Wednesday, May 05, 2010

The Market Ate My (Bear Stearns) Homework

Despite the efforts we made prior to 2007 to reduce our exposure to the subprime sector, the scale of our activities in other sectors of the mortgage market caused widespread concerns about Bear Stearns’ solvency. These concerns were unfounded. Our capital ratios and liquidity pool remained high by historical standards. Nevertheless, as a result of these rumors, during the week of March 10, 2008, brokerage customers withdrew assets and counterparties refused to roll over repo facilities. These events resulted in a dramatic loss of liquidity. The market’s loss of confidence, even though it was unjustified and irrational, became a self-fulfilling prophecy. Testimony of James E. Cayne before the Financial Crisis Inquiry Commission

Is today "Corporations' Day"? At his eponymous website, Lew Rockwell wonders why we can't feel sorry for BP and ex-Bear Stearns CEO Cayne testifies that he did no wrong, "the market ate his homework".

Of the two arguments, I have some sympathy for Mr. Rockwell's view (although to assert, as he does, It should be obvious that BP is by far the leading victim seems so silly he can't be serious). Deep sea drilling seems like tricky business and BP will, no doubt, become the "whipping boy" of the environmental zealots (which is to distinguish the radical fringe from those with justified, but more balanced concerns). Yet, I can't see why one should wax anthropomorphic. BP is a corporation. I feel for the workers who died on the rig, those affected by the spill, and those, in and out of BP, who will lose jobs as a result, but for BP itself? No.

There are risks to such activities and BP (and the governments that issued the permits) were aware of them. Given the precedent setting Exxon-Valdez case, BP knew what a mistake could cost them. If it leads to bankruptcy chalk it up as a fat tail (an event statisticians deem low probability with large risk). Moreover, corporate bankruptcy isn't death. The assets and expertise will be re-incorporated, like Frankenstein's monster, into a new or existing corporation.

Turning to another fat tail, let's consider the events that led to the collapse of Bear Stearns. While Mr. Cayne would have you believe that concerns about their solvency were unfounded and their demise, unjust, I think it's simply a case of not doing one's homework.

Bear Stearns management were surely aware that their high leverage ratio (according to Fortune Magazine, 35 to 1) was the means by which they posted profits sufficient to drive their stock price above $150. That same leverage became the market perceived Sword of Damocles over their heads as credit conditions tightened. If they had opted for less leverage from 2005-2007, their stock price might not had risen so high, but they may well have survived the crisis.

Surely Mr. Cayne's nearly 40 years at Bear were sufficient to inform him of the fickle nature of credit markets, and the financial sharks with whom he swam.

Maybe that info was part of the homework the market ate?


Bunter said...

Remember, Jimmy Cayne was a retail broker at Bear - by all accounts a very good one - not a trader. Those are two very different skill sets. I worked at Bear from 2001 - 2005 and while I certainly did not intereact with him other than an introduction when my brokers and I got there, long-term employees all had nothing good to say about him as a manager let alone as CEO. I have no trouble believing he had no clue because he couldn't be bothered to know. Just my two cents.