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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.