The following comes via Larry Ribstein, Mildred Van Voorhis Jones Chairat at the University of Illinois College of Law, proprietor of the excellent Ideoblog, and frequent contributor to The Conglomerate.

WHO KILLED THE BEAR?

On March 16, 2008, Bear Stearns, which had recently traded as high as $170/share, was sold in a government-arranged shotgun marriage for $2/share (later raised under shareholder pressure to $10) – far less than the value of its building alone.

Kate Kelly has written a highly readable book about Bear’s last weekend. It is refreshingly free of journalistic moralizing and filled with facts from which readers can draw their own judgments. Below are mine.

In general, I look to the book to answer the question, who killed the Bear? Ms Kelly provides the data for some possible answers:

1. THE BEAR KILLED ITSELF.

Or, more precisely (since “Bear” is an artificial entity consisting of many individuals) Bear’s governance was inadequate. In the wake of Lehman’s demise, I wrote that “this is the wake up call for corporate governance. Despite all the regulators, independent directors and Gretchen Morgenson, big firms were taking catastrophic risks under the radar.” I suggested that investment banking was suffering from incorporation and might return to its “partnership roots,” by which I’m referring to what I’ve called “uncorporate” forms of governance (here are the long and short versions of the uncorporation story). The bottom line is that private equity/hedge fund-type governance disciplines managers to really care about the kind of risks that brought down Bear, and then Lehman.

What comes through Kelly’s story is that Bear was not really an integrated whole, lacking firm-wide discipline. It was an autocracy that succeeded when the dictator (Ace Greenberg) knew what he was doing and failed when he (Cayne) didn’t.

Kelly blames Cayne. She says: Bear was “uniquely vulnerable” because of Jimmy Cayne’s “cavalier outlook.” “Handsomely paid and disinterested in details, Cayne embraced Greenberg’s [money-saving] philosophy in the most narrow-minded sense.” He watched expenses but “kept Bear’s business mix in the backwoods and let risk management deteriorate. Cayne himself lacked the patience to micromange Bear’s hedges, so he left that work to an overburdened Warren Spector, an aging Greenberg, and a handful of technical models.” (pp. 221-22).

This focus on individuals may explain why Bear failed and other investment banking firms (e.g. Goldman) didn’t. But good governance may still be at the core, because it’s supposed to protect firms from weak individuals.

2. THE GOVERNMENT KILLED THE BEAR.

Kelly makes clear that markets read the government’s non-recourse loan to Bear at the beginning of its final weekend as an indication of Bear’s desperation, hastening the collapse. So the government signaled Bear’s demise. Would Bear have pulled out of the tailspin without this “help”? Kelly also shows that Bear was in the midst of a bank run which the government loan was a last-ditch attempt to stop.

We’ll never know for sure. Kelly shows Bear was in a rapidly changing situation. Interestingly, two private equity firms showed considerable interest, but were blocked by the government’s and Bear’s skepticism. Citadel’s Ken Griffin “saw a compelling opportunity in Bear Stearns and was eager for an invitation to come take a look” (p. 96). But Bear executives distrusted Citadel because they thought it was profiting on the stock slide and because “they felt that Citadel lacked the seal of approval that a bigger or more widely understood acquirer might bring” (130). And Paulson rejected overtures by J.C. Flowers because it didn’t have a big enough balance sheet. Well, yes, JP Morgan would have been better than Citadel or Flowers. But would Citadel have beaten the “solution” the government ultimately foisted on Bear?

Note also that Bear suffered from bad government timing. The Fed opened the discount window after Bear went down. If this was just a bank run scenario – the assets were ok but the market just lacked faith – couldn’t Bear have been saved by this kind of temporary support rather than a government takeover?

It is important to note that the government intervention was not just a mistaken read on Bear’s condition, but followed from a deliberate policy position. Paulson told CNN’s Wolf Blitzer his “number one-priority is to minimize instability, minimize spillover into the real economy” (p. 188). In other words, the government was determined not to let the scenario play out in the marketplace if there was a risk of systemic collapse. This is a consequential government decision.

So was Bear’s demise less a failure of capitalism than the result of the government’s unwillingness to tolerate risk and failure in the face of political pressure to “do something”?

3. MARKETS KILLED BEAR.

If markets were saying that Bear was worth $170/share, then soon after nothing, was there something wrong with markets? More specifically, Kelly says “Bear was grappling with an old-fashioned run on the bank.” This suggests panic. Alan Schwartz, like Jimmy Stewart in Wonderful Life, is trying to tell everybody, truthfully, that everything was ok, but the market unreasonably refused to believe him.

But consider two problems with this panic story. First, unlike the depositors in the movie, those with little faith in Bear were, as Kelly says, “large-scale institutions” (see pp. 94-95). Moreover, the book is replete with incidents in which markets ignored all the calming talk and focused on the big hard salient fact that the government, presumably well-informed, had chosen to act precipitously to save Bear with its non-recourse loan (see pp. 39, 79, 114).

4. GRETCHEN (AND GEORGE) KILLED THE BEAR.

On Sunday, March 16, just as Bear and JP Morgan seemed to have a deal, two things happened. First, on ABC’s This Week George Stephanopoulos told Henry Paulson “why not set an example of Bear Stearns. . .The guys who have this record of dog-eat-dog, we’re brass knuckles, we’re tough. . . .You say you’re aware of moral hazard, but it does seem like you’re creating one.”

At the same time Gretchen Morgenson’s NYT story hit the street saying that “perhaps the $17 billion of [Bear] assets that hadn’t been independently valued were, in fact, close to zero under distressed conditions.” Morgan’s Steve Black saw this and realized that “the public was watching closely.” Jamie Dimon said: “We’re not going to be able to do a deal under these terms” [referring to the $10/share or so deal then under consideration] (see pp. 186-190). Yet Kelly notes that “this type of valuation, which had become common in certain parts of the fixed-income market, was sometimes the only option” for relatively illiquid assets. And later, at p. 221, she says “[Bear’s] holdings, in fact, were of higher quality than most people realize, and ultimately told only part of the story of Bear’s demise.” So were journalists, anxious to tell a good story whatever the facts, responsible for the bank run?

5. THE HEDGE FUND MANAGERS.

Kelly makes clear that the collapse of Bear’s hedge funds led to a critical loss of confidence in Bear. This is significant because it looks like the hedge fund managers are being set up to take the fall, in terms of criminal liability. In other words, they’ve lost the corporate crime lottery. See my posts here and here.

This is based on a hindsight second-guessing of their judgments as to the funds’ solvency relying heavily on an email between them. Yet if Kelly’s book makes anything clear, it is that a lot of other things were going on as well. To name just one: one reason the funds failed is that market refused to cut them slack, remembering that Bear had done likewise with respect to Long Term Capital (see p. 221).

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