The Wall Street Law Journal

Bear Stearns, Russian Roulette, and Risk Management

      LESSONS IN RISK MANAGEMENT and BUSINESS STRATEGY

By Brett Sherman, The Sherman Law Firm

Thanks to Nassim Nicholas Taleb and Jim Grant.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose. 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2] Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008). 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

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[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2]Rough paraphrase of Clint Eastwodd from the film The Unforgiven.

 

THE SCAM: HOW WALL STREET TURNED SUBPRIME JUNK INTO INVESTMENT GRADE MORTGAGE-BACKED-SECURITIES

THE SHERMAN LAW FIRM

 

Each mortgage backed security (MBS) included different tiers, called “tranches”, which permitted investors to select from a series of different risk-return profiles within the MBS.  

 

The top tier of a MBS, called the senior tranche, was the safest investment in a mortgage-backed-security and carried the lowest yield.  By giving up yield, investors in senior tranches of mortgage-backed-securities had the first claims on the cash-flows generated by monthly payments on underlying mortgages.  Even though the senior tranche of a MBS often held only subprime mortgages, S&P, Moody’s and Fitch almost always rated the senior tranche as “investment grade.”  

 

Investment banks turned low quality mortgages into investment grade securities by over-collateralizing the senior tranches of MBS's.  In other words, Wall Street stuffed senior tranches full of enough extra subprime mortgages to allegedly give investors a sufficient cushion of extra cash-flow to protect investors against the possibility that some subprime borrowers might default.  That explanation - along with the high fees Bear Stearns, Merrill Lynch, Lehman and others paid to S&P, Moody’s and Fitch for rating the securities – was nearly always sufficient to secure the all-important investment grade credit rating.  

 

Because investors had almost no way to tell what was in a MBS, or a CDO filled with many mortgage-backed-securities, the word of the ratings agencies was gold.  This is how Wall Street used a little double-talk, and a lot of cash, to get their subprime junk an investment grade rating.

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By Brett D. Sherman, Esq. 

Info@Shermanlawyers.net