31 July 2008

Bear Sterns death and the US way of banking

One of the most remarkable chapters in the long history of American jurisprudence must certainly be the saga of the United States versus Anthony Accetturo et al, sometimes known as the Lucchese trial. In 1985, following a 10-year investigation, the US Department of Justice delivered a 65-page racketeering indictment against 21 members of the New Jersey branch of New York's Lucchese crime family.

The trial that commenced in November 1986 took up 240 volumes of court record, and is the longest Federal trial in American history, lasting 21 months. As depicted in Sidney Lumet's 2006 movie Find Me Guilty, the trial proceedings frequently descended into farce, in part due to the very unorthodox and ribald efforts of one of the accused, Giacomo DiNorscio, (played in the movie by Vin Diesel) to act as his own attorney

But the verdict that the jury delivered on August 26, 1988, was simple and straightforward - not guilty, for all defendants on all charges. Following the 1995 OJ Simpson trial, when the former football star was acquitted of murdering his former wife, legal observers would resurrect an old term for the circumstance of juries acquitting presumably guilty defendants for reasons other than the actual facts of their guilt or innocence - jury nullification.

After the Lucchese trial, observers speculated that, since most of the supposed victims of the defendants' crimes were not uninvolved "civilians", but other gang members also crawling across the web of organized crime in the metropolitan New York area, the victims should have, must have, realized that simply being involved in the orbit of organized crime would make them vulnerable to the type of predatory, criminal activity that they subjected others to. As Hyman Roth (Lee Strasberg) said in Godfather 2 explaining why he did not seek vengeance for the killing of a protege, "this is the business we've chosen."

That's what somebody should tell Bear Stearns when they start squawking about what happened to them last March.

Finally, the fin-de-siecle for the Bush age has arrived in the US, and across the agencies that regulate the financial markets the bonfires of the vanities are being set alight. Holding high the burning torch of moral purification is none other than a most unlikely Savonarola: Securities and Exchange Commission (SEC) chairman Christopher Cox. Once a true devotee of the free market's conventions and customs, he has most recently been going door to door among all the great houses of American finance, ordering those inside to surrender for immolation the free-market practices and techniques he only recently was purported to have cherished.

Trying to earn a seat at the big kid's table where Treasury Secretary Henry Paulson and Federal Reserve chairman Ben Bernanke are working on saving the world, (while President George W Bush is off somewhere totally uninvolved in all these events, perhaps seeking to assure that Cliff Notes are included in the holdings at the future George W Bush Presidential Library at Southern Methodist University in Dallas) Cox has now devised a unique soothing balm for the raw, irritated financial markets. In trying to make life harder for what are now seen as the parasitic invaders besieging the bodies, shares and souls of financial companies, he seems to be hoping to be able to heal these institutions simply through disarming the forces attacking them.

Last week, I explored how the new Wall Street moral purity crusade was cracking down on the once winked upon practice of "naked" short selling (see Bush turns to the dark side , Asia Times Online, July 23, 2008). Now, it appears that Cox, seeking to stamp out sin wherever it may be found in Lower Manhattan, is also sending his financial flatfoots back onto the street with subpoenas to force all those unfortunates in receipt of one to, under pain of all of the mighty state's tortuous sanctions, confess all they know about what happened to the Bear Stearns investment house in the waning days of last winter.

With all the calamities and catastrophes that have befallen the financial markets just since the leaves returned to the trees in the Northern Hemisphere you might have forgotten just what happened in between March 10 and 17 of this year, but, for those who lived through it, it was a time of the most fundamental and far-reaching change in the structure of American finance.

Bear Stearns, the blue collar (as opposed to the rest of the Street's blue-blooded), sharp-elbowed, red in tooth and claw bond trading house, whose bankruptcy of two subprime-mortgage-based hedge funds was the starter's pistol for the entire financial crisis in the early summer of 2007, entered the week fat and happy, sitting on an US$18 billion cash reserve. It would end the week in abject destitution and penury, its stock, which had traded as high as $170 in 2007, then ordered by the government to be valued at $2.

Hunt of malfeasance

Cox wants to know if there was any criminal malfeasance involved in these circumstances; failing finding that, failing discovering the proverbial "smoking gun" that forensic tests can match with some supposed bullet lodged in Bear's now entombed corpse, it seems that Cox would be satisfied with finding practices, accepted and allowed during the long languid summer of financial markets' deregulation, that, during the current winter of reproach and rebuke, he can say that, after taking a second look, actually were crimes after all.

Whatever Cox's gendarmes' discover, it will probably be very similar to an extraordinary, 10,000 word (and you thought I was long-winded) narrative published in this month's Vanity Fair (online at http://www.vanityfair.com/politics/features/2008/08/bear_stearns200808). Authored by respected financial journalist Bryan Burrough (the co-author, with Jon Helyar, of the definitive 1990 account of the 1988 leveraged buyout of RJR Nabisco, Barbarians at the Gate) "Bringing Down Bear Stearns" certainly should be the first stop for those, from concerned citizens to Cox's corybantic cerberuses, interested in the events of the Ides of last March, for it seems that all the principals involved have been well and thoroughly interviewed by Burrough.

So just what did happen to Bear Stearns?

On Monday, March 10 of this year, in no way was there any reason to assume the travails that Bear was soon to undergo. The mephitic rank of last summer's Bear hedge-fund collapse was mostly dissipated; the company felt that, with a capital reserve of $18 billion, it was as well fortified to weather what the remainder of the credit crisis storm would bring as any other of Wall Street's great houses of money. The stock had fallen from $170 in early 2007 to open that day at $70.28, but that was roughly in line with the performances of the rest of Wall Street's more aggressive hands at the table. If they could survive, Bear thought, so could we.

By the middle of that afternoon, Bear Stearns' principals must have been looking at their quote screens with horror. The stock was selling off, was doing it hard, and nobody could figure out why. The stock closed that Monday at 62.30, down over 11% on the day, on massive trading volume.

But what about that $18 billion war chest? To their absolute horror, Bear soon realized that they were under attack from rumors spreading across the Street of a "liquidity crisis", and, for that manner of siege, not even a fortress constructed of eighteen billion one dollar bills would be enough to fend off the scaling of the walls by the attackers.

Maybe you think of a bank as a place where an elderly woman comes in to deposit her government pension check and later in the day, the bank, in order to earn the interest it has promised to pay the woman, finds someone who is willing to borrow the money at a higher rate of interest than what it is paying on her deposit.

You're correct in assuming that this is the core of modern banking and finance, except that you've got the order in which these procedures occur precisely in reverse. Modern financial institutions do not wait until the old woman hands her check to the teller before rushing onto the street to try to find someone to lend the money to. No, they're ever out there pounding the street (these days, they're more likely to be pounding their broadband data feeds), looking for profitable investments that can be made even before they get the funds to make them. These can be in US and foreign Treasury securities, corporate bonds, stocks, warrants, futures, options - even, as the financial system has now learned to its abject misery, in subprime mortgage paper.

If left to their own devices these institutions would make these types of investments, would do this type of lending, until swine self-levitate. This is what happened in capitalist economies until the introduction of modern central banking and bank regulation in the early 20th century. Banks would lend and lend and lend, all the while creating massive monetary liquidity based on nothing of any real value, until the last fool would see through the trick and the whole teetering edifice would collapse. From boom to bust and then back to boom again economies would lurch, until government regulation came in and, hearing the terrified screams of those on the ride, pulled the throttle back a bit on the roller coaster.

In what is called fractional reserve banking, banks and other financial institutions can make loans and investments only in set and defined multiples of what they actually have in the bank. In 1988, the first of two Bank for International Settlements' Basel accords adjusted the formulas according to the risk of the investments the financial institution was making: the less risky the investment (such as short-term government Treasury Bills), the less that had to be held in reserve against it; the more risky, the greater the reserve requirement.

Taking all this into consideration, it's still not as if the banks are making risky investments and then calling the old woman to see if she's coming in with her check today so they can close the daily books in compliance with their reserve requirements. What the banks do is to find out the amount that they need to have in reserve for that day, and then have their trading desk go out and get the funding.

For the most part, the bulk of the daily variability in their funding requirements is met through operations in what is called the short term repurchase market, or repos. There, if one bank finds it has a short-term, perhaps if only for one night, need to meet a reserve requirement it can borrow the funds it needs; the funds here may be being lent by another institution that at the end of the day finds it has more in reserves than its traders have made profitable loans that day for.

Repo loans can be in the range of tens to hundreds of millions of dollars, and they are in no way, shape, or form insured by the Federal government. That's the problem. If you do an overnight loan of, say, $100 million, and the next day the bank you lent the money to is out of business, with a "Coming Soon - A New Baby Gap" sign on the door, it'll be a long, long time before you ever see that money again. You'll get in line behind all the rest of the dead bank's creditors, and, since repo loans are unsecured, you'll be a long, long way from the front of the line as well.

By the end of that first day, Bear determined that it was fear that it was going under that was driving the stock price down. Rumors were spreading like wildfire that Bear was not long destined for the financial world, and, as a result, it rapidly began to lose access to the overnight repo market. In something of a self-fulfilling prophecy, without being able to fund its loan portfolio, Bear would soon be forced out of business.

CNBC in the rumor line
Burrough reserves particular vilification in this process to US cable television network CNBC. All that week its highly competitive and aggressive young reporters were continually interrupting each other's segments with breathless "breaking news" reportage on the allegedly increasingly dire situation at Bear. Burrough notes that CNBC is wired through the world financial markets as if it was its nervous system; anyone who might have been thinking of doing a repo deal with Bear would, of course, see these reports and be dissuaded, knowing that if the repo deal was done and Bear subsequently went belly up, there could be no excuse that the trader did not know what was going on that would save his head from the chopping block.

But for Burrough, the more interesting question is, where, and from whom, was CNBC getting its negative, market moving news from?

By Wednesday, March 12, it was clear that the contest was between Bear's $18 billion reserve and the much larger amount that the market could either reward or withdraw from Bear with but a twitch of a trader's finger on a mouse, and that the twitching fingers were winning. By late in the day, Bear's reserves were down to $15 billion, and urgent feelers were being extended to New York Federal Reserve Bank president Timothy Geithner about an emergency loan, which, as an investment, not a commercial bank, Bear technically was not supposed to be eligible for.

By Thursday, the flight away from Bear in the repo market had become a stampede. The bank was looking at a $30 billion shortfall in what it needed in overnight financing, far more than what it could fund from its now dwindling reserves. Then again, even if Bear emptied the piggybank to fund Thursday's needs, there was absolutely no guarantee that the bank would not need that or more on Friday, or the day after that, or the next day after that as well.

For vainglorious and prideful Bear Stearns, the choices that faced it that Thursday night would have seemed unthinkable just the previous Monday morning. Either a savior had to be found who would either lend billions to Bear or buy it outright, or the next morning the august bank would be standing in line with all the people with excess medical or credit card bills waiting to file papers at the bankruptcy court.

Bear did some of its own banking with Morgan Stanley (whose offices were right across the street), so the first person Bear chief executive Alan Schwartz called was Morgan CEO Jamie Dimon, that night celebrating his birthday with his family at a Manhattan Greek restaurant.
As recounted by Burrough, Dimon was none too pleased when his private cell phone rang during dinner. To paraphrase the famous exchange between F Scott Fitzgerald and Ernest Hemingway, the rich really are different; their cell phone calls are a lot more interesting than the ones us average folk get requesting that we bring home cat litter and hamburger meat.

"We really need your help," Schwartz begged.
"How much?" Dimon quickly got to the point, evidently wanting to get back to his dinner.
"As much as $30 billion," Schwartz replied
"Alan, I can't do that. It's too much," Dimon said.
At which point, Schwartz played his final card. "Well, could you guys buy us overnight?"

Dimon demurred on this, citing the need to consult his board, but with that the die was cast, and the boulders had been set in motion down the hillside. The outlines of the Bear rescue had been drawn.

Still, Dimon was cautious. He knew that if Morgan lent Bear the money and Bear then imploded anyway, both Bear and Morgan (along with Dimon) would probably be pulled under. He wasn't willing to stake everything, his bank, his shareholders, his career, on the possibility that Bear's loan book wasn't as poisonous as the market feared it was. Dimon wanted an insurance policy, and the only insurance company writing policies this big was Geithner and the US Federal Reserve Bank.

Come Friday morning, the markets awoke to unprecedented news. Through an extraordinary procedure, Bear had been given access to the Federal Reserve's discount window. In a rigmarole that impressed the markets that the Fed was not rewarding moral hazard about as much as a courtesan lowering her skirt to reclaim her virginity, the Fed would, for 28 days, loan Morgan an indeterminate amount that Morgan would then loan to Bear to meet its financing crunch.

Bear thought that it had been given at least a four-week stay from the executioner's blade, but by the end of the day the markets looked past the immediate moment and saw only trouble - what would happen after the 28 days? Bear's stock, which opened Friday at $54.24, closed at $30, down 57% for the week.

Over the weekend of March 15 and 16 came proof of the old adage that things are always darkest just before they turn absolutely black.

Bear was stunned to hear from Treasury Secretary Paulson that the 28-day line of credit it thought it had was being withdrawn. (Paulson says that there was a communications mix-up between the Treasury and Morgan/ Bear.) Bear had to make a deal to sell the company that weekend or be in bankruptcy court Monday morning.

In some delicious karma, Bear's lawyers informed the company's principals that, because of provisions in the 2005 Bankruptcy Reform Act that big finance capitalism had pile-driven through Congress, the standard option of a so-called Chapter 11 bankruptcy, in which the company is given a breathing space to sort out its affairs away from the braying hounds of its creditors, would be denied them. Make a deal - or on Monday the company is liquidated, and everybody's unemployed.

By Sunday evening, the deal would be done. Dimon, after finally having his people look at the extent of the illiquid, probably toxic mortgage securities on Bear's books, said it would pay no more than $4 a share for a company that had traded at $170 a share just 13 months before.

Paulson hungry for more

That, however, was still not enough punishment to satiate Paulson's hungry palette. He said it would be unseemly if Bear's shareholders walked away with even that much at a time when hundreds of thousands of Americans were being foreclosed out of house and home every month. He demanded that Bear be bought at $2 a share, the price that was announced for the deal on Sunday evening. (After Bear's shareholders screamed in pain, and after it seemed that the bank's mortgage book might not be as rancid as Morgan first feared, the final buyout price was raised to $10 the next weekend) If Morgan wasn't getting enough of a bargain buying Bear on the cheap, the deal also included provisions making the government liable for up to $29 billion if the securities Morgan was inheriting from Bear were defaulted on.

For Bear Stearns employees who had invested their life savings in the company's stock, the results were catastrophic. Former Bear chief executive Jimmy Cayne, made famous in a November 2007 Wall Street Journal article that noted how he spent the financial crisis of that August playing bridge and smoking pot, saw the value of his stock holdings fall from just under $1 billion the previous year to about $12 million (poor baby). For the rest of Bear's 14,000 employees, their future dreams of comfortable retirement were now very much in question, as was, of course, the prospect of the continuation of their employment at Morgan.

So the question remains: who killed Bear Stearns?

Burrough advances some of the usual suspects. Noting that Bear Stearns had made a lot of enemies from the time when it pulled out of the consortium of banks that the Federal Reserve had organized in 1988 to bail out the Long Term Credit Management hedge fund, he speculates that it was here that the long knives which had been waiting so long to strike were finally thrown.

On his Most Wanted list are Goldman Sachs (where Paulson, Bear's personal Torquemada, was previously CEO) along with Credit Suisse and Deutsche Bank, working in conspiracy with some smaller hedge funds. These were the plotters who were presumably feeding the bad news to CNBC, all the while holding huge naked short positions in Bear's stock - positions that, of course, ultimately proved insanely profitable.

Supposedly, these are the people now receiving the subpoenas from Cox in order to see if their actions rose to the level of criminal malfeasance. Burrough quotes an executive of another financial institution, displaying the signature worldview of the privileged that the universe revolves around them, that what happened to Bear Stearns was nothing less than "the biggest financial crime ever perpetuated".

Even if all of Burrough's speculations regarding the existence and perfidies of an anti-Bear cabal at the penultimate levels of world finance were true, I'm not at all sure that these actions rise to the level of an illegality under US securities law, and I'm even less sure that these actions bear the primary responsibility for Bear's collapse.

It is only since July 15 that naked short selling has been illegal in America, and that is only as regards to naked short selling in the shares of 19 financial institutions, for a limited time. The second requirement for proving illegal securities manipulation might be a hard sell for a prosecutor to present to a jury, since, in the final analysis, the rumors that somebody spread across Wall Street that Bear was in trouble turned out to be absolutely true.

'Why?' - not 'who'?
But the most important policy issue here is not who killed Bear Stearns, rather, it is why did it have to die?

Imagine a police detective coming upon a most peculiar crime scene. A group of people standing in a swimming pool filled with gasoline have burned to death. Investigating who shorted Bear's stock is like trying to ascertain who lit the match that started the inferno. The much better question is, of course, what were all those people doing standing in a pool of gasoline?

The history of political economy in the capitalist world, and after the fall of the Communist bloc what was added to the capitalist world, since about 1979 is a story of the progressive impoverishment and enfeeblement of governments, and, in their place, the rise in power, influence and wealth of the private markets.

Taxes, especially taxes on capital, have been cut over and over again, across many national borders. With these tax cuts heavily benefiting the wealthiest members of society, the result was huge pools of wealth being amassed and controlled by ever fewer and fewer hands. (See Hedge funds: Playing dice with the universe, Asia Times Online, July 6, 2006, for my discussion about the world financial architecture being subjected to ever increasing strains from the movements of these great pools of wealth.)

What befell Bear was nothing but a modern version of a 1930s bank run, with, instead of seeing hardscrabble men waiting to withdraw their meager deposits from the bank's vaults, what you saw was a stampede of computer mice directing funds away from Bear's requirements for repo financing.

Even if Bear had been as financially healthy as its $18 billion cash reserve implied, there was no way it was going to survive once these great pools of wealth started moving in unison against it. What happened to Bear could happen to any financial institution subject to the same stresses; Bear was only a little bit more vulnerable due to the reputation as a troubled institution it carried forward from its hedge fund debacles the previous year.

If you load a wheeled grand piano on a rowboat, and a rogue wave shifts the piano and thus sinks the boat, was it really the wave that sunk the boat, or was it the idiotic decision to put the piano on the boat in the first place? That's much like the situation of the current world financial architecture - the great pools of private wealth ever sloshing across the computer vaults of financial institutions are subjecting it to far greater stresses and strains than it was ever really expected to withstand.

As for Bear's protestations of being violated ("This is rape!" Burrough reports one Bear employee screaming at Schwartz upon learning just how cheaply the company was being sold to Morgan), aww, c'mon fellows. Did you really think that you were immune from all the high inside fastballs (when an American baseball pitcher throws hard at an opposing batter's head) and clothesline tackles (a similarly underhanded and unpleasant move in American football) you delivered to others? Like the jury's verdict in the Lucchese trial, wasn't your victimhood here only what you in the past delivered to others? If not, why would Goldman Sachs et al go through all the trouble to kill you?

In the words of Hyman Roth, wasn't this the business you've chosen?

Another classic in the American gangster genre, Martin Scorcese's 1995 Casino, has mob-installed Las Vegas casino manager Ace Rothstein (Robert De Niro) observing that, during his time in the 70s and 80s, "Running a casino is like robbing a bank with no cops around." For influential players and traders in the deregulated world financial markets over the past quarter century, their professional life frequently matched Rothstein's experience in running a casino without having to worry about any government intervention.

If Cox's crusade really does represent the forward wave of a re-regulation movement, as economics Professor Paul DeGrauwe suggested in the Financial Times on July 22, then a lot of wealthy hedge-fund investors are going to have to get used to not beating the general market indices by 30-50% anymore, and a lot of their previously well-compensated traders are going to have to see if they like selling bakingwear as much as they did selling bonds.

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