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.
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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.
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.
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 prime brokerage in July, 2007 to Goldman Sachs from Bear Stearns, principally over concern about the firm’s MBS exposure, according to an excerpt of Sam Molinaro’s deposition in the Sherman suit.
In August, 2007 the gap between what Bear executive’s told the public and what they discussed privately became pronounced.
After Standard and Poor’s signaled that it was likely to cut Bear’s credit rating on August 3, the firm’s executives hosted a conference call to reassure investors. Molinaro again struck a confident tone and told participants that “with respect to liquidity, our balance sheet, capital base and liquidity profile remain strong.” Treasurer Robert Upton added, “Bear Stearns’ liquidity and capital position is very solid” and that “the firm’s liquidity position, capital adequacy and funding capacity remains extremely solid not withstanding the difficult market conditions.”
Yet at 7:22 am that morning Sam Molinaro sent an email to Bear’s former Treasurer and then-clearing chief Michael Minikes, “We need liquidity ASAP” after Minikes told him of the looming downgrade.
In the following days emails between Bear’s executives responsible for funding its balance sheet took on an increasingly bleak tone.
On August 9, an email thread between Upton, repo chief Friedman and others discussed Bear’s loss of $1.65 billion of equity repo, or repurchase agreements using stocks as collateral, as opposed to the standard government or corporate bonds. Within days it had become a torrent, and Friedman laid out the brutal details in a long email to fixed-income co-head Jeff Mayer.
To start, he told Mayer about the loss of “$14.5 billion in funding” most of which had been used to fund the MBS trading desk’s whole loan and non-agency securities portfolio.
(Whole loans were loans to a single residential or commercial borrower that had not been carved into a bond. Non-agency bonds were carved from loan pools that mortgage guarantors Fannie Mae and Freddie Mac would not insure, usually because of credit concerns; these pools were the epicenter of the credit crisis.)
Nor did Friedman see any relief on the horizon.
Friedman told Mayer that “against (the loss of $14.5 billion) we’re taking in only $2.7 billion of money from [a] new source. We have an additional $3.1 billion of funding that is either already scheduled to be pulled or at risk of leaving. Roughly $500 (million) is going back this week. Another $1.9 billion is borrowed from (commercial paper) conduits that we are having trouble rolling.”
While Bear’s repo desk scrambled to keep the firm funded in mid-August, Sherman seized on its declining share price as an opportunity to buy stock for his personal account and a charitable foundation he controlled, ultimately purchasing 67,000 shares in the month at prices between $110.14 and $103.15.
Throughout the fall of 2007, despite getting daily–and sometimes hourly–updates about the funding difficulties, Molinaro and colleagues proclaimed to analysts, investors and the media the strength of Bear’s capital base and its access to myriad sources of funding. During the third quarter conference call on September 20, Molinaro told investors the firm was “increasing our cash liquidity pool” and had been “building excess liquidity at the parent company.”
At the Merrill Lynch Banking and Financial Services conference on November 14, 2007, Molinaro said, “Our capital and liquidity position, we think, is very strong. Liquidity, in particular, is as strong as it’s ever been. We think our funding structure is very prudent, mostly secured term repo facilities.”
Molinari presented a slide that said as of Aug 31, 2007 the totality of Bear’s subprime securities exposure was $1.558 billion.
Yet in a January 2008 reply to an SEC letter seeking clarification on Bear’s subprime risk disclosures in 2007, Molinari said it was $2.97 billion as of August 31, 2007. He wrote that the firm had $770 million worth of retained interests in subprime securitizations and $2.2 billion of investments in securities backed by subprime loans.
The Southern Investigative Reporting Foundation called Molinaro, now the chief operating officer at UBS’s investment bank, to ask about this $1.41 billion differential in subprime exposure. He did not reply to voice messages left on his cellphone and his house.
Bear’s constant stumping about its solid financial health didn’t work with the constituency that most mattered: its lenders.
By mid-December, according to Sherman’s claim, Friedman wrote to Marano in an email that even if Bear was not downgraded and managed to “raise a couple [of] billion dollars of new equity [it would] still have all the same funding and liquidity issues [it has] now.”
Three days later, Marano emailed the new CEO Alan Schwartz, to demand capital be raised immediately: “The repo desk is in a constant state of concern with respect to funding the firm. We have inadequate long term and short term financing facilities. . . . We may have inadequate funding resources to address investment in technology for risk management and reporting of positions.”
The Southern Investigative Reporting Foundation spoke to Tom Marano–now the Denver-based CEO of vacation-marketer Intrawest–and he said that, “While I was pretty hard on Alan, it was necessary. We needed more capital but I didn’t get through to him.” Marano declined additional comment about the case.
An exhibit that was attached to Sherman’s claim shows that the SEC was alert to Bear Stearns’ looming problems by late 2005 but granted “confidential treatment” status to its communications with the firm, thus exempting it from being publicly uploaded.
In its review of Bear’s 2005 10-K filing, the SEC had some pointed concerns about its disclosures of subprime MBS exposure and its failure to implement a firm wide value-at- risk limit. The SEC’s 2005 examination concluded that Bear’s risk management framework was problematic, relying on “outdated models created over a decade ago” and that Bear had “limited documentation on how the models work.”
Sherman’s lawyers allege that Bear’s risk management apparatus was nothing like the best-of-breed unit it portrayed to the public. Instead, they allege that the trading department came to dominate risk management operations. According to the 2005 SEC examination, Bear used a “bottom-up,” trader driven approach where “risk taking is evaluated first and foremost at the trading desk level.” Moreover, the SEC’s analysts found that “certain business heads can establish new trading limits and approve existing limit breaches with their sole written approval without direct approval from risk management.”
His lawyers also point to a report commissioned by Bear’s board in 2007 that assessed Bear’s risk management operations. The outside consultancy, Marsh & McLennan’s Oliver Wyman unit, wrote that “Bear’s risk policy and limits were proposed by the business units and frequently overridden.”
Bear even admitted in their January 31, 2008 response to the SEC the possibility of their subprime exposure potentially being fatal.
“We believe that based on the Company’s level of involvement in subprime lending and the broader impact on the global credit markets, a material adverse impact on the Company’s: financial condition, results of operations or liquidity is reasonably possible.”
They went on to promise the SEC “in future filings we will consider our level of involvement in subprime lending, and we will seek to enhance our disclosure of positions, if necessary.”