Tuesday, June 26, 2007

Bear Stearns' Miscalulations

The Wall Street Journal has, understandably, featured several recent articles regarding the Bear Stearns hedge-fund debacles. A piece in the Weekend Journal focused on whether or not Bear would stand behind its one failing fund. Another, yesterday, discussed the mechanics of marking sub-prime-backed CDOs to market. Today's Journal returned its focus to Bear Stearns' corporate situation, as it manages the two hedge funds which have racked up such appalling losses so suddenly

I've spoken with several friends about the developing situation at Bear Stearns. We all agree that this is yet another instance of financial service CEOs on the non-commercial bank side of the sector seemingly ignoring obvious signs of public discontent with their behavior.

To understand some of what is occurring with Bear Stearns, you need to recall that James Cayne, the company's CEO, refused to join the rest of Wall Street in bailing out Long Term Capital Management in 1998. I have been told that he personally rebuffed Merrill Lynch's then-CEO, David Komansky's request that Bear join the party in working out a rescue.

Instead, Bear stood on its legal claims, and refused to reset terms of its loans to LTCM.

Now, of course, the shoe is on the other foot. This probably explains, in large part, why Merrill recently moved quickly to seize and auction collateral it held for margin loans to Bear's troubled hedge fund.

Yes, what goes around, comes around. Even if it takes a decade or so to do so.

This weekend's piece in the Journal was eye-opening, as Bear's fund manager, Ralph Cioffi gathered his fund's creditors in a meeting and demanded, among other concessions, a 12-month moratorium on margin calls against the fund by its lenders. While doing so, however, he acknowledged, to an inquiring creditor, that the fund's notional parent, Bear Stearns, did not anticipate providing any capital to shore up the fund's losses during this period.

This is the sort of attitude that not only irks other Wall Street firms, but is seen by the less-well informed public as simply walking away from responsibility.

It's likely that, as with most funds, the two troubled Bear Stearns funds are technically separate corporations, 'owned' by their shareholders, with a separate 'board,' and a contract given to Bear Stearns to manage the fund. Thus, Cayne's attitude that Bear has no technical obligation to assume, or make good on, or even simply provide capital for, the egregious losses in these funds.

Let's be clear on the sort of funds these are. They were developed within the past year or so, explicitly to bottom-fish the sub-prime loan market. They constitute organized efforts to take advantage of the sector's problems, buying low and, so the funds' managers hoped, holding and selling as the sector turned around. Only it hasn't turned around.

Basically, Cioffi and his colleagues made a naked bet on the direction of yields and prices of sub-prime mortgage loans, and got it wrong. By leveraging something like 10:1, they blew through the equity behind their fund with recent losses.

If the two funds were actually just standalone entities, that would be the end of the story. Their creditors would seize the collateral, organize asset sales, satisfy what obligations they could, and the funds would be closed.

However, since the notional parent is a large, stable, well-capitalized Wall Street investment bank, the picture looks somewhat different. Even though the funds' customers are 'sophisticated investors,' the public and, perhaps more importantly, the Democratically-controlled House of Representatives, will view the situation as a wealthy investment bank sticking its customers with losses, while it reaps management fees from the funds, and declines to share the losses.

Sometimes, businesses hurt themselves by ignoring the effect of their actions on the larger society in which they operate. I suspect this is one of those times. I think James Cayne is making a serious mistake vis a vis his company's troubled sub-prime mortgage hedge funds. After shuffling his feet and first refusing to help the funds with loans, to allow them to make margin calls without selling assets, he has already sent a message to the markets, other Wall Street firms, Congress, and the public. His reversal on this issue, and decision to lend to the funds, now comes a day late, if not a dollar short.

Who would now want to invest in a Bear hedge fund? What other firms will extend loans to Bear funds now, without extra protection for the value of those loans? Perhaps they will restrict the leverage that a Bear Stearns-backed fund may use.

And surely, Barney Frank will be using this example to drive new hedge fund regulation through Congress.

It's a shame that James Cayne is repeating such callous, ill-considered and naive behavior in this matter. By attempting to take refuge in the legalities of the situation, he may win the battle, but will almost certainly help lose the war for all of the capital markets, and other Wall Street firms.

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