Saturday, March 15, 2008

Bear watch: Why it failed

(Naked Capitalism) As I am sure you all know by now, Bear Stearns started coming spectacularly unglued last night, and called JP Morgan, who in turn tapped the Fed, who sent examiners who stayed at the firm all night. In the morning, a plan was announced by which the central bank would assume the risk of lending to Bear against collateral which would be posted at JP Morgan (it's mechanically easier for the Fed to work through a member bank; the JPM loans are back-to-backed with the Fed).

The firm nevertheless unraveled with surprising speed. When CEO Alan Scwartz dismissed concerns about liquidity on Monday, he wasn't fibbing. The SEC, in what appears to be a CYA statement late Friday. From CNN (hat tip Alea):
SEC officials said in a statement that they had been monitoring Bear Stearns' financial situation on a daily basis in recent weeks, and had no cause for alarm earlier in the week. Bear's holding company capital exceeded regulatory standards at the end of February, and information supplied by Bear Stearns to the SEC on Tuesday showed the holding company had a "substantial capital cushion," according to the SEC. As of that date, the firm had more than $17 billion in cash and unencumbered liquid assets, the SEC said.

"Beginning on that day, however, and increasingly throughout the week, lenders and customers of Bear Stearns began to remove funds from the firm, despite its stable capital position. As a result, Bear Stearns' excess liquidity rapidly eroded," the statement says....The SEC division that oversees U.S. markets said it is continuing to monitor Bear Stearns' condition and believes its registered broker-dealers "remain in compliance with commission capital rules."

Lazard Freres has been engaged by Bear to try to find suitors, but the believe is that unless someone emerges over the weekend (odds low), a few choice pieces, like Bear's headquarters building, its prime brokerage and its asset management businesses, will be sold, and the rest liquidated (it is remotely possible that JP Morgan, who has inside knowledge via its involvement in the bailout, could make a deeply discounted bid for the entire firm, in effect getting the good bits and doing the liquidation itself). JC Flowers, Citadel, and some other private equity funds are expected to have a look, but if I were in their position, I'd be loath to bid against JP Morgan, given their information advantage.

The interesting thing about this collapse is that the general conditions that made Bear vulnerable are pretty clear; the immediate triggers less so. Let's go through both lists.

BEAR'S WEAKNESSES

High leverage, high exposure to risky credit businesses. The firm was widely seen to be, like Lehman, both highly geared, heavily dependent on credit market businesses, and therefore less stable.

Not well liked. This is not a trivial matter. Maintaining decent relationships with the Street is important. Bear created a lot of ill will in 1998 by refusing to chip in to the rescue of LTCM; it also incurred a lot of ire in its handling of its failed hedge funds last June (it planned to let them collapse, which would have left its counterparties with losses, until they ganged up on Bear).

Poor liquidity management. Bear should have known it was vulnerable due to its high gearing and the continuing crisis in the credit markets, Yet astonishingly, the firm was ill prepared for sudden cash demands. As the Wall Street Journal recounts:
Brokerages amass large cash piles -- often called liquidity reserves in their financial statements -- that are meant to see them through rocky periods in the markets....

Compared with other brokerages, Bear's cash reserve gives it the least cushion for a cash crisis....

Brokerages break out the size of this emergency cash in their financial filings with the Securities and Exchange Commission. To gauge its sufficiency, the reserve can be compared to the main type of debt that brokerages rely on to finance their operations. This debt is called collateralized borrowing, because to get the loans the brokerages have to pledge assets as security to the creditor. If these creditors pull back sharply, a brokerage is in deep trouble....

Bear would have been particularly exposed to this withdrawal, because its emergency cash pile was small compared to this debt. On Nov. 30, that cash reserve of $17 billion was only about 17% of the $102 billion owed through secured financings.

The same measure is 38% for Goldman, 39% for Morgan Stanley, and 34% for Merrill Lynch.

Possible worries about management. Bear had been perceived to be a tightly run ship under Ace Greenberg; by contrast, his successor James Cayne (who stepped down as CEO in January but remains chairman) had never been a trader and current CEO Alan Schwartz was formerly an investment banker. While I haven't seen this raised specifically as a concern, the image that Bear was a savvy, well run trading firm suffered a great deal in the last year. The risk management failings that led to the implosion of the subprime hedge funds was a shocker; just as troubling, for those who've been in the securities business, was the sloppiness in procedures (e.g., the inattention to taking the steps to prevent squabbles about the hedge funds' legal domicile) and possible failure to supervise fund manager Ralph Cioffi adequately in his personal dealings with the funds. And then we had the stories in the Wall Street Journal of both ousted co-president Warren Spector and Cayne himself spending a good deal of time on recreational pursuits when the firm was under duress.

POSSIBLE TRIGGERS

Elevated concern about counterparty risk. Remember that the first two eruptions of the credit crisis (August-September, then November-December) showed high stress in the bank lending markers, with banks hoarding liquidity, reluctant to engage in what would at other times be routine transactions.

This sort of widespread distrust has now infected the securities markets. The near-cessation of the auction rate securities market was the one result of this new sensitivity to risk. Investment banks have gotten tough on the terms they extend to hedge funds who borrow from them, increasing the haircuts on collateral. Less visibly, they have also evidently become more cautious in taking on routine trading risk.

As the Wall Street Journal noted:
Word began to spread among fixed-income traders nine days ago that European banks had stopped trading with Bear. Some U.S. fixed-income and stock traders began doing the same on Monday, pulling their cash from Bear for fear it could get locked up if there was a bankruptcy.

The pullback in Europe began around the time that Carlyle Capital started to founder, so the prospect of a Carlyle liquidation (remember, the hedge fund was a big MBS player) may have raised doubts about Bears' balance sheet.

Hedge fund flight. This to have accelerated the crisis. If a brokerage firm fails, customer assets are frozen which if you are a trader is already a terrible thing. Worse, as a reader told me, is that margin accounts become part of the bankruptcy, to be divided among all the creditors. While there is some debate on this point, Jim Rogers' Beeland fund had a considerable amount of assets custodied at Refco which went belly up when its CEO was found to have embezzled on a grand scale, and he took big losses as a result. The Journal indicates that Renaissance Technologies moved several billion of assets away from Bear this week. As the Financial Times's Lex column notes:
Counterparties either reduced their exposure to the firm or ratcheted up collateral requirements. The need for a rescue became self-fulfilling.

The New York Times provides a good synopsis:
[Bear] is also among the biggest firms in the prime brokerage business, or the financing of hedge funds. In recent weeks, nervous fund managers have scrambled to protect themselves. Robert Sloan, who is the managing partner at S3 Partners, a financing specialist that works with hedge funds, has shifted $25 billion out of Bear Stearns accounts in the last two months, he said.

“The problem is the financing of the hedge fund industry is very concentrated and very brittle,” Mr. Sloan said. “If they go under, you will have thousands of funds frozen out,” he said, adding that everyone might then have to wait for a court to name a receiver before business could resume.

But that still fails to explain why so many counterparties got an itchy trigger finger now. Recall that the SEC statement said the agency had been monitoring Bear's liquidity daily over the last few weeks. There must have been an event or rumor back then, and who knows, if word of intensified SEC oversight got out, that alone could have been very damaging.

But how would that affect Bear's liquidity? The specter of hedge fund accounts leaving no doubt was seen as confirmation of the possibility that Bear would go under. One would think that hedge fund customers paying off collateralized loans would improve Bear's liquidity, but by all accounts, the migration made matters worse (anyone who knows the operational details or valuation issues that might have played a role is encouraged to speak up).

Carlyle/TSLF collateral damage. This theory is hoisted from comments, and makes a good deal of sense:
The TSLF probably had the perverse effect of killing Carlyle Capital, the exact opposite of what was intended (Robert Peston @ BBC, via Alea). The TSLF gave creditors every incentive to seize Carlyle Capital's collateral in order to present it at the Fed window in exchange for "lovely liquid Treasuries", something which Carlyle Capital itself couldn't do. Bear, on the other hand, is allowed to use the TSLF... but the TSLF doesn't go live until March 27.

This suggests two things: first, the Bear bailout is much less significant than meets the eye, because it's just a Bear-only jumpstart to the TSLF which would have saved Bear anyway. In other words, it's nothing really new or different from the TSLF itself.

And secondly, an awful conspiracy theory presents itself: were Bear's creditors trying to deliberately hasten its demise (a la Carlyle) before Bear could take advantage of the TSLF, so they could grab Bear's collateral and turn it into desperately needed liquidity for themselves?

I'll go with a variant of the conspiracy theory: the collapse of Carlyle no doubt heightened worries about everything mortgage-related, and thus probably accelerated hedge fund withdrawals.

Alt-A losses. This comes from the Times (hat tip Michael Shelock):
Banking sources speculated that Bear Stearns could have been hit by last night's collapse in value of so called alt-A, or low-end prime mortgage securities.

"The Alt-A market fell out of bed last night and Bear would have been completely caned by this. They hold a bunch of these securities," one investment banking source told Times Online.

"Against what you might normally expect, the sub-prime market rallied, but alt-A sold off."

Given what we learned about the timing, it doesn't seem this factor was operative. Remember, Bear concluded that it was in trouble as of 4:30 pm on Thursday; it called James Dimon at JP Morgan at 6:00 pm., who immediately called the Fed, which then sent a team of examiners over to Bear that worked through the night. One has to wonder if the Alt-As collapsed because the rumor of Bear's extreme duress got out.

Regardless, this is a sad day. The Bear Stearns of old was a meritocratic place where someone from the wrong side of the tracks could be extremely successful. Ace Greenberg also made very generous donations and insisted his partners do so as well (my recollection is that the expected level was 5 or 6% of income). But as firms went public and started running on other people's money rather than putting partnership capital at risk every day, they became slicker and more reckless. I don't know the contermporary Bear all that well, but it is a casualty of the Street's sorry devolution.

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