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I read the book Street Fighters to get a real sense of history about the collapse of Bear Stearns. I truly felt that only an industry professional could understand the actual cause of the collapse. A lack of liquidity speculatively fueled by rumor mongering caused Bear Stearns to essentially beg the Federal Reserve for a bailout that fueled a large run on the bank.

There are several key bits of information leading to Bear Stearns collapse, some more obvious than others. I read this from the point of view as an analyst trying to figure out if in hindsight there was any hint that there could be a leading indicator into the failure of Bear Stearns. I have only identified leverage at 30:1 as the smoking gun. There is, however, buried in the footnotes talk of the actual corporate culture of Bear Stearns. The quote “Criticism is not welcome” was given to a higher up subordinate directly out of the mouth of Schwartz. Only an insider would have been privvy to this type of inside information. Though non-public, it would seem that to probe this question with regard to any company’s financial analysis a qualitative assessment of corporate governance would have revealed this fatal flaw.

We all know that leading to the Bear Stearns collapse was a shotgun wedding in which Paulson did not approve of what would have been an initial $10 bid by JP Morgan for Bear Stearns. Upon further review of the balance sheet there was $30 billion of unmarketable collateralized mortgage obligations that would normally be sold to obtain more CDO’s to sell. This process froze during the Credit Crisis, particularly around March 16th, 2008 and caused the liquidity crunch that stopped Bear Stearns from functioning in the market. Coupled with a run on the bank it appears to me that one particular facet could have spared Bear Stearns. Nearly 15 minutes after the acuisition was announced at 7:05 pm on the following Sunday around 7:18 the Federal Reserve announced that they would accept the CDO’s with AAA ratings as collateral for overnight funds. It is my assesment that this would have saved Bear Stearns. Around this time, I issued a statement last year calling these Corporate Liar Loans, which is what they are. Far from worthless, yet without a functioning secondary market to price theses assets, banks would mark to model these securities. The deal with JP Morgan would never have been completed without Geithner and Paulson lobbying for the acceptance of AAA paper as collateral for immediate overnight funding.

As an analyst, what struck me most was the absolute arrogance of Schwartz in all this. By the end of the book everyone was yelling at other saying “You should have sold” (our CDO’s) three months ago, but they refused to take the loss and ended up losing everything. This is surely hindsight, but a point of fact was the former corporate governance mentality of Ace Greenberg that essentially would never hold slightly losing positions. The losing positions, particularly the CDO’s, that caused the liquidity crunch would have been alleviated if these positions were not on the balance and cash was in hand.

During a conference call the prior weekend to BSC’s sale, an analyst had a buy rating on BSC. Understandably so, as the book value was $80, and BSC had closed at $30. JP Morgan made a fortune instantly on this deal. The original deal was announced at $2 with a crown jewel clause of the $1 billion headquarters of BSC. The later deal was upped to $10, which still was astronomically low from the book value of $80 per share.

As an analyst, I would say a much greater analysis of qualitative corporate governance documents as well as higher level interviews would have been a signal that something was amiss. Me personally I’ve long advocated for low debt to equity rations, no more than 20% of net worth should be debt. Just by Modigliani and Miller the company was nearly completely debt, and the costs of financial distress especially for BSC’s debt mispriced.

It has long been accepted that high debt to equity ratios are acceptable in the case of financial companies because of there ease and lower cost of issuing debt obligations. BSC did not have a capitalization problem. They had a liquidity problem. I cannot see the data anymore with any companies after BSC was sold, but I would bet that the current ratio was greatly below 1, meaning their short term obligation far exceeded their short term liquid assets.

I thought the book laid out in an understandable chronological fashion the events of the last 72 hours of Bear Stearns very clearly. I do think that the tangents to explaining the backgrounds of the players involved would have made a much better introduction than jumping straight into the liquidity panic at the beginning of the book.

In the end, the epilogue written with hindsight drew a parallel with the debt leverage ratios and overall economic conditions as the cause of not only BSC’s collapse, but Lehman’s, and AIG’s. I would posit that a combination of greed and hubris caused all of these firms essential demise. There’s no short straw that these were competitive cultures, but somewhere higher up there has got to be some form of humility. If I learned anything from this book, it’s that a good financial analyst explore qualitative somewhat nonpublic sources before making their assessment of a company’s long term prospects. Mainly I read this book to see if there was any way to at least know what was coming. In the end, there was only the smoking gun of intense leverage that caused operations to cease when large institutional clients began to pull money out of the accounts. Know that any company receiving Federal Funds is on the government’s time. What this means as investors is that all TARP receivers are failed companies, and are now controlled by the Treasury and Federal Reserve with quite a few strings attached. Normalcy will only return when the Treasury and the Federal Reserve are satisfied that the funds not only were repaid but that they are sure they will never have to re-issue bailout money again.

As it relates to Bear Stearns, the overnight receipt of funds from the collateralized mortgage obligations if they could be used by an investment bank to tap the discount window would have absolutely prevented BSC from being acquired at brutally heinous levels. This ability to tap the discount window ended a whole culture of investment banking, as more companies then turned into bank holding companies or financial supermarkets.

It’s a quick read, but an essential read if you truly want to understand the credit crisis and what is being done to correct it.

http://thomas.loc.gov/cgi-bin/query/z?c111:H.R.1068.IH:

This bill is the epitome of the destruction of capitalism and the free flow of capital.  These representatives do not have any idea how detrimental such a tax would be to the very foundation of modern financial markets. The 0.25% tax proposed on every securities transaction covered in the Securities Act of 1934 as well as on all futures contracts will destroy the decrease in transactions costs that have been seen since the decimalization of the stock market.  Any argument to the contrary stating that there is a benefit to this is an uninformed opinion, and would be made by only the stupidest of economically ignorant individuals.

I will add the caveat emptor in that this proposal has been attempted several times in the last decade, and has always been denied.

That, however, covers up the fact that these representatives do not have good economic advisors on their side.  Were we to do a cost benefit analysis of this bill, I would bet millions of dollars and up to the equivalent of world GDP for the next thousand years that this will be the worst disaster in the history of modern finance.

If you do not want to see equity values decline by 99% as everyone flocks towards guaranteed securities like treasury bonds, please contact these representatives and request that they remove this ill-conceived proposal.

It’s not on the senate floor, and probably will never make it there, but the fact it even made it to the house is troubling.  Every single American in particular is at risk of losing nearly all of their life savings through this bill.  Transactions costs have to be minimized in order to provide a free flow of financial information through the proper pricing of securities.  The imposition of this tax creates such a wide margin for valuation that it would be severly disruptive to the assesment of value for institutional and financial managers that are actually the main participants moving the market.

We have seen that the free flow of capital is of paramount importance in this day of instantaneous financial digestion.  Prices move quickly in response to new information.  The imposition of this tax means that the best investment would be savings accounts, and destroy the very fabric of all traditional forms of investment.

While I acknowledge we used to have this tax, I will say that this tax was absolutely an impediment to financial progress for decades where only the richest could take advantage of the mispricing caused by this tax.  We do not want to return to these times, and this will destroy much of the progress of financial markets and pricing that we have seen over the last two decades following the lowering of marginal corporate tax rates by former President Ronald Reagan.

If you do not want to see the only source of saving be your bank accounts with a paltry, non-inflation beating rate of return, please contact the representatives responsible for this proposal of financially unenlightened legislators.