Wall Street Law Blog

Loss Frequency v. Loss Magnitude - A Financial Risk Management Lesson

 

By  Brett Sherman

The Sherman Law Firm

In finance, risk is the chance that an investment decision or strategy will result in loss.  Any analysis of risk must consider two major elements

- FREQUENCY OF LOSS and MAGNITUDE OF LOSS. 

 

First, defining terms:

Frequency refers to how often an investing or trading strategy generates losses. 

Magnitude refers to the size, or severity, of potential losses. 

 

  A profitable strategy that generates losses most of the time?  Sure.

  

Some really good investing or trading strategies result in losses more often than profits. Suppose, for example, that hyothetical Plan X results in a $10 loss 80% of the time, but a $100 profit 20% of the time.  So, 8 out of every 10 times you attempt the strategy, your expectation is that you will lose $10, for a total loss of $80 dollars.  However, if your expectation holds true, you also will make $100 two out of every ten times the strategy is executed.  

Thus, Plan X is risky from a frequency standpoint because you will lose money most of the time.  However, as long as you can afford to take losses and keep pursuing the strategy, Plan X is still a pretty good gamble because your expectation is that it will pay off over time, generating - on average - a net profit of $120 for every 10 times the strategy is used.   

 

 A strategy that is almost always profitable can still wipe you out.

 Some investment or trading strategies are extremely risky even though they rarely produce losses. Take, for example hypothetical Plan Y, which - on average - produces a $10 profit 90% of the time.  

A 90% success record sure sounds good.  But, if Plan Y results in losses of at least $500 roughly 10% of the time, then the strategy's risk magnitude (potential for large losses) makes it a bad long-term bet.  Why?  Because, for each ten times you execute Plan Y, you expect to suffer a net loss of $990 or more.  

 

Of Short-term Genius and Long-term Disaster

Now, suppose that Trading Desk A1A follows Plan Y for 5 years.  In each of the five years, the Trading Desk A1A makes money for its parent company.  This is no surprise, because Plan Y is profitable 90% of the time.

After five great years, the Company proudly points to its track record of superior performance.  To the investing public (which is ignorant of the fact that Plan Y will eventually generate high  losses), the Company seems to be thriving.

In year 6, the Company's luck begins to run out.  It loses $300, not as bad as the expected loss of at least $500, but still a big enough loss to put the Company on shaky ground.  In year 7, the Company decides to allow Trading Desk A1A to stick with Plan Y.  After all, the investment strategy is almost always successful.  Unfortunately, year 7 is another bad year.  This time, the Company takes a $500 loss.

For the Company, the size (magnitude) of the losses in years 6 and 7 proves to be  catastrophic.  The Company avoids bankruptcy only because JPMorgan Chase agrees to buy the Company for $2 a share.

Disclaimer- this is a hypothetical situation, any similarities to real world events are purely coincidental! 

 

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The two most important words in financial risk management?

WHAT -and- IF

By Brett Sherman, The Sherman Law Firm                  

Worst Case Scenario Analysis - Management of low frequency / high magnitude risks. 

 

Companies must have methods for controlling risks inherent in activities with -

(a) a high probability of success, but

(b) can produce catastrophic losses with just one failure.

***

The ultimate risk management responsibility for publicly owned corporations is to assure that a company cannot be crippled if a business strategy / model goes horribly wrong.  

It is impossible to manage against the risk of high loss magnitude events unless corporate risk managers and senior management agree to start all risk analysis with two words - 

"WHAT" and "IF"

 

FOR EXAMPLE-

 

What if our hedging strategy fails?

 

-or- 

 What if home prices fall?  (the common sense question that could have prevented the failure of Lehman Brothers, and Bear Stearns - and maybe even the financial crisis)

* * *

So, why weren't these basic questions asked by nearly enough companies during the housing bubble?  

That's right - Because an overloaded money train was pulling into Wall Street and Orange County, California (the epicenter of nonprime lending) on a regular basis, and asking "what if" questions would have yielded (pun intended) answers that lenders and bankers did not want to hear.  This is risk management by denial (also called willful blindness or, more colorfully, burying one's common sense in the sand).

Tell us what you think: Wall Street Law Blog welcomes your comments and your criticism.

Bear Stearns, Merrill Lynch Expected Housing Disaster (our all-time most viewed post; first published Oct. 2010)

"These aren't simply the comments of some junior level analysts" Lee Sherman, securities litigation consultant

the question of foreseeability asks at what point in time senior management at these investment banks should have foreseen the possibility of the disasters that eventually befell them.

the significance of these reports is that they conclusively establish the views of top economic analysts at Merrill Lynch and Bear Stearns. Whether plaintiffs' attorneys prove that senior management at the two investment banks actually read the reports ought to be immaterial.

UPDATE: Because Bear Stearns Execs' FCIC testimony largely focused on allegedly unforeseeable, "unprecedented" market forces to defend their lack of competent management, Wall Street Law Blog decided to re-post one of our favorites. 

Long before their respective employers ceased to exist as independent companies, former Merrill Lynch Top North American Economist David A. Rosenberg and former Bear Stearns Chief Equities Investment Strategist Francois Trahan published research reports with explicit warnings about asset and credit bubbles in the U.S. housing and mortgage markets.

As early as August 2004, Mr. Rosenberg, Chief Economist at Merrill Lynch for North America, published a detailed analysis regarding the precarious state of the American housing market. Rosenberg warned that there could serious problems ahead in an Economic Commentary entitled: "Housing: If not a Bubble Then an Oversized Sud."

Former Bear Stearns Chief Equities Investment Strategist Francois Trahan first published a report that raised serious questions about housing and real estate investments in a May 2005 report called "REIT all About it." Trahan and his team at Bear Stearns followed their 2005 report with publications in 2006 that explicitly warned about the difficult future facing the U.S. housing market and even raised the possibility of a global credit crisis. The 2006 Bear Stearns reports definitively described the housing market as an unsustainable "bubble" and further cautioned that the term bubble was not one the Bear team used lightly.

It was not until 2008 that overcommitments to mortgage-backed securities (a byproduct of the housing boom), CDO's and related products tied to residential and commercial mortgages caused Merrill Lynch and Bear Stearns to suffer backbreaking losses so severe that Merrill sold itself to Bank of America and Bear Stearns narrowly avoided bankruptcy with a Fed-assisted fire sale to JP Morgan.

--Background

Along with a number of other Wall Street firms, Merrill Lynch and Bear Stearns lost tens of billions of dollars because of their firms' respective commitments to securities backed by mortgages in the "subprime" and "Alt-A" categories. Subprime and Alt-A residential mortgages are considered risky loans because they carry higher default rates than "conforming" mortgages (also called prime mortgages, or agency-quality mortgages). Typical subprime or Alt-A borrowers cannot qualify for a conforming mortgage due to factors that include, but are not limited to, bad credit histories, personal bankruptcies, insufficient income, and the inability to make sufficiently large down-payments.

--Significance of the Merrill Lynch and Bear Stearns reports

While the ultimate import of the reports remains to be seen, The Sherman Law Firm says there is no doubt that the documents are crucial to the touchstone litigation element of foreseeability. "In a litigation sense," said Managing Attorney Brett Sherman, "the question of foreseeability asks at what point in time senior management at these investment banks should have foreseen the possibility of the disasters that eventually befell them."

According to The Sherman Law Firm, the reports at issue may show that senior management at Merrill Lynch and Bear Stearns should have foreseen the liklihood of a looming financial crisis with ample time to permit business model shifts that may have prevented crippling losses and, ultimately, the end of these former pillars of Wall Street as independent companies.

--Likely Defenses and Response

When confronted with documents like the reports at issue, senior managers may respond that they cannot be expected to read the huge volumes of research produced by their companies. The view of Brett Sherman, securities fraud lawyer and Managing Attorney of The Sherman Law Firm is that "the significance of these reports is that they conclusively establish the views of top economic analysts at Merrill Lynch and Bear Stearns. Whether plaintiffs' attorneys prove that senior management at the two investment banks actually read the reports ought to be immaterial."

Litigation strategist and recently retired attorney Lee Sherman - a frequent consultant to The Sherman Law Firm, former municipal court judge, and founding partner of a top Philadelphia area firm - concurred. "These aren't simply the comments of some junior level analysts," Sherman said. "I mean, we're talking about the Senior North American Economist of Merrill Lynch and the Chief Equities Strategist at Bear Stearns. Any claims by their CEOs and the other senior decision makers at these banks to the effect that they should not have been well-aware of the opinions and outlooks of the top economic and market experts at their companies are simply not credible." 

Lee Sherman continued: "Remember, from mid-2004 until the subprime crisis had clearly arrived, the Fed steadily raised interest rates. For lesser quality borrowers, most of whom had adjustable rate mortgages, higher interest rates meant higher default rates. To say the least, there was great uncertainty as rates were rising about where we were headed. Then, the housing market slowed. I'm talking about 2005 now, before home values really fell off the table. It strikes me as incredible that the kinds of warnings in these reports were out there for years, yet seem to have gone unheeded."

The Sherman Law Firm represents investors in securities fraud / investment loss claims of all types, including claims against investment banks for losses related to mismanagement and other misconduct during the housing and credit bubbles.

Brett Sherman, The Sherman Law Firm

How Wall Street Manipulated the Risk-Reward Tradeoff (updated)

Did The Sheer Complexity of MBS, CDOs, and related "Structured Products" Enable Wall Street to Cheat Investors out of A Reasonable Risk Premium? 

 

 

An impromptu analysis of securities fraud and the mortgage securitization boom that led to the great 21st century Financial Crisis.  

If pressed to identify one factor that made Wall Street's subprime securitization frauds of the last decade so successful (as of this writing, it cannot be credibly argued that these mortgage-based frauds were anything other than an enormous financial success for most of the individuals who ran major investment banks), we would select complexity as that one factor.

In this post, we attempt to explain how we believe the big banks used complexity to disguise risk and con the markets.  

 

Background: Investors bought subprime mortgage bonds for a simple reason. 

For most of the housing bubble era, AAA-rated tranches of nonconforming mortgage bonds (those backed by subprime mortgages and alt-a mortgages) offered investors slightly higher returns than other AAA-rated bonds.

 

Since the risks were ostensibly the same for a mortgage bond carved out of a AAA-rated tranche of an MBS or CDO and other AAA-rated securities, Wall Street knew that most big institutions would choose to buy the higher yielding mortgage bonds.  And this is precisely what happened. 

 

As the housing bubble expanded, investor demand for private label MBS and CDOs seemed insatiable.  Only when market conditions changed enough for the investments to be exposed as the frauds that they always were did investor demand finally disappear.  By that point, however, the personal wealth accumulated by senior management at the major Wall Street banks from securitization and sales of fraudulent mortgage bonds during the 2000s was staggering. 

The housing bubble era was, in sum, a short-term money grab.  Management enriched themselves at the expense of the shareholders they were obligated to serve (not to mention the financial health of most nations on Planet Earth).

 

"Fraud by Complexity": Hiding Risk from Investors.

During the housing bubble era, very bright people designed mind-numbingly complex financial products to conceal risk from investors.

Bear Stearns, Lehman Brothers and the rest of what were the big 5 investment banks (and a group of other powerful financial institutions) knowingly marketed and sold high-risk mortgage bonds to institutional investors all over the world for years as if those risky investments were, instead, extremely safe AAA-quality securities. 

 

Indeed, we believe that complexity is the ultimate x factor that allowed Wall Street to collude with and/or bribe credit rating agencies, which then stamped securitized subprime/Alt-a mortgage bonds with AAA credit ratings.  It was complexity that allowed investment banks and rating agencies to construct formulas and models with bogus inputs and flawed assumptions to "justify" what investors now know were fraudulent credit ratings.

 

It was, of course, the vaunted AAA credit rating that guaranteed a massive market for dodgy (to put it mildly) mortgage bonds for as long as market conditions were such that the true risks of those bonds remained hidden.  When the housing bubble popped and mortgage defaults spiked, firms like Lehman and Bear Stearns kept up the pretense of quality for as long as they could. 

Thus, management at most (though not all) of the big banks squeezed as much personal profit as possible from their fraud factories before mortgage defaults inevitably reached high enough levels, in or around early 2007, to undermine the credibility of previously unquestioned AAA credit ratings. 

When the number of investors who began to doubt the credlt-ratings for mortgage bonds hit a critical mass, the scheme reached a tipping point and the game was up. 

From summer 2007 on, the handwriting was on the wall for the few that, like the big investment banks, were privy to enough information to read it. Soon came the foreseeable, indeed the inevitable, flight to quality that is a core feature of all bond market panics.

 

Flight to Quality

In a flight to quality, investors try to dump everything that is touched by uncertainty and move as much money as possible into investments that they know are safe.  Most often, that means a mass movement of money into Treasuries.  When investors began their flight to quality, demand for mortgage bonds essentially disappeared.  From that point, those on the inside knew, or should have known, that there was no stopping the dominos from toppling.  

 

Concealing Risk; Paying Lower Risk Premiums

Complexity of structured mortgage bonds - from mortgage-backed securities to even more complex CDOs, CDOs-squared, Synthetic CDOs and so on -- was intentionally exploited by Wall Street to hide risk.  By concealing the true risk of these investments, the Bear Stearns and Lehmans of the world manipulated the risk-return tradeoff (from econ 101) so that these financial institutions could profit by paying far less return than is warranted by the risk of these products. 

If a bond issuer uses deception to convince investors to accept a lower risk premium (a lower yield than would be required if the true risks were known to investors), then the issuer fraudulently profits from the difference between the comparitively high risk premium the investment should require and the low yield that is actually paid out.

 

The beauty of this type of scheme, of course, is that -- until the foundation finally caves in -- investors actually believe that they are getting a generous return because the yield is a bit higher than Treasuries and other AAA-rated investments. 

 

The truth, hidden from investors, is that the return on mortgage bonds blessed with bogus AAA-ratings was far too low given the risk of these products.

 

As for those executives who claim they did not understand their own businesses, remember that fraud includes intentional misconduct and wilfull blindness.  

Hiding the true risk of mortgage bonds produced well-documented windfalls for Wall Street's top executives and their lieutenants, even as many of those executives presided over the destruction of the companies they managed on behalf of thousands of public shareholders.  

 

Conclusion: A "AAA-Rating" Does Not (Necessarily) Equal "AAA-Quality"

The fact is that these banks knew the majority of the AAA "private label" mortgage bonds they peddled in the 2000s were high risk, but not high quality.  

 

The banks knew the true risks of subprime MBS and CDOs, but few investors had access to sufficient information to decipher these risks for themselves. 

Instead, investors justifiably relied on the representations of mortgage traders and salespersons and especially on the supposed integrity of credit ratings. Today, we all know what the big banks knew all along -  

AAA is in the eye of the beholder.

 

By Brett Sherman, Wall Street Law Blog

 

Risk, reward and investments: The Harder They Come, the Harder they Fall...

Revised and updated

From the Wall Street Law Blog:  Caution, common sense ahead-

These days, we hear too many people mistakenly describe the risk-reward tradeoff with incomplete, shorthand definitions like "risk equals reward," or "the greater the risk, the greater the reward." 

Investors should use the following definition for market risk: 

Market risk is the chance that an investment in securities might produce an unexpected bad outcome; a/k/a  financial loss.  

This definition for risk applies equally to the actual fact of losing money on any investment - an outcome that is always unexpected to some greater or lessor extent - and also to investments that produce higher magnitude losses than the investor expected.  

To digress for a moment: An expected bad outcome is not really a risk because a company will build expected losses into its business model. For example, suppose a bank assumes that the default-rate on a credit portfolio will be 2 percent. Because the losses are expected, the bank should build a 2 percent loss into its revenue forecasting as a cost of doing business.  

 

Thus, while some investors are enticed to put their money in risky ventures because there is the potential for greater upside for a risky investment than there is for a conservative (safe) investment, the higher upside is far from free.  

Thus, the more risk you take, the more you increase the chance of an unexpected bad outcome.

Which brings us to this pearl of wisdom:  When it comes to risk, it pays to remember the warnings of the great Jimmy Cliff (and the late great Jerry Garcia):  The harder the come, the harder they fall, one and all... 

By Brett Sherman

The Sherman Law Firm

Derivatives and Financial Risk Management: Wikipedia "books"

A GREAT RESOURCE FOR EVERYTHING

If you already know that Wikipedia has collections of related articles on just about every topic under the sun, then skip this post (but feel free to spend some quality time browsing our archives and topical index!) ... 

These Wiki-books come with tables of contents and a very smart-looking layout that can really help when you need some quick answers (the usual warnings about checking facts and Wikipedia omitted on the grounds that you already know them). 

The link takes you to a Wiki-book that Wall Street Law Blog downloaded this morning -

Great Resource  - Derivatives / Risk Management in Finance

 

You can also very easily create a custom book that includes pretty much anything on Wikipedia.

*  *  *  * 

Thanks for all of the clicks, follows, reads, feedback, etc. in 2010.  On behalf of Wall Street Law Blog, let me be the 10,000th person to wish you a Happy New Year!  We look forward to a productive 2011.

Brett Sherman

The Sherman Law Firm (publishers)

A JEDI APPROACH TO RISK MANAGEMENT (updated)

By Brett Sherman,The Sherman Law Firm

THESE ARE NOT THE RISKS YOU'RE LOOKING FOR... 

True risk management begins with one fundamental concept: Companies must prepare for the fact that outcomes can and do differ from expectations. 

• SENIOR MANAGEMENT AT FORMER INDEPENDENT WALL STREET INVESTMENT BANKS LIKE LEHMAN BROTHERS, MERRILL LYNCH, and BEAR STEARNS CHOSE TO MAKE VERY BIG BETS ON THE "CONVENTIONAL WISDOM" THAT HOUSING PRICES DO NOT FALL.  THIS IS SOMETHING NO JEDI RISK MANAGER WOULD EVER DO.

• A LONG TIME AGO . . . YODA, OBI WAN AND THE CREW  COULD HAVE TOLD YOU THAT THAT THERE ARE INFINITE NUMBER OF FORKS IN THE ROAD TO THE FUTURE.  PUT ANOTHER WAY, THE FUTURE IS UNKNOWABLE.

• HOUSING PRICES MAY NOT HAVE FALLEN NATIONALLY FOR MANY YEARS BEFORE THE HOUSING BUBBLE POPPED;

• AND WALL STREET MAY NOT HAVE EXPECTED THEM TO FALL (a topic for a different post);

• BUT WALL STREET CERTAINLY KNEW THAT OUTCOMES CAN AND DO DIFFER FROM EXPECTATIONS.  THUS, LEHMAN, MERRILL LYNCH, AND BEAR STEARNS KNEW THAT HOUSING PRICES COULD FALL.  

• BECAUSE SENIOR EXECUTIVES AT THESE FIRMS WERE MAKING SO MUCH MONEY FROM BIG BETS THAT ULTIMATELY DEPENDED ON THE CONTINUED (AND UNPRECEDENTED SUCCESS) OF THE U.S. HOUSING MARKET, THE FIRMS EITHER HAD NO ANSWER OR DID NOT ADEQUATELY PREPARE TO ANSWER THE MOST BASIC AND OBVIOUS QUESTION:  

WHAT WOULD HAPPEN TO OUR COMPANY IF HOME PRICES PLUNGED?

****

Background: Why the Future is Unknowable

No one can predict the future - even the immediate future - with any certainty.  Sometimes, events unfold as anticipated, and so we may fool ourselves into believing that we knew what would happen before it happened. 

For example: We predict the Patriots will beat the Jets.  The Patriots do beat the Jets.  We knew it all along.  Well... Not quite.  

In reality, we made either an educated guess (we watch the teams a lot and we believe the Patriots are better) or a random guess (we know nothing about football, but we like the Patriots uniforms a lot), and our guess turned out to be correct.

The fact that our prediction was right is mostly a matter of luck.  The outcome matched our expectation, but that does not mean our prediction was certain to come true.  Not even close.  What if Tom Brady had broken his leg in the first five minutes of the game?  What if half of the Pats defense was struck down with the swine flu the morning of the game? What if Randy Moss caught a long pass and was running free "certain" to score the winning TD and the ball just squirted out of his hands on the ten yard line as he began to celebrate before he reached the end zone?

Maybe the Patriots win despite this seemingly amazing run of bad luck.  Maybe they lose.  

The main points are these - 

While you may expect an outcome, you never be certain that the outcome will in fact match your expectation.  

The impact and interplay of infinite variables can make actual outcomes deviate significantly from expected outcomes.  

Thus, certainty comes only after the fact.  Until that point, there is always a chance that your expectations will be wrong.  

Put another way, it is impossible to eliminate the risk that things will not turn out as expected.

****

Some of our favorite variables that can impact outcomes (positively or negatively) include weather, timing, mood, whether or not you accellerate through a yellow light or step on the breaks, sunspots and solar flares, the length of the line at Starbucks, sleeping on a decision or making a snap judgement, whether you run to catch your train to work or walk to the platform, content to wait for the next one, and so on and so on, etc., etc.  The point, of course, is that our list of variables could go on for millions of pages and still be nowhere near complete.

* * * *

RISK MANAGEMENT AND THE FINANCIAL CRISIS

• For financial institutions, minimizing the impact of unexpected outcomes (losses) is the heart of risk management.  
  

   

Even assuming for the sake of argument the very dubious proposition that senior management and the best analysts and economists at Lehman Brothers, Merrill Lynch, and Bear Stearns truly believed the housing boom would continue indefinitely would be a  responsible (even competent) risk management policy required these financial institutions to build into their business models the very real chance that the views of their best analysts and economists could be wrong.  Because the future is unknowable, preparing for unexpected outcomes needs to be priority one for risk managers and top decision makers.   

 

 

• JEDI RISK MANAGEMENT CONCEPTS: RISK MAGNITUDE is as Important as RISK FREQUENCY.

No amount of risk management can account for every contingency. But effective risk management must account for the fact that unexpected events will happen, and those unexpected events will produce unexpected losses.  Losses come with the territory. However, crippling losses can and should be prevented.  

THE FORTRESS BALANCE SHEET

Banks can never be too prepared for unforeseen (and unforeseeable) financial shocks. Banks can never have enough capital.   Risk managers must be prepared to circle the wagons and withstand a crisis.  

Like JP Morgan Chase CEO Jamie Dimon (Wall Street's current Obe Wan Kenobe) preaches - Banks need a "Fortress Balance Sheet."  

 **************

A fortress balance sheet - per Mr. Dimon - is a balance sheet strong enough to assure JP Morgan Chase can withstand severe shocks that arise with little or no warning. 

The CEO of JP Morgan Chase has become a rock star for many reasons. One of the main reasons surely must be that Jamie Dimon knows what it means to be a Jedi Risk Manager.  

 

 

The confession of Bear Stearns CEO Jimmy Cayne... (greatest hits)

Updated 
 

By Brett Sherman, The Sherman Law Firm

In July 2007, Bear Stearns CEO Jimmy Cayne wrote to Bear Stearns hedge fund investors.  Cayne's mission that day was critically important, and he knew it.  In the wake of the shocking failure of two leveraged Bear Stearns hedge funds with heavy ties to the subprime mortgage market, the CEO needed to convey his confidence in the future of his company. Cayne cooly reassured hedge fund investors that Bear's conservative tradition, strong risk management culture, and plan to pare its mortgage backed securities portfolio would assure Bear Stearns a speedy and full recovery from the summer's disastrous fund collapses.   

A year later, Cayne sang a completely different tune in an interview with Fortune.  Fortune Magazine, "The Rise and Fall of Jimmy Cayne," August 2008.  The ex-CEO of Bear Stearns revealed that the strength he projected in the summer of 2007 was in fact false strength. 

According to Fortune,

Cayne "did not know how to deal with the devaluation of the firm's mortgage-backed securities and other illiquid assets. Nor did he know what to do ... when two hedge funds that contained those same toxic assets collapsed and further poisoned the company's balance sheet."  

But wait, there's more!

Bear's all-powerful dictator admitted he was paralyzed by the crisis that his firm helped ignite in mid-2007.  Cayne had absolutely no idea how to cope with the company's financial troubles. 

"It was not knowing what to do. It's not being able to make a definitive decision one way or the other, because I just couldn't tell you what was going to happen."  

Cayne even indicted himself regarding Bear Stearns' debt-laden balance sheet.  

"I didn't stop it. I didn't reign in the leverage..." 

said Jimmy Cayne.  So there you have it.  Cayne understood that Bear was super-leveraged and blamed himself for doing nothing about it.   

 

While Cayne's numerous admissions to Fortune may sound like a deathbed confession, the former Bear Stearns CEO somehow still tries to convince us that Bear Stearns was done-in by a conspiracy of short-selling, rumor spreading hedge fund managers.  

Perhaps the long-time CEO cannot face the fact that he was a primary contributor to the destruction of a company that, by all accounts, he loved to run.  In any event, conspiracy theories about the end of Bear Stearns have been raised time and time again since March 2008.  These theories have consistently wilted under even modest scrutiny. 

 

Wall Street Law Blog has attacked many of Bear conspiracy theories in prior posts. Fortune discredits Cayne's delusions with simple common sense -

 

"What Cayne's conspiracy theory overlooks is the fragility of Bear's balance sheet. Regardless of whether hedge funds and short-sellers exploited the firm's weakness, it was Cayne and his colleagues who made the firm financially vulnerable. They sealed the firm's fate by choosing to finance the vast majority of the firm's daily needs - about $50 billion a day - in the overnight repurchase agreement(or "repo") market, using some 71% of its mortgage book as the collateral." 

 

"Bear's reliance on overnight repo effectively gave the overnight lenders - such as Fidelity and Federated Investors - a vote on the firm's viability every night. And during that fateful week in mid-March, those overnight lenders voted a collective no."  Id. Emphasis added.

 

*****

 

Breakingviews.com made this insightful comment about the Fortune Article:

"Cayne’s admission that he didn’t know what to do, even last summer, is extraordinary. If that was the case, [Cayne] should have handed the reins to someone else with more ideas – or been forced to do so by Bear's board. But no-one seems to have challenged his leadership until too late."  

 

The consensus around the Wall Street Law Blog water cooler is that the Fortune article is remarkable.  

Jimmy Cayne -  still the all-powerful Oz at Bear Stearns for all of 2007 - admitted he was a deer in the headlights when he conducted damage control following the unprecedented collapse of Bear's subprime hedge funds. Clearly, Cayne misled the public by writing letters, issuing press releases, and participating in conference calls designed to sure up shaken confidence in Bear Stearns. 

Cayne conceded he had no clue how to right the ship at Bear Stearns. Therefore, his false words of reassurance about Bear's future are fraud.

 

The CEO was not doing a thing to fix the numerous problems at Bear Stearns following the collapse of the subprime hedge funds (nor, apparently, was anyone else).  Jimmy Cayne did not even bother to address the only real issue - how to restore Bear's health for the long-term. Cayne, in his own words, "didn't reign in the leverage."  He could have. 

 

Bear's 2007 fund disaster demonstrated in bright neon lights the extreme danger of over-reliance on leverage.  By not taking affirmative steps to reduce leverage throughout the company, and by continuing to rely on short-term financing for the bulk of Bear Stearns operating costs, Cayne and the rest of Bear Stearns senior management (including soon to be CEO Alan Schwartz) were continuing a pattern characterized by a laser-sharp focus on short-term profitability, overconcentration of mortgage-backed-securities (MBS) in Bear's own portfolio, dangerous reliance on overnight repo financing to fund daily operating costs, a desperate need for a cash infusion, a total disregard for risk management, and a lack of concern for Bear Stearns shareholders or the long-term welfare of the Company.