Bear Stearns and the Bodyguard of Lies

Editor’s note: Due to a CMS problem, Teri Buhl’s name was not on the byline. She was a co-author of the piece.

More than seven years after Bear Stearns’ collapse, its former senior leadership has pushed a narrative centering on the once-proud firm’s collapse having been unforseeable.

In the telling, the metastisizing subprime crisis suddenly slipped free from fixed-income portfolios, and the only response the globe’s biggest financial institutions could muster was to cease lending, birthing a maelstrom wholly apart from any other market cycle. Cut off from vital short-term credit markets, and buffeted on all sides by self-serving rumor and the raw panic of their counter-parties and clients, Bear Stearns was forced into a fire sale.

It was “a run on the bank,” a five-word phrase stopping just short of “Act of God” in explaining the inexplicable and diffusing blame.

[drizzle]Two weeks ago the Southern Investigative Reporting Foundation obtained a just-unsealed lawsuit arguing the contrary: Bear’s financial health was in full-bore decline months before the June 2007 multi-billion dollar implosion of its asset management unit’s two massively levered hedge funds.

The lawsuit and related exhibits were unsealed as a result of a February 5th motion to unseal the case which was granted on March 17. (Lawyers working on behalf of Teri Buhl filed the motions; Buhl is a New York City-based independent journalist whose work appears on TeriBuhl.com and Market Nexus Media’s Growth Capitalist Investor.)

In September 2009 Bruce Sherman, the founder and chief executive officer of Naples, Fla.-based Private Capital Management–it once owned 5.9 percent of Bear Stearns’ shares–sued its auditor Deloitte & Touche LLP and a pair of its former senior executives, chief executive officer James Cayne and president Warren Spector. Sherman’s lawyers at Boies, Schiller & Flexner LLP allege Spector and Cayne repeatedly lied to him about the firm’s financial health, especially its valuation and risk management practices. (Sherman is a once revered value investor who sold Private Capital Management to Legg Mason in 2001 for $1.38 billion; he is suing over approximately $13 million of losses in his personal, charitable foundation and escrow accounts.)

Specifically, Sherman’s lawyers allege that because of the numerous assurances Cayne and Spector gave him throughout 2007 and 2008 that the firm was appropriately valuing its mortgage portfolio–and thus would be unlikely to have an asset write-down large enough to affect book value–he bought additional stock. As of publication, lawyers for the two executives had not returned emails seeking comment.

Between the start of January and mid-March 2008, the value of Private Capital Management’s investment in Bear Stearns declined by $478.5 million.

Bear’s lawyers have insisted since January 2009 that the firm’s operational risks were fully disclosed in numerous public filings and that its management did nothing wrong. Two weeks ago they filed a motion that seeks summary judgement on all of Sherman’s claims. (See here for a defense team comment on the Sherman case; Joe Evangelisti, a J.P. Morgan spokesman, declined comment. )

Sherman’s claim cites previously unreleased emails between key Bear executives bluntly discussing its troubled balance sheet and fretting about its declining short-term funding options. (Here is a sample.)

For example, Bear’s mortgage-backed securities chief Tom Marano wrote to Paul Friedman, the repo desk head, on May 9 and May 11, 2007 discussing the firm’s balance sheet which in his view already had serious challenges. “You guys need to get a hit team on blowing the retained interest bonds out asap. This is the biggest source of balance sheet problems.”

When two Bear Stearns Asset Management hedge funds filed for bankruptcy on July 31, 2007–incinerating $3.2 billion of Bear Stearns’s own capital–mortgage security prices collapsed, especially those that had been carved out of sub-prime mortgages. Trading volumes dropped across the entire MBS universe and the balance sheets of brokerages like Bear, Lehman Brothers and Merrill Lynch began to expand sharply as traders wrestled with not only their own mortgage inventories but billions of dollars worth of bonds sold by increasingly anxious customers desperate to reduce their MBS holdings.

What’s more, Bear Stearns’ management’s handling of its hedge fund disaster suggested that the firm’s risk management–particularly their computer models–valuation procedures and financial strength were suspect. The Securities and Exchange Commission’s Office of Inspector General’s September 2008 report on Bear’s collapse stated that “significant questions were raised about some of Bear’ senior managements’ lack of involvement in handling the crisis.”

There is no good time for a brokerage to signal to a marketplace–especially one where they are one of the dominant players–that they own way too much of an asset class that is rapidly declining in value and that they don’t have the financial resources to absorb the inevitable losses.

The summer of 2007, however, was the worst possible time to send that message.

In short order Bear’s executives were working very hard to keep word of its troubled balance sheet from leaking.

Timothy Greene, co-head of the fixed income finance department, sent a June 25, 2007 email to his boss Paul Friedman, “We are being very careful not to signal any hint of liquidity distress and would not want to do so as a result of a spike in the balance sheet.”

Friedman’s response: “We’re going to think how to craft the message in terms of getting rid of aged positions, paring down risk, etc. so as NOT TO spook anyone.”

A vicious circle was emerging and Bear Stearns was in the middle of it.

When the MBS market collapsed, Bear’s counter-parties (who likely had their own mortgages losses to contend with) quickly began demanding higher interest-rates to enter into repurchase agreements with the firm. As repo counter-parties began to be scarce, there was nothing Bear could do–unlike commercial banks it did not have a diverse stream of funding sources–but to accept what was offered. Getting the capital to support its mortgage- and asset-backed securities stuffed balance sheet became more expensive, forcing Bear’s trading profits to drop. What’s worse is those MBS and ABS were dropping in value, leading to unexpectedly large write-downs. Watching the charge-offs erase book value and with no profits to offset it, customers and lenders alike began to reduce their exposure to the firm.

Bear’s chief financial officer Sam Molinaro would become its public face, reliably pounding the table at every opportunity to assert that come what may, the firm’s financial health was fine. On a June 22, 2007 conference call, for instance, he said the firm’s “financial condition remains strong” and that it had “ample liquidity.”

Unit chiefs, often facing anxious customers worried about whether their prime brokerage account at Bear was safe or if the firm would be around to meet its counter-party obligations in a derivative contract, would come to see matters differently.

Prime brokerage chief Steven Meyer, in a July 20, 2007 email to Warren Spector and Molinaro, wrote that “the impact of the hedge funds problem on the prime brokerage business is very significant, not least because it gave brokerage clients a reason to question Bear’s judgement and risk management practices.”

Meyer’s concerns were not idle.

Vicis Capital, a $5 billion hedge fund, became the first big fund to move their