Wall Street Law Blog

The Fight Was Fixed - Risk Managers had no chance v. CEO's

By Brett Sherman, The Sherman Law Firm

I know it may be hard to remember at this point, but it wasn't so long ago that the sight of drywall and the sound of hammer striking nail was as common as the ubiquitous "For Sale" signs are today.  The economy was was moving forward so quickly that it was sweating.

During the height of the housing bubble, how many of you forgot the lessons of the technology stock implosion?  As a general rule, we tend to ignore/block out/forget the lessons of past financial traumas whenever the markets are humming and money is flowing. Risk managers are paid to disregard that general rule.

While the rest of us enjoy a bull market, risk managers must be corporate police officers.  A vital part of the risk management function is to guard against a business strategy that capable of crippling a company when the boom market cycle ends (and they always end).

During a boom, risk managers are unpopular.  Hardly anyone wants to hear that a sizzling market will eventually burn out.

The unfortunate reality, however, is that market bubbles have always popped.  Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. The unfortunate truth is that, no matter how strong a bull market may seem, we can never know for sure that disaster isn't lurking around the bend.

The future is now and always will be a mystery. Therefore, corporate risk managers must manage risk by devising strategies to mitigate potential negative consequences in the event of a market downturn.

Consider the last market bubble, the tech-wreck.  Remember how many people were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied?

Remember all the "paper millionaires"? Remember Dow 36,000?  Remember how it all ended?  Of course you do.  And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers.

The tech-wreck is a textbook example of a market bubble.  On its heels (thanks to the Fed's loose monetary policy) came the housing and mortgage boom.  Subprime-based mortgage- backed securities were the perfect investment to sell to unwitting investors.  So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles.

Wall Street firms reported record profits during the housing boom.  High annual profits meant high annual incentive-based compensation for senior Wall Street executives.  Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns.  Guess who won that battle?

As someone once said, the brightest stars burn out the fastest.  With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom. Then again, former investment banks like Bear Stearns and Lehman Brothers still may still have been profitable and lived to make more money another day.

In this day of ultra-sophisticated engineered securities, risk management is vital to the long-term success of any financial institution. Maybe corporate managers will realize that one day soon.

WALL STREET LAW BLOG WELCOMES YOUR COMMENTS.

 

CEO's Cayne and Schwartz refused to raise a cushion of capital. (greatest hits volume 2)

The Sherman Law Firm

Repeated decisions by Jimmy Cayne and Alan Schwartz not to seek an equity investment after the onset of the subprime crisis are not protected by the business judgement rule. 


Bear Stearns' CEO Jimmy Cayne and his successor Alan Schwartz each made  deliberate decisions not to raise equity after the collapse of Bear Stearns' subprime hedge funds in the summer of 2007.  These decisions were irresponsible and driven in part by self-interest.  


Credit markets began to constrict when the subprime crisis began in the summer of 2007.  Lenders grew more cautious during the flurry of bank mark-downs on mortgage-backed securities and collateralized debt obligations.

From early September 2007 Bear Stearns executives frequently urged Bear Stearns CEO Jimmy Cayne andPresident Alan Schwartz to obtain a substantial cash infusion.  

Cayne and Schwartz met with potential investors but ultimately found a reason why each deal could not work. Ultimately, Cayne concluded that he was not interested in an equity investment, and Schwartz concurred. 

In January 2008, when Schwartz took over as CEO, Bear Stearns executives stressed the need to raise money.  Schwartz expressly stated that Bear Stearns had no need for additional equity.  

Bear Stearns had a huge portfolio of mortgage-backed securities and related products, which the firm estimated to be worth 45 billion in October 2007 and 46 billion in March 2008.  

Regardless of Bear Stearns' appraisal of its portfolio, during the week of March 10, no lender was willing to accept the mortgage portfolio as collateral worth 46 billion (or anything remotely close). 

Bear Stearns could not have been surprised at the further tightening of credit and the dimmer view that lenders were taking of mortgage securities in the early months of 2008.  

In mid-February, UBS had written down more than 20 billion from its Alt-A mortgage holdings.  

In early March a large mortgage-backed securities hedge fund owned in part by the white-shoe Carlyle Group could not meet margin calls and ran out of money.  

On March 10, 2008, Moody's downgraded an Alt-A offering issued by Bear Stearns itself.  The markets clearly were according virtually no value to mortgage-backed securities.  Bear Stearns had a liquidity problem.  The rumors were true.  


Still, Executive Committee Chairman Ace Greenberg and CEO Alan Schwartz publicly claimed that the Company did not face a liquidity crisis until late in the week of March 10.  They pointed to the $18 billion in cash Bear held in its accounts.


However, Bear Stearns' liquidity requirements were far greater than $18 billion. 

In fact, Bear had a daily liquidity requirement of about $50 to $75 billion to fund its businesses. Most of Bear Stearns daily liquidity came in the form of overnight repo loans.  Overnight repos must be renewed, or rolled, each business day.  Repo loans are secured. They require collateral.  

Much of the collateral Bear Stearns regularly used to secure repo loans came from the firm's huge portfolio of toxic mortgage-backed securities and related instruments.  

In March 2008, Bear Stearns showed 45 billion in mortgage-related securities on its balance sheet.  No lender was willing to accept Bear Stearns' valuation, and many lenders chose not to accept  mortgage-backed securities as collateral at any price.    

Board Chairman Jimmy Cayne and CEO Alan Schwartz each knew the MBS collateral the firm used to secure its short term lending was distressed if not totally illquid.  Allowing the firm to reach that point without raising equity, selling the Company, or selling off mortgage securities was more than an error in judgment.  It was plain ignornance and incompetence by men who have a duty  to be knowledgeable and competent.   Bear's executives cannot be protected by the business judgment rule.