The Wall Street Law Journal

What does risk really mean anyway?

By Brett Sherman, The Sherman Law Firm

 

Here is a nice compact definition of risk I like:  Risk equals the inherent chance of a bad result from a decision or course of action.

 

Here is a bit more comprehensive explanation: Risk is a foreseeable possibility that an uncertain future will produce an unexpected negative outcome.  The more risk a given action carries, the greater the chance for bad results and/or increased negative consequences.  

  Amazing that more than a year has passed since the Bear Stearns went up in smoke.  Even more amazing are the hundreds of articles that describe Bear Stearns as having a reputation for maintaining one of the saviest risk management operations around.  There is no doubt that risk management was a priority for Bear in decades past, particularly when Bear Stearns was led by former Managing Partner and CEO Ace Greenberg. In fact, Greenberg chaired the Risk Management Committee while he was CEO.  His devotion to that role was the primary reason Bear Stearns gained a reputation for excellent risk management.

 

  After Jimmy Cayne ousted Ace Greenberg from the CEO spot in a bloodless coup in 1993, Greenberg surprised some observers by electing to remain with the company.  One of the roles Greenberg retained was head of the Bear Stearns Risk Management Committee.  Unfortunately, Cayne was a salesman.  The only risks he understood were the risks of failing to do enough business.  And Cayne never thought Bear Stearns did enough business.  

 

  Character reflects leadership.  The character of Bear's risk management function was eroded by the leadership style of CEO Jimmy Cayne.  Risk modeling systems aged and became anachronisms.  Personnel responsible for monitoring risk were not properly trained.  In sum, the decline of risk management at Bear Stearns resembled the fall of the Roman Empire. 

  Even though Ace Greenberg is credited with establishing Bear Stearns so-called strong culture of risk controls, the ever-increasing complexity of investment products on Wall Street during the 1990's and 2000's exposed Greenberg's risk management style as a relic from a simpler era.  The raw truth is that Ace Greenberg was a hopelessly overmatched Risk Committee Chairman.  Nevertheless, he held that job until 2007, when he was 80 years old.  

  By the time mortgage-backed securities became the centerpiece of Bear Stearns's business,  Greenberg continued prominence in Bear's risk management function was an inexcusable and reckless act of gross negligence. During the current decade, the era CDOs, CDSs and equally opaque derivitives, how could anyone argue that Ace Greenberg was even remotely qualified to lead Bear Stearns' Risk Management Committee.  

  Ultimately, CEO Cayne and the Board of Directors had a legal duty to shareholders to pay much more attention to managing Bear's risks.  They cannot justify their repeated decisions to leave Greenberg in charge of risk control.

  Ace Greenberg deserves a lot of credit for Bear's rise.  He was and is well-liked and respected by many on Wall Street.  But he deserves his share of the blame for the collapse of Bear Stearns. 

Two Professional Sports Teams and Bear Stearns Compensation, a Morality Tale

Short and sweet tonight...

By Brett Sherman

In 2006, total compensation for five Bear Stearns senior executives, including CEO Jimmy Cayne, exceeded the payrolls of the NFL's New York Giants and MLB's Philadelphia Phillies.  The payrolls of these two professional sports teams make for a particularly interesting comparison with the total compensation that was wasted on Bear Stearns’ five executive officers in 2006 (which blew away the money the Giants spent on their 50 plus players and the combined salaries of more than 25 Phillies).   What's our point? Well, only two years later, in 2008, the Giants won the Super Bowl, the Phillies won the World Series and Bear Stearns was out of business.   

Bear Stearns Mismanagement Confirmed by Confession of ex-CEO Jimmy Cayne

In August 2007, Bear Stearns CEO Jimmy Cayne wrote to Bear investors.  Cayne's mission that August was critically important, and he knew it.  In the wake of the shocking failure of two huge 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 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 disasterous fund collapses.   

In Cayne's words, "You can count on us."  Less than seven months later, Bear was purchased by JP Morgan for $10 per share.

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. Fortune reported that 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."   Id., Emphasis added.

The truth according to Jimmy Cayne himself is that Bear's all-powerful dictator was paralyzed by the events of mid-2007.  He 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."  Id., Emphasis added.

Cayne even indicted himself regarding Bear Stearns' irresponsible reliance on leverage.  "I didn't stop it. I didn't reign in the leverage," Cayne conceded to Fortune.  Id., Emphasis added.  Clearly, Mr. Cayne understood that Bear was overleveraged and blames 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 funds.  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.  These theories have consistently wilted under even modest scrutiny. 

 

The 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."  Id. Emphasis added.

 

"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."  Emphasis Added.

 

The consensus at the Wall Street Law Blog is that the Fortune article is remarkable.  Jimmy Cayne -  still the all powerful Oz at Bear Stearns in the summer of 2007 - admitted that 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 the shaken confidence of investors, banks, and journalists in Bear Stearns. Cayne admitted that he had no clue what to do, and 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 grossly irresponsible, and probably fraudulent, course of conduct that began at Bear Stearns far earlier than the summer of 2007.  It was a pattern characterized by a laser-sharp focus on short-term profitability, an inexcusable overconcentration of (what became) toxic (illiquid) mortgage-backed-securities (MBS) in Bear's own portfolio, maintenance of startling debt to equity ratios, dangerous reliance on overnight repo financing, a desperate need for a cash infusion, and a truly mind-boggling disregard for risk management.  

 

By March of 2008, Jimmy Cayne had been deposed.  Bear Stearns, however, still was on a road to likely destruction.  In March, the company was probably even more highly leveraged than it had been the preceding summer. Huge sums of overnight repo lending still were absolutely required to fund Bear's daily operations.  There had been little if any thinning out of the huge positions Bear held in toxic MBS.  Despite some false starts and a deal with Chinese bank Citic, the needed substantial cash infusion had not materialized.  Risk management appeared no better.  The same problems that plagued Bear for so many months were the primary factors in the destruction of the once-respected investment bank. 

 

When Bear's MBS portfolio was no longer acceptable to secure financing from short-term lenders, Bear Stearns found itself without sufficient funds to operate the company.  Combined with a run on the bank, Bear Stearns simply ran out of money and time. The rest is history.  

 

By Brett Sherman