Bringing Down Bear Stearns
July 1, 2008 3:22 PM   Subscribe

Bringing Down Bear Stearns, from Vanity Fair's August issue.
posted by SeizeTheDay (17 comments total) 8 users marked this as a favorite
When you owe a million dollars the bank owns you. When you might owe 200 billion the bank worries about their image. So, borrow a few trillian and you can own them.

Thats right China I'm looking at you.
posted by Parallax.Error at 4:39 PM on July 1, 2008

Wow such a long article and never once do they mention even one of the FASB accounting standards that many of us feel kicked this entire mess off?

FASB 157 started the balance sheet meltdown of many banks, Bear included. It wasn't the only cause, but once institutions were required under GAAP to report according to FASB 157 (market assets to market, not to model or explain in writing why they won't), things got very interesting.

I've commented on FASB 157 (as well as other accounting standards and their impact) on Meta before, but at the time these standards were distributed I was writing market commentary for one of the bigger European Tier 1 banks, and part of my usual deal is I get to write on whatever interests me.

Q2 2007 FASB 157 started interesting me, specifically what impact tighter accounting standards might have on banks in general. I wasn't alone - no, lots of people were curious (like we are now about other things being discussed or even passed). At that time, I wrote three columns on FASB 157 and will present a brief excerpt from one here (I've also commented briefly recently on FASB 159 which it seems the mainstream media hasn't picked up much yet - I'm still waiting for that one to hit):

"FASB 157, which emerged Q4 of last year, has markedly changed how institutions account for the fair value of assets. Under FASB 157 assets are divided into three groups – Level 1, Level 2 and Level 3. Assets are segregated into each group according to how they’re traded. Let’s see how this works in practice and perhaps learn something about what’s making market participants so nervous.

Level 1 assets are fairly straightforward - instruments that trade on organised exchanges. Examples would be shares bought and sold on the CAC, the AEX, the FTSE or the NYSE. Prices are clearly available from the exchanges. There is absolutely no doubt about the price or value of these assets, these shares, as they are exchange traded instruments. In finance terms, there is an active secondary market. We have a lot of confidence in the fair value of Level 1 assets as we can always consult the relevant stock exchange for a price. So we don’t have anything to worry about there.

Level 2 assets are those for which a secondary market exists, but trading volumes are low. We may not be able to directly observe prices, but we can get a relatively good idea somehow, but from market sources. An example might be some smaller corporate bond issues, where there is little or no trading after issuance. Typical practice has us using proxies to infer fair value for these instruments as real prices are difficult to come by. In banking we say the market for such assets is thin. As there are few buyers and sellers there isn’t much trading in the instruments. Because there isn’t much trading liquidity is suspect. Prices can change a lot, but as there are prices which can be observed we can arrive at a reassuring idea of fair value, of the instruments price. So we can see Level 2 assets, while not as secure as Level 1 assets from a price point of view, are ok to own. Once again, no worries.

But what about Level 3 assets the careful reader asks? Ah yes, Level 3 assets. Well sir, Level 3 assets are what we call “alphabet soup” – CDO, CLO, CDS, MBS, ABS, Synthetic CDOs or CDO squared– to name but a few. These structured products don’t trade anywhere on an organised exchange; rather banks, hedge funds and other market participants trade these instruments amongst themselves. These are also known as Over the Counter or OTC securities, and the secondary market for such instruments is not a physical place like a stock exchange, rather the market exists only between buyer and seller and only as private transactions. In other words, if a bank wishes to sell a CDO they must find a willing buyer. There isn't an exchange where this trade can take place (this is a simplification, but it helps explain what's going on here). Once a price for this CDO has been agreed the sale is consummated. Everything takes place between buyer and seller.

So the definition of Level 3 assets is clear except for a not so minor point: price. Level 3 assets, those arcane sounding instruments of modern finance have in the past been priced using models; in bankers terms we say they’ve been marked to model. That is, given a CDO we then use a mathematical model (the Gaussian Copula by David Li, 2000, is widely used at present) to establish a price for the instrument. That’s right. A mathematical model. In other words, and in our view this is critically important to understand current market nervousness – A THEORETICAL PRICE.

And that was ok, as long as both buyer and seller used the same, or roughly similar models. Still no worries.

But FASB 157 changes this, requiring Level 3 assets to be marked to market; that is, banks holding CDOs (or other alphabet soup instruments) must now establish fair value by getting prices for these instruments.

So what’s the problem you ask?

Well, once banks and hedge funds starting getting market prices for these structured products we found that many of them weren’t worth what the models were telling us. In many cases, actual market prices were 20% - or less – of the theoretical value. The causes for these pricing discrepancies are legion and beyond the scope of this paper, but we know they are real, and we know there are presently very few buyers for these instruments and we also know these pricing differences are, to use an accounting term, material. Nobody realised these assets were so overvalued until they were actually marked to market – not model.

And we’ve seen the fallout. Banks are taking huge losses as assets are written down to fair value. Folks are increasingly nervous because we’re finding out that not only banks are holding the alphabet soup, but pension funds and other entities that typically have been deemed safe and conservative have some as well.

So we believe a lot of the fear is driven by the realisation that large portions of the balance sheets at many institutions are being sharply marked down."

All of this stuff at Bear happened when folks were very scared, lots of rumours whizzing about, and nobody really knew the full impact of FASB 157.

In any case, lots of banks were evaluating the impact of FASB 157 (and other, tighter accounting standards) on bank's balance sheets. This is actually still ongoing. I've recently seen somebody's numbers rank ordering financial institutions for balance sheet vulnerability, and while the worst seems to be behind many banks, others may not fare so well. Regardless, we're probably going to see more Bear / LTCM style shotgun weddings.

But why do people look at these accounting standards to being with?

Well, me, I'm a curious sort and always wonder about possible market impact. But Banks, Hedge Fund and other market participants track this data and take a forward looking view of possible impact on specific share prices, trying to identify opps both ways.

Classic arb play; short the weaker institutions shares and use the cash flow to acquire shares in stronger banks. They won't have to put up much of their own money, if any, but will see a very sharp return should things move as expected.

And in a climate of fear like we saw during the run on Bear, things usually do.

So I think the article nailed most of the blow by blow (as I've already heard it) with good insight into the personalities, but left out the most important part that fueled the rumours, gave them credibility and perhaps even started hitting Bear's balance sheet before the shorts noticed the (potential) weakness and targeted Bear: FASB 157.

Interesting article - thanks!
posted by Mutant at 4:42 PM on July 1, 2008 [10 favorites]

Man saves bear from drowning (two posts above). Hank Paulson?
posted by Frank Grimes at 4:43 PM on July 1, 2008

Can any former IB folks attest to the characterization of Bear Stearns being kind of the loner-bad boy of Wall Street, as opposed to the more milquetoast houses of Merril Lynch, etc? I didn't realize there were those sorts of major differences between those firms. Made for some interesting reading, that's for sure.
posted by bardic at 4:45 PM on July 1, 2008

but left out the most important part that fueled the rumours

I think the article deliberately left out that part because it wasn't part of the story: that people were gunning for the demise of Bear Stearns. If 157 was a critical element of the story, we could argue that Lehman faced/faces the same hurdles, and somehow it's still limping along.

I'm not saying that I completely buy into the theory the article posits (although the rumor that the Street hates Bear is pretty infamous given LTCM), but Bear's demise wasn't mechanical, or based on fundamentals... it was based on something even more insidious than a bank run: rampant speculators and activist investors with too much sway and not enough brains. And I think that if you read the Journal or watch CNBC on a regular basis, you can see that same insidious, crappy rumor-mongering occurring right now with Lehman and Wachovia.
posted by SeizeTheDay at 4:54 PM on July 1, 2008

Vanity Fair is always able to pull a story together with issues I didn't understand but knew I should. It helps put a human touch on many names, dates, terms, and actions that are thrown around by other figureheads in the press. The only way I can remember and understand the world today is if I make it into an interconnected story, and I don't think I'm alone.
posted by Parallax.Error at 5:02 PM on July 1, 2008

bardic -- "Can any former IB folks attest to the characterization of Bear Stearns being kind of the loner-bad boy of Wall Street, as opposed to the more milquetoast houses of Merril Lynch, etc? I didn't realize there were those sorts of major differences between those firms. Made for some interesting reading, that's for sure."

I can't comment in detail on Bear's culture, but there are pronounced cultural differences between the banks, and even amoung divisions at many institutions. I almost joined Bear in the late 90's when my employer at the time (Deutsche Bank) asked me to relocate to Europe for a few years. As I had a perfectly useful life in New York, I wanted some alternatives should I have decided to remain in Manhattan.

There was an interesting crew there, very direct and yes, almost everyone I interviewed with was either a life long New Yorker or fit in / acted the part rather well. I recall the firm as being very, very frugal - I interviewed during my lunch hour at their offices and we dined on white bread baloney sandwiches with coffee from the hallway machine. It didn't influence my decision not to work for those guys, at least not negatively as I'm frugal myself.

But I spent most of my career at Deutsche and there were / are distinct differences in culture between different trading groups, even physically located on the same floor.

I hear it's different at other firms where the corporate culture is stronger and more pervasive.

SeizeTheDay -- "If 157 was a critical element of the story, we could argue that Lehman faced/faces the same hurdles, and somehow it's still limping along."

Well, rivalry at banks is and always was intense. I don't think folks were gunning for Bear anymore than some big funds sensed some balance sheet weakness that could be exploited. After all, the name of the game is to make money, not kill off other banks.

That being said, I suspect much of the exploitation of Bear's perceived (and real) weaknesses wasn't totally above board. But this stuff goes on all the time, its nothing new - what's new is when someone gets caught doing it.

And FASB 157 is still applicable - it hasn't gone away or been rescinded in spite of the complaining, and yes, firms including Lehman & Wachovia are marking to market now - but The Fed has grown sharply more accommodative. As Bernanke and The Fed felt many of the existing Central Bankers tools were too limited, particularly in terms of the collateral accepted for loans, they deployed several new tools.

Some, like the TAF have already been discussed on Metafilter. I don't think the others have (these three points are excerpted from something I wrote last week inventorying Central Bankers tools that Bernanke has at his disposal, and how The Fed is using them to fight current problems) :

1) Term Discount Window Program

Similar to the long existing Discount Window, the "Term Discount Window Program" or TDWP also offers collateralized loans to borrowing banks. Like The Discount Window, US Government Securities or high quality corporate bonds are accepted as collateral, but unlike The Discount Window, the TDWP allows institutions to borrow for up to thirty days. Even so, borrowing institutions must roll over, or renew loans obtained under the TDWP on a daily or weekly basis.

2) The Term Auction Facility

The Term Auction Facility, or TAF, is very similar to the TDWP but markedly broadens the collateral that may be used. Controversially, the TAF allows banks to pledge Mortgage Backed Securities - even those backed by sub-prime loans - as collateral for loans.

3) The Term Securities Lending Facility

The Term Securities Lending Facility, or TSLF is very similar to the TAF, however it is directed at Primary Dealers such as Bear - institutions who deal directly with The Fed as part of regular treasury auctions. Via the TSLF The Fed is specifically addressing a segment of the banking community to help increase the money supply and add liquidity.

Keep in mind the TSLF wasn't operating when the run on Bear took place. In fact, the first TSLF auction was only held on March 27, 2008 , and JP Morgan finalised terms the Bear deal acquisition on March 24th 2008 (close date of April 8th I believe)

Had the TSLF been operating then Bear might not have gone under and everyone would have known liquidity wasn't an issue.

The last thing The Fed needs is another Primary Dealer going under.
posted by Mutant at 5:44 PM on July 1, 2008

What happened? Was it death by natural causes, or was it, as some suspect, murder? More than a few veteran Wall Streeters believe an investigation by the Securities and Exchange Commission will uncover evidence that Bear was the victim of a gigantic “bear raid”—that is, a malicious attack brought by so-called short-sellers, the vultures of Wall Street

That kind of thing can happen 'automatically' without any specific conspiracy.
posted by delmoi at 5:44 PM on July 1, 2008

Can any former IB folks attest to the characterization of Bear Stearns being kind of the loner-bad boy of Wall Street, as opposed to the more milquetoast houses of Merril Lynch, etc?

Yes, this is generally true. I don't entirely agree with the image of Bear as the leather-jacketed rebel though--it was definitely thought of as scrappy and also really frugal (the old story is that Bear had a strict limit on rubber band/paper clip usage under Ace Greenberg's tenure). And Merrill Lynch isn't considered milquetoast--that's more like Morgan Stanley's image.

There was a recent New Yorker piece on Stan O'Neal, the ousted Merrill Lynch CEO, that also talked about this sort of thing (unfortunately, it's not available online yet). It breaks the banks down by ethnicity: WASPs (Morgan Stanley, First Boston [now Credit Suisse]), Jews (Goldman Sachs, Bear) and Irish-Catholic (Merrill Lynch). These divisions are obviously quite outdated but I think the characterizations persist, however inaccurate. More recent and more accurate images also exist: the LA offices of UBS and Credit Suisse are sweatshops staffed with bankers who made their names under Michael Milken, the Menlo Park office of Credit Suisse was Frank Quattrone's old stomping ground and his reputation lingers there and, of course, Goldman Sachs' arrogance is through the roof nowadays.
posted by mullacc at 5:53 PM on July 1, 2008

Also, the same sort of thing exists with the big NYC law firms, though I'm struggling to remember how those broke down.
posted by mullacc at 6:04 PM on July 1, 2008

the whole FASB 157 angle is bull**** - i refer you to prudens speculari today:

I caught the following article "Are Bean Counters to Blame" out of the NY Times, in which Stephen Schwartzman of Blackstone (ticker BX) blames the problems in the financials on FASB 157. Yup blame the accountants, as if they aren't the brunt of enough jokes and criticism they now are responsible for the financial firestorm we are in ! The level of arrogance and hubris on Wall St. and Washington are truly breathtaking.

Note to all, when there is no bid on a position in your account, DO NOT BLAME YOURSELF, blame the accountants as it is their fault for forcing you to mark to market. The nerve of them !!
posted by carlodio at 6:10 PM on July 1, 2008 [2 favorites]

I worked for Bear Sterns in 1993. They are just as rude and crude as depicted. Very ugly corporate culture - they deserve what they got.

I also worked for Merrill Lynch. I'd characterize them as brawling barroom Irish bullies.

I worked at Kidder Peabody for a short time. They were very kind people; no wonder they didn't last.

Prudential Bache (at the time) was one of the easiest-to-get-along-with firms I worked for.

Not so with Smith Barney. Bunch of assholes.

Oppenheimer, kind of foolish people.

Bankers Trust - heads up their rear ends, but not as bad as Chase.
posted by Marygwen at 7:13 PM on July 1, 2008 [1 favorite]

The article is pretty good (although the WSJ ran essentially the same thing a few weeks ago), but the headline oversells the story. There is basically no evidence presented of any "shadowy group of short-sellers" who "murdered" Bear.

Also, of course people formerly associated with Bear blame everything on shadowy figures (international banking, the freemasons, the Bilderburgers, hedge funds etc.) rather than their own gigantic mistakes. I mean, the CEO was outed in the WSJ as a major pothead who refused to disrupt his own bridge and golf schedule even as the whole firm was collapsing around him.
posted by Mid at 8:30 PM on July 1, 2008

The following was a blogspot post from a first-year MBA student who wisely removed it when it started getting linked everywhere. I was not that student, as I know better. I saved it.

How the Banks Differ

Okay, I'm almost done with all of this crap. One offer on the table--sure it wasn't the one I really wanted but everyone agrees, "All you need is one offer", and that's what I got. Plus I still have a couple other chances, but we'll see. Anyway, after 3 months of meetings, presentations, phone calls, cocktail hours, asskissing sessions, and then interview after interview after interview, here's my take on the major banks and their personalities.

Goldman: Ironic that a bank founded by Jews could now be run by Nazis. Interviewing with them was like standing before a military tribunal. No human emotion. They also care enormously about grades, the name of your business school, the name of your undergrad school, your GMAT scores, your undergrad grades, etc. Personality won't get you too far here.

Morgan Stanley: White shoe organization if there ever was one. Small summer class but easier to get a full time offer in your second year at b-school. Lean staff also makes you less likely to get swept up in a massive layoff. Little known secret: bankers have to pay for their own coffee at MS. Billions in annual revenues but they don't give their employees free coffee....

JP Morgan: The other Morgan makes you come in 10 times more often than any other bank for "informational interviews". The guys seemed a bit full of themselves. For example, when I credited a banker for working in "one of the best leveraged finance groups on the Street," he testily corrected me: "Not one of the best, THE best." Whatever, dude. Relax.

Merrill Lynch: Very distant recruiting process where it's tough to get to know the bankers. And their interview questions are extremely technical and tough. Be very prepared to answer advanced accounting and finance questions on the spot, as well as questions about the markets and economy as a whole.

Citigroup: A machine. The entire recruiting process is super-organized and structured, with no margin for error and every detail accounted for. I was generally treated with respect and found the bankers to be down to earth and friendly. They have a reputation for God-complex MD's, however.

Deutsche Bank: The most down to earth of all the major banks. Only bankers I met that can actually be described as "cool". Apparently their COO has instituted a No Assholes Policy to try and combat the widespread arrogance in investment banks. Seems to actually be paying off.

Lehman Brothers: Deutsche's exact opposite. What a bunch of assholes. I have nothing positive to say about this firm.

CSFB: Their emphasis on diversity seems to be for real. Most of the incoming associates were not analysts before b-school, and the people are pretty friendly and interesting. However, CSFB has a reputation for working its associates harder than any other investment bank, and that's saying something in an industry that regularly demands 100+ hours a week.

Bear Stearns: The little guy on the street. Nice people over all, and more opportunity to rise fast. You don't benefit from some of the perks of the gigantic banks, such as having your own secretary and lots of quality tech services, etc., and the $$ is not as good in the long run, but it's still fine by any reasonable standard.

Bank of America: The last company on this list needs to increase its brand equity. Their name doesn't carry much weight, although their business is improving and in particular they have a great leveraged finance department because of their massive balance sheet. Half of the MD's in their capital markets groups are ex-Goldman guys who got sick of getting beat out for deals with PE firms that are asking for multi-billion dollar loans.

posted by Kwantsar at 8:58 PM on July 1, 2008 [8 favorites]

And FASB 157 is still applicable - it hasn't gone away or been rescinded in spite of the complaining, and yes, firms including Lehman & Wachovia are marking to market now - but The Fed has grown sharply more accommodative.

The last thing The Fed needs is another Primary Dealer going under.

i'm always shocked, shocked by how calm and reasonable investment types sound about government subsidies and bailouts of their own industry... because the same types of people tend to get hysterical when governments do the same things for other industries: agriculture, energy, water, ...

not that I am necessarily saying that the Fed shouldn't be propping up Wall Street, but as I remember it FASB 157 came out in an environment where lots of people seemed to be concerned that the big banks were sitting on a pile of 'assets' who value could as well be zero as anything else. the whole episode speaks to the perils of "self-regulation." i'm not sure why there seems to be this idea that there are evil accounting elves who parachuted down into lower manhattan and ruined the party. the post- Glass-Segal era has proven over and over again that when people think a bet is a sure thing they will try to get a loan on any 'asset' they can get their hands on and the banks were itching to provide those loans.
posted by geos at 2:01 AM on July 2, 2008

carlodio - "the whole FASB 157 angle is bull**** - i refer you to prudens speculari ..."

I'm not sure I'd agree with this guys conclusion. He certainly doesn't present any proof and neither does the New York Times article the blogger linked to. So what do they believe is the underlying problem? What changed so quickly?

After all, nobody reading this would deny there was / is a problem. So lets lay it all out on the table, see where we can go.

Here's what we know:
  • Before FASB 157 everyone marked Level 3 assets to model.
  • Post FASB 157 everyone must mark to market.
  • Post FASB 157 some on balance sheet assets now are worth much less, in some cases only 20% of what these assets previously were worth when marked to model.
  • Assets held on balance sheet must offset liabilities.
  • Assets and liabilities must match.
  • Once assets were marked down by 80% many banks liabilities were now much, much larger.
  • Many banks are scrambling to attract capital to shore up the asset side of their balance sheet (equity).
  • Banks aren't doing this because they just want to sell large parts of their firms and dilute existing shareholders.
  • Banks are doing this because they either are or may become technically insolvent (by definition when assets <>
I'm not sure how else to explain a major shift in accounting convention: once upon a time everyone market to model. Then they were required to mark to market. Only problem is, the market was a hell of a lot thinner than everyone thought. And some firms started wobbling as a result.

And this is very interesting:

"Of course, Mr. Schwarzman’s theory only holds up if the underlying assets are really worth much more than anyone currently expects. And if they are so mispriced, why isn’t some vulture investor — or Mr. Schwarzman — buying up C.D.O.’s en masse?"

This is going on BIG TIME. Everytime a bank is forced to dump some assets that have been marked to market there are lots of people with lots of money just waiting to scoop these assets up for a song.

There are many funds either being formed or have been recently formed to do just this. I personally know several people who are very, very active in this space. They've got so much business they're working 20+ hour days and still can't keep up.

And some of these folks are gonna end up very rich as a result.

-- "There is basically no evidence presented of any "shadowy group of short-sellers" who "murdered" Bear."

Well, sometimes cases of market manipulation take a long time to be investigated. It's only retail that gets caught "at the scene of the crime" as it were in cases of market manipulation.

If there were some manipulation going on, then you can be those folks will be very adept at covering their tracks. If Bear were shorted and manipulated out of business, it was done by professionals who know precisely how the case would be investigated, professionals who would take every advantage of the scope of international markets and the lack of a single, unified regulatory framework. No doubt about it, "shadowy" would be the correct word to use.

In any case, the SEC is now looking into Bear for signs of market manipulation.

So here's what makes me a tad suspicious - there are rumours everyday on every trading desk around the planet. Twenty four seven it goes on. This business is driven by news. No matter how bizarre the story is today, tomorrow you'll hear something weirder. And nobody will remember what we were talking about yesterday 'cause we're all onto something different.

But what was different in Bear's case was the rumours didn't go away. The bad news was relentless. And coming in from all angles. The Vanity article mentioned CNBC and Cramer, but everyone was talking about it then. It just didn't end.

And after all, someone was fueling those rumours. These things don't take on a life of their own, and spread without the aid of humans. Sure, maybe some folks didn't like Bear - perhaps even hated the firm. Folks don't get paid for spreading negativity unless some firm goes under like Bear did.

I'm not saying Bear wouldn't have gone under. But when someone is on a cliff, wobbling, there is a fundamental difference between falling and being pushed.
posted by Mutant at 2:16 AM on July 2, 2008

But you said it yourself -- every public company is always swimming in a sea of rumors and short-selling pressure; I think Bear just became more vulnerable to the effects of that constant contagion by its mistakes with the big hedge funds, Jimmy's horrible press, etc. It's like getting a hole punched in your spacesuit -- all the bad stuff out there suddenly rushed in.
posted by Mid at 5:13 AM on July 2, 2008

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