Wednesday, August 08, 2007

Risk Week: Bear Stearns, Jim Cayne & Warren Spector

Last weekend's Wall Street Journal edition carried a rather detailed article on the people and actions that led brokerage firm Bear Stearns to its current, sub-prime mortgage fueled debacle. A debacle that has now claimed one casualty, board member and head of stock and bond trading, Warren Spector. And may yet claim another, Chairman James Cayne, contrary to his rather boastful statement that he intends to remain until 2011.

Basically, Cayne and Spector screwed up and lost significant amounts of shareholder value, owing to their failure to properly oversee risk management among Bear's positions in various esoteric debt instruments.

Bear Stearns deserves to be in trouble. From just the cursory details in the Journal piece, you can see Spector's rise as a fast gun trader. The type of swaggering trader who demands ever more lush and powerful packages, in order not to bolt to a larger firm, like Goldman, or some hedge fund. In his case, Spector happened to share an interest with the current Chairman. They both play bridge, and Spector was a phenom as a youth. Cayne recognized his name.

As my partner mentioned at lunch today, wasps like Cayne, at Wall Street firms like Bear, are more clubby and parochial than people might imagine. Having passed muster as a bridge maven, it appears that Cayne essentially gave Spector a pass on any more supervision.

Thus, Spector was given a board seat at Bear at age 30. Shortly thereafter, apparently after elbowing a rival off the path upward, the command of Bear's equity and fixed income trading functions. Last year, Spector was paid some $33MM by Bear.

It's important to note how such large compensation packages affect the behavior of management at such a firm. Neither Cayne, nor Spector, was going to go homeless if whatever their equity interest in the firm became worthless. Even the lack of many more years of such compensation isn't exactly becoming poor.

So, if anyone thinks that financial consequences would ever figure in supplying some sense of risk awareness and prudence to either Cayne or Spector, think again. Folks at that level are motivated more by power and prestige than by money. The former are provided by others, as a function of staying in power, while the latter becomes a non-motivator pretty quickly at those sums.

Thus, we find both Cayne and Spector, laughably, attending a bridge tournament during a key week in July, when the fortunes of their firm were souring. You cannot make this stuff up.

It's debatable whether Spector, or anyone else, can do much about Bear's position. Let me make some conjectures.

First, the problems stem from rather exotic debt instruments which are not always traded. See this post , from yesterday, for some more details on how this works. Perhaps some forms of credit derivatives are also involved.

How do you price instruments which are either seldom traded, individually tailored, over the counter, and/or based upon exotics? Well, without much confidence is the answer.

As a one-time partner of mine, B, who built a well-known Street mortgage business, used to tell me,

"A model can tell me what something was worth yesterday, or may be worth tomorrow. But the only way I know what it is worth today is to take a piece and offer it, and see what the bid is."

Just so. And very scary, since if the bid is much lower than the carried value by the firm, the difference in value must be marked down.

Now, if these instruments were hedged, with credible counterparties, then one reasons that the damage would be contained, right? For limiting upside profit, a downside loss could be minimized.

What do you want to bet very few of Bear's positions were hedged? Because, after all, limiting profits limits bonus pools and, therefore bonuses. And who wants that? The firm pays out bonuses from those profits. It never allocates the losses to the traders.

With such a handsome asymmetric payoff matrix, why would the traders or their managers hedge much of the risk? Besides, the models probably assumed they could simply sell problem instruments when needed, per my earlier post.

So, it's not hard to imagine Bear having held, unknown to the senior managers who didn't really want to, or know how to, ask many piercing questions, that, in mutual funds and/or on proprietary trading desks, there has been substantial, unhedged exposure to some thinly-traded, esoteric debt.

That Cayne would so callously and dangerously declare the current debt markets to be the 'worst in 20 years,' is a measure of the depth of Bear's desperation and situation. By attempting to make the system and market the problem, he hopes to deflect observers from the truth- that Bear got into this mess on its own.

Fortunately, quite a few pundits, and Ben Bernanke, have vocally disagreed with Cayne's view, since his over the top comments in last week's conference call.

As Herb Greenberg, of Marketwatch, noted, this is one case where the retail investor dodged the bullet, because the class of instrument which has disintegrated is too complex and inaccessible for most of them. The institutions which have been brought down or damaged- mortgage companies, fund managers, brokerages- all knew what they were doing.

Typically, every decade has its financial debacle. It usually features young, inexperienced traders and risk managers who believe they have everything under control. More senior managers, with prior experience during financial market meltdowns or major problems, are typically further from detailed knowledge of the risk management and positions, and better insulated, financially, from damage, should the firm go under.

Bear's senior executives, Cayne and Spector, deserve to lose their jobs. Bear, as a firm, probably deserves to be bought or acquired by a better firm. In the final analysis, the company finally seems to have run afoul of its buccaneering attitude and less-than-adequate risk management, losing

As the nearby, Yahoo-sourced chart displays, Bear has lost considerable value this year. More than two-thirds of its returns for the prior two years.
Management like this deserves to be replaced. But in a firm with a culture like Bear's, that may not be sufficient. The whole firm may need to go down.

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