The Bear Necessities: Law of the Jungle Rules

The Story Line

Just to be clear: Bear Stearns (BSC) isn't Baloo the bear, Ben Bernanke isn't Mowgli the Jungle Boy, panicked clients aren't Kaa the serpent and we're not talking about Kipling's Jungle Book. That said, the law of the jungle rules in this story. We are witnessing history, to be sure. Old, "been there, done that" history. History that has been replayed again and again. This is no different than any other bank run, when a crisis of confidence rapidly sucks liquidity out of the firm and book value, as such, becomes meaningless. When the most basic animal instincts kick in. Wikipedia has an interesting definition of a bank run:

A bank run (also known as a run on the bank) is a type of financial crisis. It is a panic which occurs when a large number of customers of a bank withdraw their deposits because they fear it is, or might become, insolvent. This action can destabilize the bank to the point where it becomes insolvent. Banks retain only a fraction of their deposits as cash (see fractional-reserve banking): the remainder is invested in securities and loans. No bank has enough reserves on hand to cope with more than the fraction of deposits being taken out at once.

********************

As a bank run progresses, it generates its own momentum. As more people withdraw their deposits, the likelihood of default increases, so other individuals have more incentive to withdraw their own deposits. A bank run is a kind of positive feedback loop which has much in common with the reflexive processes described by George Soros, amongst others. Another example of a reflexive process is economic bubble.

The Bubble in Reverse

I like how the concept of an economic bubble is used, the converse of the bank run. Up momentum as opposed to down momentum. In the case of Bear Stearns, the credit bubble supported a series of unwise decisions, developing excessive reliance on a business line (mortgage securitization and associated derivative products) and structuring portfolios (such as the now defunct mortgage hedge funds) that were designed to succeed only in a "perfect storm." It should be noted that this storm existed long enough for a passel of ill-conceived deals to get booked across the credit spectrum, from retail home loans to "toggle" PIK leveraged buyout loans. Back in April of last year I wrote a post titled Volatility Management in a Complacent World. This was the world in which Bear Stearns' stock price was rising and enjoying the boom times of a flush credit market and a bullish economic outlook. What a difference a year makes. The bubble burst, a crisis ensued, and our first bank run (in the U.S., that is - remember the UK's Northern Rock?) is now in our midst.

The Fragile Nature of Book Value

Book value is something that is accumulated and realized over time, and does not equal liquidation value. If investors didn't know this before they certainly know it now. Less than liquid positions are valuable only to the extent you can finance them, and if you operate a capital structure that lacks such permanence, you are skating on thin ice (see the earlier post It's the Liquidity, Stupid). To an extent the entire banking system operates on the edge of a precipice, running massive leverage and grossly mismatching asset cash flows with liability cash flows. In most non-financial businesses, the concept of asset and liability matching (by calculating and attempting to balance the modified duration of each) is a well-worn financial management objective. And while this is certainly discussed (and should be deeply ingrained in the DNA) within banks, their financial position seldom reflects this reality.

The Moving Target Called Liquidity

And the problem is further exacerbated by the ever-changing definition of what is "liquid" and what is not. Super-senior CMO strips? Liquid today, illiquid tomorrow. At their essence banks, especially investment banks that don't have the luxury of core retail deposits, are like hedge funds. Much of their capital structure is short-term in nature, and leveraged to the hilt (especially when off-balance sheet obligations like derivatives are taken into account) and in a crisis can be dramatically upset as lines are suspended, additional collateral demanded and assets sold to meet short-term obligations. All of these actions, of course, only exacerbate the problem, further hastening the decline. And as I've mentioned previously, once a hedge fund drops 50% it is toast. It could be a $20 billion fund whose NAV drops to $10 billion. It doesn't matter. Such a dramatic loss of value rattles investors to their core and causes a synchronous rush for the exits.

The Parallels With LTCM

This is kind of like LTCM redux. In many ways, startlingly like LTCM. A large, complex financial institution. Cumulative exposures (again, taking derivatives into account) exceeding $100 billion. A tangled web of counterparty relationships across most major financial institutions and relationships with investors large and small. A book of uncertain value, but a book whose value is likely to be far greater than it is today if only there were sufficient liquidity to carry it beyond the current crisis. Too big to fail. Too complex to fail. Sound familiar? It should. Oh, and lest anyone think this is a true "bailout," my guess is that equity holders in BSC will only do a bit better than the GPs in LTCM. The lion's share of the value will accrue to they who are willing to bridge the liquidity gap and carry the business until things stabilize. This is something to be gained by the risk-taker. The current equity holders are, in my opinion, largely screwed.

The Chance to Go Shopping

So what of the current market and the state of U.S. financial institutions? Clearly, they both suck. However, we've got JP Morgan Chase, B of A, Berkshire Hathaway, and maybe a few others who have the financial strength and business models to benefit from the rapid decline of Bear Stearns and the other inevitable meltdowns (Washington Mutual, anybody?). I think it is going to be shopping time for these firms, where they will selectively pick off people, business lines and entire firms at fire-sale prices. This is when good risk management and business judgment come in handy; parlay the crisis into an even stronger position at your less-prudent competitors' expense. Berkshire starting up a municipal bond insurer? It is just the tip of the iceberg.

The Victims: Too Many to Count

The decline of a proud firm like Bear Stearns is really hard to stomach for a long-time Wall Street denizen. I know dozens of people who work there, who are great at what they do and who had absolutely no hand in the strategies and steps that precipitated the current crisis. And they are all major stockholders of the firm. They are screwed. And it's just not fair. Think about retail investors who hold the stock. Firms that came to rely on Bear's advice and support. Sure, Bear will exist in some form, likely inside another financial institution, but it will never be the same. Maybe I'm just corny or getting long in the tooth, but this stuff really gets to me. This is no Barings; this is much, much closer to home.

The Punch Line

Bear Stearns, as we know it, is gone and never to return. Why did Ace have to give up the reins? Ace was all about managing risk. It is hard to imagine this happening with him at the helm. But bottom line: we are seeing another LTCM-style bail-out, only with the Fed's more active involvement. I believe moral hazard will be skirted because equity will largely be wiped out. This is a crisis of liquidity as well as a crisis of uncertainty. Just how much are those illiquid assets worth? Incalculable at this time. It only makes sense if a buyer can purchase them at a steep discount, much as how Citadel bought E*TRADE's mortgage portfolio. But buyers will emerge, just as they did when LTCM needed a sugar daddy. Buffett tried to get it then, but the difference here is that it is not merely a portfolio - it's also thousands of people. And that is a headache he likely won't sign up for. He had enough fun with Salomon Brothers. B of A? No way. JP Morgan Chase? A very strong possibility due to the business synergies and knowledge of their book. A headache for sure, but at the right price they'll simply take a few aspirin and call me in the morning. They'll print the trade.

Other Helpful Links:

1. WSJ
2. Felix Salmon
3. Barry Ritholtz
4. Bloomberg
5. Fortune

Addendum

This from an article in today's Wall Street Journal titled Debt Reckoning: U.S. Receives a Margin Call

Mohamed El-Erian, co-chief executive officer of Allianz SE's Pacific Investment Management Co., says the hedge-fund community is unwinding its leverage. "This will push more of them into 'survival mode,' further accentuating distressed sales and nervousness among the prime brokers," he wrote to his colleagues Thursday morning. "In such a world, the quality of the assets matters less than whether you can finance them [or] how liquid they are."

Exactly.

Comments

[j4thelonghaul]

Bear was in trouble in the 1980s and 1990s. It has been a poorly run firm for a long time. In my opinion the Fed shouldn't have bailed them out. How is it fair that the banking industry deals with regulators like the FDIC and OCC and are scrutinized and dictated to as to how they make loans? The playing field certainly isn't level for capital formation between banks and investment houses. However, the investment houses got into the business of originating loans (i.e. mortgages) and buying them for their own account. No one was looking at the quality of the borrower's ability to repay or the collateral.

A new unit should be created immediately similiar to the OCC that oversees the quality of the assets held by the likes of Bear Stearns, Goldman Sachs etc. They should be accountable to Congress given that these Capitalist institutions seem to want a tax payer bailout instead of policing and working with each other to preserve the integrity of our financial system.

I hate regulation but if Goldman and Morgan Stanley and all the others aren't going to work with each other to clean up the collective mess they created, then I the taxpayer want some control for my money.

[Purl Gurl]

Roger Ehrenberg comments in his editorial, in part,

"The decline of a proud firm like Bear Stearns is really hard to stomach for a long-time Wall Street denizen."

Well then, Roger, you are aware Wall Street is truly a massive organized crime industry. Those of us who are not close to Wall Street and do play the stock markets, are not blinded by a close view nor by close friendship. We savages out here in the wilds clearly see Wall Street as a corrupt high White Tower in the process of crumbling and falling. I am absolutely delighted by this collapse of Wall Street proper; revenge is finally ours, revenge for decades of Wall Street defrauding our American public.

In keeping with my firm but fair attitude, this current financial crisis is not entirely the fault of corrupt Wall Street. No, there is much responsibility to be shouldered by Americans who made rather poor financial decisions, such as borrowing more than they could afford. This collective poor financial decision making by our American public is the squeeze of the trigger of a shot heard around our world.

This time, a poorly aimed public bullet has struck Wall Street right in its corrupt and unethical heart. This heart is cash liquidity. I have no heart for Wall Street. In rural Oklahoma we often say, "He needed killing." This is a reflection of our rural farming justice system.

The heart of our current financial crisis is trust and confidence. Our American public, rightfully so, does not trust Wall Street and our American public, rightfully so, has no confidence in Wall Street. This is rightfully so because of decades of fat cats riding on the backs of our American public.

Americans are to blame for borrowing more money than could be afforded. Wall Street is to blame for generously lending money to those Americans, lenders knew right off could not afford to borrow. Our public borrowed, unwisely, based on hopes and dreams of enjoying a better life, based on a hope of simply owning a home to provide comfort for family and children. Wall Street, while enjoying lavish flats in Manhattan and driving Porsche cars, stepped right up and like a sly fat cat said, "No problem, we have lots of money for you."

This Wall Street fat cat knew ahead of time those borrowers would eventually default because of living beyond their means. This is of no concern to a Wall Street fat cat. No, instant gratification, instant cash for a Jaguar, this is the only thought of a Wall Street fat cat; “Be damned the future, I want my Brownstone right now.”

A curse and a blessing, our American public is out of their homes through foreclosure, out of money because Wall Street fat cats have defrauded all of their money, and our American public is now in a panic leading to a jerk of a financial trigger which has nearly fatally wounded Wall Street.

This is a curse because so many American families are suffering injury through poor financial decisions. This is a blessing because American families have learned Wall Street is organized crime. America families, today, are smartening up. I doubt Wall Street is doing the same.

Our financial crisis is all about trust and confidence. This is not about Bear Stearns being bailed out, this is not about Bank of America buying out a troubled company. This is about our American public having no trust in and no confidence in Wall Street.

You boys of Wall Street are having your butts spanked and this spanking is decades overdue.


Okpulot Taha
Choctaw Nation

[rnairb]

J4 - The fed needed to act to save Bear's counterparties and those who use Bear as a broker. With the exposure Bear has to the mortgage industry if the Fed were to simply allow Bear to fail we would see a domino effect unseen in the financial markets.

Purl Gurl your post reeks of ignorance.

[FrankLive]

Bear needs to fail to demonstrate what Purl Gurl is getting at (although overstated). I really would like to see the brokers who put together the loans to get their butts handed to them.

I can't tell you how many times I have sat down with a broker and worked out all the details of a loan just to have them at the last minute (at the time of signing when you have to have the money) point out that there were a few things they needed to go over. And these things were always to their advantage and not mine.

Based on my experiences, I believe this happens more than we'd like to think. The problem always is that a person goes to many different lenders and finally one steps up with what you have been told are favorable terms, then they change them on you. You are at their mercy in effect because you believe that there is no one else to turn to and that at least they are willing to lend you the needed money (for a car, for a house) and feel that no one else will lend you the money. So you sign the papers.

There is a bias on financial sites that people are smart about money because most people who write and respond to these articles are smart about money. Most people are not. And when they need a loan, they usually need the loan now and are not in a think it over and find the best loan available mode. They are shown what they can get now and how much it will cost now. "Yeh, the payment will go up in a couple of years", but you can "write your own ticket at that time" by getting a better loan at a lower payment...guaranteed!

I have not one bit of sympathy or empathy for these banks. They have had none for me and will get none from me.

[SIMPLE d]

rnairb ~ what reeks about what she said? Why don't you offer specific objections? Purl Gurl clearly stated her opinion and offered illustration beyond a one sentence comment.

Maybe she is only considering Now. What is happening seems to be limited to two camps:

Either 1) We really are greedy (Fat Cats) and needy (Average Citizen)
OR
2) The financial system is specifically designed to lower the ability of the common man to improve his condition.

Think about it. Money does not have to inflate. According to the Constitution, one dollar is to be set equal to 32 some odd grains of silver, or some such standard.

The Fed usurps.

Yes, greed has always existed. Stand back and consider, however, that perhaps the system we live under at present is encouraging greed to further other objectives...such as rendering the common man a serf, a slave, an economic prisoner to an elite ruling class.

WAKE UP. PLEASE. This is not conspiracy theory gibberish. Read Creature from Jekkyl Island.

When Bear Sterns is bailed out, as with all companies prior, the weight of the burden is shifted onto the American Taxpayer, lowering incrementally their standard of living. Time and time again. This is not new. The Fed along with Congress and w/e intermediary has bailed out many banks, firms, and companies throughout the years.

My stance = do not discount someone's opinion just because it is not yours. Wall Streets' butts may not really be "spanked"...... Wall Street is owned by the same people who run this place on the human level. Why are almost all Presidents Council on Foreign Relations members? Why are the original banking interests tied up with media, economic, and governmental control? Wall Street simply shifts the burden to the taxpayer via the Fed and Congress. Do you really think they will have pained gluteals?

However, we do live in a big house even if we are oblivious to that fact. X the stress. There is room for everybody.

Michael Gould
Celtic, Cheyenne, Cherokee

[bruin532]

The Fed is opening the door to accepting this morgage debt and for an eventual extension of Fanny and Freddie. Why was bear down to $26 then up to $30 on late day buying before close of business 3/14 and why was every share figuratively traded. If there worthless they should have gone to 10$ and stayed there. They'll be worth alot more when the debt is made tradeable. Lets start the bidding @ $50.
Secondly inflation and devalueing the dollar reduces the foreign debt and payments to SS . George Bust said he was gona fix SS, well be getting pennies on the dollar at retirement. Two ways to skin a cat. Lastly all the big industrial multy nationals are on sale and are continueing to be bought on down days and up days. Lots of foreign interest with cheap US greenbacks. Dont sell this market short.

[j4thelonghaul]

rnairb - I said they shouldn't have been bailed out but if they are going to get bailed out (since that is the news and the fact of the day) the entire street needs to be examined and new laws will need to be passed.

Wall Street certainly had no problem raising billions to pave the way for LBOs and mergers and workers at companies were the main target of the acquirers cuts. So since Wall Street isn't able or isn't willing to save itself and requires the help of the taxpayer there needs to be a new sheriff in town. Wall Street now wants to play with my money - other than what I have invested myself.

First it was insider trading in the 1980s, next it was deception with tech stock offerings and locked up thinly traded shares in the 90s and now this subprime mess. So over 25 or more years the Street's track record hasn't been real good.

I am a believer in America and capitalism and we will get through this mess. But if we all have to suffer for a time to send the message, I am prepared to do that. I don't care about the counterparties (the hedge funds and their wealthy clients). Those guys invested in illiquid instruments as it turns out so they can go to court and fight about why they lost money and who is responsible.

Basically, I expect the other investment banks to step up and figure out a way to attract capital to work through this mess. If they can't do it, then we don't need them.

[hook]

this article is very short sighted. again, why would anyone in their right mind buy BSC and assume possible federal indictment risk from the ongoing investigation by the us attorney's office in brooklyn. kind of like buying arthur anderson before the deluge.

[zenalgorithm]

I was short BSC at the beginning of its decline this past year, but I didn't hold onto my short - too volatile with too many major short squeezes...

I haven't checked lately, but BSC had $48 billion in subprime holdings about 9 months ago. They were also leveraged at 23X before the subprime meltdown occurred. So I knew they were basically insolvent 9 months ago...

But FED officials constantly hinted on CNBC that they wouldn't allow BSC or Lehman to go under. So just like how the big banks are protected by the FED and immune to any investment mistake they make, I realized that BSC was protected. So just like the big banks' shareholders stock prices are protected from BK, so is BSC share price from that dreaded $0.

I think the fear of the rumor that BSC was going insolvent and collapsing has really been a huge weight on the equities market. Now that BSC has been publicly shielded by the FED from insolvency and that this splinter has finally been removed from the market's hand, I would think that a pretty significant short squeeze is coming to this market over the next 3-5 days. The VIX at 31+ seems ready to top out on Monday morning if it hasn't already.

[sammyg123]

Bear was a pig, and pigs get slaughtered. It's about time the brokers got hit like this. It's a terrible industry, and very poorly regulated. It's chaotic, greed motivated, and with little or no enforceable ethical standards. Our finance industry has morphed into a wealth transfer mechanism to take money from others. Sometimes, it actually helps businesses grow and creates jobs, but those days are long gone. We, the regular folk, are paying a terrible price for their misdeeds..

[Dragant]

This story really points to why Warren Buffet clearly wants his successor to have a key understanding of risk. Investment banks with the leverage they use, the shadow financial world of derivatives and structured investment vehicles is a toxic, pure-risk play. Sometimes they get lucky but other times they do not.

[AmesTiedeman]

Who ever at BSC believed it wise to leverage itself 30-1 needs to be seriously spanked. Taking on this kind of risk is simply stupid. BSC is said to have had about 12 billion in equity. They rolled it up 30 times to 360 billion. A loss of a mere 3% and change and their equity would vanish. Pretty stupid. And for what? A few more pennies a share in quarterly earnings? Had they been conservative they would still have a $50.00 stock and most importantly they would survive. Not now. Total fools these morons.

[Purl Gurl]

Simple d states a simple truth,

"Wall Streets' butts may not really be 'spanked'...."

Before you can suffer having your butt spanked, you must first enjoy pride and dignity. Wall Street fat cats have neither.

These recent bouts of Wall Street fat cats being kicked out of corporate jets is meaningless. Those fat cats enjoy Golden Parachutes worth hundreds of millions, making for soft landings. More insulting is Capital Hill raising a big ruckus but taking no action; politicians are in the pockets of Wall Street fat cats.

All of us pissants out here would love to be paid hundreds of millions of dollars to be complete failures. We are really good at failure.

A lack of pride and dignity is almost impossible to cure. Accountability can be cured but is very difficult when government regulators and politicians are owned by Wall Street fat cats.

Recently, I submitted a shareholder proposal to a company for proxy vote. This proposal is to hire a specific person for a CEO position. Part of my proposal is linking his pay to share price performance; share value goes up, his pay goes up. Falling share prices, his pay also falls. This shareholder proposal will never fly like those corporate jets. This type of accountability is grossly unacceptable to Wall Street fat cats whose only intent is to continue ripping off the American public for as much money as possible.

There is no pride and dignity amongst those of Wall Street. There is no accountability amongst those of Wall Street. While I write of butt spankings, there truly are no butt spankings because those of Wall Street are untouchable; they are well guarded behind closed doors of vast estates of luxury bought with ill-gotten gains.

I probably should have my big butt spanked for stupidly thinking those of Wall Street can be held accountable for their actions. However, wishful thinking does feel good, at times.

I do wish I could take a switch to the bare butts of Wall Street fat cats.

Okpulot Taha
Choctaw Nation

[TN hick]

me thinks you avoid "moral hazard" by 100% recapture of the salary, bonuses, and severance of departing directors and corporate officers; 65% recapture from all other executive and supervisory personnel BEFORE any mark-down of equity

or in other words, stick it to the pigs that brung us to this sorry dance

[bruin532]

Now word is now out that JP Morgan put a bear squeeze on Bear Stern. Not enuf to get the assets on the cheap lets steal them instead. Can't imagine where the liquidity rumors were comming from and they've (Morgan) allready told the clients to hold pat since the'll soon be running the show. Sound like Bear has every reason to hold out go bankrupt and reconsolidate then go after Morgan for yelling fire in a crowded theater. Thanks Jamie