Wall Street Law Blog

Banking is a Confidence Game. (updated)

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THE UNIQUE VULNERABILITY OF FINANCIAL INSTITUTIONS TO THE DREADED CONFIDENCE CRISIS

More than any other type of business, financial institutions are vulnerable to crises of confidence.  The demise of former powerhouse investment bank Bear Stearns is an ideal example.  

First, the financial world lost confidence in Bear's assets, which impaired its access to short-term credit.  Then the market lost confidence in Bear Stearns itself.   Hedge funds raced to pull their assets out of prime broker accounts at Bear.  The cycle repeated itself until Bear's failure was a foregone conclusion

Bear's mortgage assets were an albatross;  liquidity of the oversized portfolio dropped like a lead weight in water.  

Bear Stearns had a substantial prime brokerage unit. In simple terms, this means that other financial institutions - primarily hedge funds -  used Bear Stearns like you and I would use our local bank. Bear was custodian of billions of dollars for these prime brokerage clients. And it was these customers that drove the much talked about "run on the bank" that ate up Bear's insufficient liquidity and forced it into the arms of JP Morgan.

To paraphrase the Corleone men, 'it isn't personal, its only business.'  The "run" on Bear Stearns (i.e., hedge funds and other prime brokerage clients pulling their assets out of Bear the week of March 10, 2008) was not only justified, but fund managers would have been incredibly stupid / grossly negligent to leave assets with an investment bank that conceivably could end up filing for bankruptcy.  

There was no way  customers of Bear Stearns could afford to gamble millions and millions of dollars on the possibility that Bear would solve its nearly insurmountable problems and live happily ever after. 

When the market has no more confidence in your bank, the only prudent thing to do, the only smart thing to do, the only thing that makes any sense at all, is to get your cash out of Dodge. Why?  For this reason: When doubts arise about the viability of a major financial institution like Bear Stearns, you can bet that there are serious underlying problems at the heart of the matter.  

Therefore, any financial institution that suffers a crises of confidence must act swiftly and decisively to restore the market's faith and trust.  Failure to do so can mean a death sentence.

Excuses (difficult market conditions, evil short sellers) and denials (we don't need to raise cash, our balance sheet is strong, there is no pressure on our liquidity) only exacerbate a crisis of confidence.  That is exactly what happened to Bear Stearns.  The executive officers and directors of the fallen investment bank know very well that they can only blame themselves for the demise of Bear Stearns.

There is no question that the crisis of confidence suffered by Bear Stearns was the product of self-inflicted wounds.  

For starters, the company had a distinctly undiverse business structure. Bear Stearns was far too dependent on its fixed income businesses, and the firm lacked business units capable of replacing mortgage revenues after the market for mortgage-backed securities (MBS) collapsed. 

Lacking reliable replacement streams of revenue was bad enough, but Bear Stearns had also overloaded its own portfolio with, you guessed it, MBS. Bear Stearns drank its own cool-aide, and creditors eventually decided that illiquid (and therefore worthless) MBS were not acceptable collateral. 

To complete the trifecta, Bear Stearns buried itself beneath a mountain of debt. Bear was the most leveraged firm on Wall Street, at close to 35:1.  In other words, the firm borrowed almost all the money it used to fund its investment activities. Bear Stearns also depended on borrowing more than $50 billion each day in the overnight repo market just to have enough money to cover daily operating expenses. 

Bear Stearns was a mess and the markets knew it.  Instead of fixing the mess, or even owning up to it, management pretended everything was going to be fine.  Bear's strong culture of risk management would see it through some rough times.  In October 2007, Bear publicly declared that its businesses were recovering. Bear's reassurance was one of many lies senior executives foisted on the public.  Apparently, Bear hoped to stall long enough for market conditions to miraculously reverse and save the firm. 

For many months, Bear Stearns navigated dangerous, icy waters.  In March 2008, the firm slammed into an iceberg.  It took only a few days for the firm to go under. 

Jamie Dimon coined the term "fortress balance sheet."   By fortress balance sheet, Dimon, the CEO of JP Morgan, means financial institutions must have sufficient liquid capital to survive any shock to their balance sheets. 

Bear Stearns ignored this golden rule, and the firm paid the ultimate price.      

Black Swans*, Fraud by hindsight, and Mortgage-Backed Securities. (greatest hits collection)

Events are not unforeseeable merely because they are unprecedented... 

One of the primary arguments upon which Wall Street firms rely to defend themselves from securities fraud allegations is something like this -

We could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of "fraud by hindsight." 

The fraud by hindsight defense is pretty much automatic in securities fraud cases.  The meaning of the defense is, as it sounds, that there is no fraud if the alleged deceit can only be discerned after the fact. Hindsight is, after all, 20/20.  The legal issue is foreseeability.  

In financial crisis litigation, Wall Streeters insist that their actions (like marketing CDOs stuffed with subprime mortgages as ultra-safe investments) are not fraudulent because banks that sold toxic waste allegedly could not reasonably foresee the housing and credit bubbles or the consequences that would rain down when the bubble inevitably ruptured.

Further, Wall Street execs insist that mass defaults of subprime mortgages were not foreseeable simply because (they contend) the U.S. has never experienced a nationwide housing slump.  Presumably, these same Wall Street executives would argue that they cannot foresee the possibility that they will one day die because they haven't yet been dead.*     

OK, Wall Street:  From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  From 1995 through 2006 alone - even after adjusting for inflation - housing prices rose by more than 70%.  That type of housing growth certainly is unprecedented.  Why shouldn't such an unprecedented "up-cycle" in the housing market end in an unprecedented way?  The answer is that there is no reason.  

In fact, the housing boom was so far out of line with any previous housing cycle that one could easily argue that a reasonable economist, real estate professional, or CEO of an investment bank should have anticipated that a the story of housing's record-smashing growth would eventually come to a very ugly ending.   

The fact is that a huge number of respected experts from private industry and academia publicly warned of a huge housing bubble that could only end badly.  Certainly, many others kept quiet, wary of rocking the boat while the profits poured in, even though they too foresaw the end of the housing bubble and predicted its devastating impact on mortgage-backed securities.  

The fact is that, once the MBS industry became dependent on subprime mortgages, an eventual disaster was unavoidable.  Until the bubble popped, however, Wall Street was raking in far too much money to worry about the ramifications of the immense risks banks were taking.  

Fraud by hindsight is inapplicable in most financial crisis litigation.  Why?  Because choosing to ignore the apocalypse is far different from failing to foresee it.

      

*Inspired in part by the writings of Nassim Nicholas Taleb.

By Brett Sherman, The Sherman Law Firm