to six times the discount asked for by the Fed.

  I was against the Fed’s actions. It was like watching a trailer for the Fed’s version of a financial horror movie: 28 Days Later—four weeks after the Fed debases the dollar by exchanging treasuries for trash, the raging virus of inflation infects the planet.

  The Carlyle Group was off the hook; only investors in Carlyle Capital’s fund would lose money. On March 13, 2008, Carlyle Capital announced the fund’s collapse. It had failed to find financing and it had failed to negotiate the standstill agreement it sought. On March 13, 2008, Carlyle Capital announced it defaulted on about $16.6 billion in loans.27 The Fed had conveniently provided Carlyle’s creditors with a source of liquidity. Now Carlyle Capital’s assets need never come under public scrutiny. Carlyle Capital said its assets were mostly agency AAA mortgage-backed paper, but the agencies had owned up to having AAA rated subprime-backed RMBS tranches, so what exactly backed Carlyle’s investments? Carlyle Capital’s $940 million fund went under and its creditors took approximately $22.7 billion in assets back on their balance sheets. Now they had to fund them (with a little help from the Fed).28293031 Some said the Carlyle Group took a hit to its reputation, but others disagree. One banker told me: “This shows how much clout the Carlyle Group really has.”

  As for the investors that lost money in the Carlyle Capital fund, David Rubenstein made a cryptic remark: “We will try to make this experience ultimately feel better than it does today.”32 I do not recall ever before hearing a fund manager say anything like that to investors that lost money in a fund. Don’t worry, we’ll make it up to you; we’re connected, so you’re connected.

  Carlyle’s creditors included Bear Stearns, Merrill Lynch & Co., Deutsche Bank AG, and Citigroup, Inc.33 Bear Stearns could not yet access the Fed’s largesse, since the proposed borrowing plan for primary dealers was not yet in effect. One might be tempted to blame market rumors for Bear Stearns’s demise, but there were plenty of troublesome facts to infer that anyone with exposure to Bear Stearns should consider reducing that exposure.

  Benjamin Graham had warned of new conditions causing a nervous market to stampede, and creditors could infer they had reason to be nervous.

  Neither Moody’s affirmation that Bear Stearns’ rating was stable, nor the press release issued by Bear Stearns convinced the market that Bear Stearns had enough liquidity. The morning of March 11, Bear Stearns’ CFO Sam Molinaro appeared on CNBC to flatly deny that Bear was having liquidity problems. Bear had used up its good will, an important source of Wall Street liquidity in a crisis. Carlyle had not yet announced its March 13 collapse but market watchers wondered: How much exposure did Bear Stearns have to Carlyle Capital? What about the money-losing credit derivatives (long exposure to subprime CDOs) trades that Paulson mentioned the previous year? What about the assets Bear Stearns took back on balance sheet from the two hedge funds in the summer of 2007—how were they doing? One could infer from publicly available information that these were reasonable questions, but Bear Stearns again created its own PR disaster by failing to anticipate these concerns.

  Rumors circulated that highly leveraged Lehman Brothers was also having liquidity problems. Lehman informally denied it, and unlike Bear, Lehman still had many market supporters (Lehman would not declare bankruptcy until six months later).

  On March 11, SEC Chairman Cox said he was comfortable that Bear Stearns, Lehman Brothers, Merrill Lynch, Goldman Sachs, and Morgan Stanley had enough capital. Based on what, exactly? “We are reviewing the adequacy of capital at the holding company level on a constant basis, daily in some cases.”34 This statement gave me no comfort. The SEC’s failure to shut down investment banks’ financial meth labs (Byzantine CDOs) made it as credible as a rating agency in my eyes. Given that investment banks priced tens of billions of dollars of assets using only managements’ assumptions, and given their excessive leverage, no one should have been comfortable.

  Earlier in the day, rumors spread that Goldman Sachs35 or CSFB36 or both had sent an e-mail letter bomb to hedge fund clients saying that it would no longer take fees for intermediating Bear Stearns’ derivatives transactions. Up until then, investment banks pocketed cash to stand in the middle of the hedge funds’ derivative trades with Bear Stearns. In credit derivatives speak, sending an e-mail like that was as good as saying you expected Bear Stearns to lose its investment grade rating and possibly go bankrupt. Goldman later told Fortune the e-mail did not say it would categorically refuse to sell credit protection on Bear Stearns.37 By the end of the day, on Tuesday, March 11, 2008, it seemed the entire credit derivatives market was reluctant to sell credit default protection on Bear Stearns.

  That afternoon, I spoke with Jonathan Wald, CNBC’s senior vice president of business news, saying there was a lot of turmoil. I mentioned that it looked as if there would be a large fund failure. I was referring to Carlyle Capital Corporation Ltd., but did not name it (it collapsed two days later). Wald said we might get together for coffee the following day, unless Eliot Spitzer resigned since the sex scandal would cram his schedule. I responded,“In that case, we should schedule it another time.” Spitzer was out of options.

  On the morning of Wednesday, March 12, 2008, Alan Schwartz, then CEO of Bear Stearns for less than one fiscal quarter, was in Palm Beach, Florida. He gave an early morning interview to CNBC. Schwartz claimed he saw no liquidity pressure on Bear Stearns. He said the holding company had a liquidity cushion of $17 billion in cash, plus there were billions of dollars in cash and unpledged collateral at the subsidiaries. He smiled and I thought he looked relaxed. CNBC was not trying to be funny when, partway through Schwartz’s interview, a female commentator broke in to announce that Eliot Spitzer would resign that day.38

  Was Schwartz bluffing? It appeared to me he was. He said the previous week had been a “difficult time” in the mortgage market with rumors about problems at the government-sponsored entities (Fannie Mae and Freddie Mac), funds (he did not mention Carlyle Capital Corporation by name) invested in “very high quality” mortgage instruments with high leverage that were having problems, and that people might “speculate” that Bear Stearns also had problems since it was a “significant” player in the mortgage market.39 The only part of Schwartz’s spin that the market bought was his observation that in tough markets, there is a tendency to “Sell first and ask questions later.”40

  While $17 billion sounds like a large number, if market prices moved down 5 percent—$17 billion and more could disappear faster than a car in Gone in 60 Seconds. For securitized lending, the market now asked for 3 percent more collateral for mortgage-backed bonds issued by Fannie Mae and Freddie Mac (Carlyle Capital-type assets); and was now asking for 30 percent collateral on Alt-A backed bonds. Jeffrey Rosenberg, head of credit strategy research for Bank of America, said this funding dried up an
d “that appears to have been Bear’s problem.”41

  In fact, the Fed’s new lending program may have contributed to Bear Stearns’s downfall. Banks took Carlyle Capital’s assets knowing the Fed would soon provide liquidity for them, but the program was not yet in place, and Bear Stearns had fewer funding options than other banks.42 As one CEO of a boutique investment bank told me: “Bear Stearns had no friends.” The Fed indirectly bailed out Carlyle’s creditors—and saved the Carlyle Group from pressure to come up with bailout money—but now Bear Stearns had a problem.

  Kevin O’Leary, the managing director of Boston’s Tibbar Capital, was in St Bart’s with other hedge fund managers. The hedge fund managers did not mess around. O’Leary said they felt Bear Stearns might be forced into bankruptcy, and it was not worth the risk of losing a part of their cash by leaving it tied up in margin accounts at Bear Stearns. They simply pushed the button and boom, billions moved out of their trading accounts and into custodian accounts, so Bear Stearns was no longer able to borrow against these assets.43 That made quite a dent in Schwartz’s cash and unpledged collateral at the subsidiaries.44

  The CEO of a small New York investment bank said he was concerned about his clearing account, given that Bear Stearns’ sources of liquidity were turning their backs. He explored other alternatives. He was relieved after Jamie Dimon announced his bid for Bear Stearns a few days later and told me: “It doesn’t get better than a guarantee from JPMorgan Chase and the Fed.”

  On Friday March 14, 2008, there was still hope for Bear Stearns; it was not yet dead. The Fed announced a stop-gap loan (Bear Stearns later found out it was only good for a day), but since its lending program was not yet operational, it agreed to accept collateral via JPMorgan Chase. It was odd. If JPMorgan Chase had confidence in Bear Stearns’s collateral, it could have accepted the collateral itself (on a recourse basis) and made the loan to Bear Stearns. JPMorgan Chase has access to the Fed and could meet its own liquidity needs there.The announcement made it seem as if JPMorgan Chase did not trust the value of the assets. The market will price the assets, but you may not like the price.

  That day, I discussed this move both Bloomberg Television and Canada’s business news network, BNN. The market still questioned the survival of Bear Stearns, but Lehman Brothers was able to get financing. There seemed to be a view that “a firm is only as solvent as people think it is.” I pointed out that is not true. If you are liquid, solvent, have a positive cash flow and you have no leverage—you do not have to borrow money—and it does not matter what the market thinks about you.

  If you are solvent but not liquid (you need cash but the value of your assets make you more than good for it) and you can prove you are solvent, you tend to get the liquidity, since people will lend you money. But if you are highly leveraged, it only takes a small negative change in the perception of the value of your collateral for you to be in trouble.

  The investment banks were playing a very dangerous game, and they were losing that game. They could not prove they were solvent (if they were). No one trusted their own pricing, and there was no transparency.

  If no one can figure out if an investment bank is solvent, short-term financing disappears. In fact, the investment bank itself may not know whether or not it is solvent.

  If you lend a brother-in-law $100,000 for the down payment on a $1 million home, and the price of the home goes to $1.1 million, you might be willing to give him a short-term loan of $1,000 knowing he’s temporarily short of cash, but he’s good for it. If you know, however, that the price of all of the homes in his neighborhood are down to $900,000, you know he will be lucky to pay you any of the money you originally lent him.You might say no to an additional short-term loan of $1,000.

  Warren Buffett and Charlie Munger avoid leverage so that they are not at the mercy of the manic depressive Mr. Market. By supplying investment banks with liquidity, the Fed introduced huge moral hazard. The Fed rewarded those who brought down the housing market.

  I told Bloomberg: The $200 billion lending program “is really bad for the dollar; the Fed is now practicing junk economics.”The Fed agreed to accept ersatz AAA rated paper in exchange for treasuries, and the rating agencies now had further incentive not to downgrade these securities. The problem is lack of trust in the underlying collateral. The problem goes right back to the mortgage market and leveraged corporate loans on investment banks’ balance sheets. The Fed swept the problem under the rug by taking the collateral. “This is a bailout of the rich . . . You are worried about recession? You should be terrified about inflation. Inflation is the great destroyer” The Fed is counterfeiting dollars, but we call it debasing the currency because the Fed is behind it instead of gangsters.45

  Bruce Foerster, president of South Beach Capital Markets, told Bloomberg Television that the publicly traded large investment banks and commercial banks are a “national asset.”46 A commodity trader in Chicago heard Foerster’s comments “Bear Stearns,” he said, “. . . a ‘national asset’ Gag!”

  I observed that large investment banks had failed before; for example, Drexel Burnham Lambert went bankrupt in the 1980s. In the 1990s GE made a quick sale of its troubled Kidder Peabody holdings to Paine Webber. Let it happen. Jim Rogers, head of Rogers Holdings, asserts that a bear market cleans out the system, and it is good for capitalism and the markets. Bear Stearns was the fifth largest investment bank in the United States. If you believe the Fed’s excuse that the whole system is so fragile that will fall apart if Bear Stearns goes under, what happens when one of the larger investment banks goes under? The Federal Reserve is using up its balance sheet. It will have no weapons in its arsenal for the next time.47

  By the weekend, Bear Stearns was looking for a rescuer. Warren Buffett turned down a request to lead the rescue. He could not evaluate Bear Stearns in one weekend, and he didn’t have enough capital.48 Alan Schwartz later told Jamie Dimon that Bear Stearns directors wanted a double-digit bid because there was a “psychological limit.”49 Warren studied under Graham, who would probably advise that emotional directors should not set a stock price any more than the emotional Mr. Market should set the price at which an investor buys or sells. A low price does not mean a company is trading at fair value, and not even Warren Buffett can come up with a value on these hard-to-price assets in that period of time.

  JPMorgan Chase bought Bear Stearns with some assistance from the Federal Reserve. Now JPMorgan Chase has to decode Bear Stearns’s $400 billionish balance sheet including mortgage backed securities valued at $56 billion.50 No matter how one spins this, JPMorgan Chase bought a pig in a poke, and it is not in the interest of the health of the financial system for banks to be forced to operate that way.

  Since Bear Stearns was so highly leveraged, the stock was probably worth zero, and it was unclear if all of the creditors of Bear Stearns would be paid in full. Those who later talked about the “value” of the Bear Stearn’s headquarters building may not have realized that in bankruptcy, sales of all of Bear Stearns’s assets—including the building—might not have covered its debts. Creditors would probably have had to write off bad debts, and there would be nothing leftover for shareholders. Even if every Bear Stearns investment banker hocked their jewelry and watches, it probably wouldn’t be enough.That is the nature of leverage.

  It would have looked bad if Jamie Dimon bid, say a penny or a dollar for Bear Stearns’s stock, so JPMorgan Chase bid $2. This was still probably $2 too high, but if it wanted to take control, Dimon had to possess the shares. Jamie Dimon told Congress: “We could not and would not have assumed the substantial risks of acquiring Bear Stearns without the $30 billion facility provided by the Fed. . . . We are acquiring some $360 billion of Bear Stearns assets and liabilities. The notion that Bear Stearns’ riskiest assets have been placed in the $30 billion Fed facility is simply not true. And if there is ever a loss on the assets pledged to the Fed, the first $1 billion of that loss will be borne by JPMorgan alone.”51 As part of the deal, the Federal Res
erve agreed to take $30 billion of Bear Stearns’s securities, and JPMorgan Chase put up only $1 billion as security (at 3.3 percent, this is less than the margin the Fed proposed for its lending program). However, if the price of the assets declined, JPMorgan Chase could walk away. Were the assets already overvalued? Who knows? As Dimon himself said: “Buying a house is not the same thing as buying a house on fire.”5253 The Fed did not provide the necessary transparency for anyone on the outside to offer an independent opinion. JPMorgan Chase may have paid $1 billion for the right to put potentially overvalued and deteriorating assets to the Fed. Within three months the Fed admitted that if it used market prices, JPMorgan Chase’s $1 billion would be history and the Fed itself had a loss.54

  The deal temporarily went sideways after JPMorgan Chase discovered it had inadvertently given away a valuable option for free. Buried in the 74-page agreement brokered and partially financed by the Fed was a clause putting JPMorgan on the hook to finance Bear Stearns’s trades for a year, whether or not shareholders accepted the deal. In the end, JPMorgan Chase increased its bid from $2 per share to $10 per share (or $2.2 billion—not counting the $1 billion at risk that JPMorgan put up as collateral to the Fed) and the shareholders approved the deal. By the end of May 2008, Bear Stearns was no more.5556

  Was the bailout necessary? It is convenient that supporters cannot prove their case, and I cannot prove mine, either. But I can hypothesize. If Bear Stearns failed, the banking system could have bid on Bear Stearns’s derivatives books just as it did when Drexel went under. The system may have purchased cheaper assets if Bear Stearns had gone bankrupt. While temporarily painful, once the system trusted each other’s prices, easier trading might have resumed. I am much more worried about the inflationary consequences of the balooning bailouts.

  Was the purchase of Bear Stearns a good idea for JPMorgan Chase? The rushed weekend purchase of a highly leveraged company led to a costly mistake and is the same thing as buying a bag of mystery meat. JPMorgan Chase looked in the bag, and it is still trying to figure out what it is. It seems to me that JPMorgan Chase overpaid, and Jamie Dimon seemed a bit testy afterwards. When Vikram Pandit, Citigroup’s CEO, asked a question about long-term guarantees during a conference call, Jamie said:“Stop being such a jerk.”57 This is when I first realized that Jamie and I graduated from the same charm school.