Bailout Nation (29 page)

The good news is the final bill should be considerably smaller than $15 trillion. Many of the loans will be repaid, and the vast majority of the Fannie/Freddie portfolio is sound. My best guess is the final costs for the cleanup of Wall Street's worst excesses bill should total somewhere between 10 and 20 percent of that number. But that is merely an operating assumption. It is certainly conceivable that circumstances, and the final bill, may change.

But even so, that is a lot of money.

Trying to explain a trillion dollars to most humans is difficult. Indeed, a trillion is a lot of anything. It is a nearly impossible number to conceive of, and it is much larger than most people's conception of time and space. Consider these comparables. The average lifetime is a little longer than two billion seconds (72 years = 2,270,592,000 seconds). One trillion seconds is 31,546 years. In astronomical terms, the universe is believed to be 15 billion years old—that is just shy of 5.5 trillion days old (5,475,000,000,000 days). Suffice to say a trillion is a big number.

The only event in American history that even comes close to matching the cost of the credit crisis is World War II: In 1940 dollars, it cost the Treasury $288 billion. Adjust that for inflation, and it is $3.6 trillion.

That's a fair guess as to what the net cost of the 2008 bailouts will be to the taxpayers in terms of actual expenditures; $15 trillion is the gross cost. Perhaps the United States will show a profit, or maybe the monetary cost will be much greater than that of World War II. Your guess is as good as mine. No one knows.

Let's take a closer look at all of the bailouts from March 2008 to March 2009 in the next chapters. Perhaps we might discern if there is some method to the madness.

—Jamie Dimon, CEO of JPMorgan Chase, on his $2-per-share offer for Bear Stearns

 

 

W
hen Bear Stearns fell apart, few suspected a cascading collapse across the entire financial firmament. Yet that is precisely what occurred as the house of cards built atop residential mortgages wavered, then crumbled.

The first signs of the mess to come burst into view in the early summer of 2007. That was when Bear Stearns reported heavy losses at two of its internal hedge funds. The announcement would prove to be the tip of the iceberg for the coming global financial crisis and the beginning of the end for the firm that had survived the Great Depression, two world wars, the 1987 crash, the Long-Term Capital Management implosion, and the 2000 dot-com tech wreck.

The culture at Bear was unique. The firm was heavily focused on fixed-income trading and institutional clients, as opposed to equity trading and retail clients. It was considerably smaller than rivals such as Merrill Lynch and Morgan Stanley. The firm had a history of hiring traders with street smarts, rather than the best pedigrees. This was a polite way to say Bear Stearns didn't hire only WASPs when that was the de rigueur on Wall Street. You could be Jewish with a degree from Brooklyn College, or (later) from India or Pakistan, but it didn't matter as long as your trading made money for the firm.

Bear was different from most other Wall Street firms in one other crucial way as well: It was the only primary dealer of Treasury securities that refused to participate in the 1998 bailout of Long-Term Capital Management. This, despite the fact that Bear was LTCM's prime broker. It was an act of selfish defiance that many on Wall Street never forgot—or, apparently, forgave.

Oh, and one last thing: Bear was the biggest underwriter and trader of mortgage-backed bonds.

T
he firm's 14,000 employees and its many shareholders were victims of Bear Stearns' management. Bonuses included stock and options, so many of Bear's employees were stung twice when the firm failed and the stock crashed. Management allowed (and indeed encouraged) the investment bank to become overexposed to mortgage-backed securities. This alone was a significant factor in its demise. When the firm didn't seek additional liquidity when it was available, its fate was sealed.

In part, the vagaries of the prime brokerage business, where hedge funds park capital with a prime broker in exchange for broker services, further exacerbated conditions at Bear Stearns. The lucrative business of facilitating trades for hedge funds became a millstone for Bear in 2008: As the firm's problems became public, many of its prime brokerage clients—Jim Simon's Renaissance Technology, Citadel Investment Group, and PIMCO—sought to protect themselves from a messy collapse, pulling their capital out of the firm. Each departing client depleted the company's capital base; each led to more Wall Street rumors of a possible bankruptcy. Each rumor prompted more prime brokerage clients to pull capital, and so on.
¹
Plummeting almost 90 percent, Bear Stearns' liquidity pool went from $18.1 billion on March 10, 2008, to $2 billion by March 13, 2008. It was evidence of how quickly fortunes can change on Wall Street, especially at highly leveraged firms.

“A lot of people, it seemed, wanted to protect themselves from the possibility of rumors being true and act later to learn the facts,” Bear Stearns President and Chief Executive Alan Schwartz said in a March 14, 2008, conference call.

Was it a self-fulfilling prophecy? Funds fled Bear because they feared it might become insolvent; hedge funds shorting Bear Stearns' stock passed along rumors that others were doing as much. Others bet on credit default swaps linked to the company, and were none too shy about e-mailing negative analysis to their peers and colleagues.

Hardly.

Bear was a highly leveraged firm that bought lots and lots of bad assets with mostly borrowed money. The assets these products were based on—namely, subprime and Alt-A mortgages—were going bad at an increasingly rapid pace. It was readily apparent to the analysts and short sellers who crunched the numbers that Bear Stearns' days were numbered.

That was the factor Wall Street CEOs like Dick Fuld, Hank Paulson, and Jimmy Cayne failed to consider: When you are a bank, your existence depends on the confidence of your clients, investors, and counterparties. “A company is only as solvent as the perception of its solvency,” said noted analyst Meredith Whitney, formerly of CIBC Oppenheimer.

Anything you do that puts that perception at risk is extremely dangerous. If you want to run lots of leverage and push the envelope, well, then, you'd better hope nothing else goes wrong. At 35:1 leverage, you do not leave a lot of room for error. If your business model is highly dependent upon access to cheap capital, what happens when that access to liquidity disappears?

Which raises this question: Why aren't there ever runs on semiconductor firms or software companies? Why don't the integrated oil companies or railroads suffer from similar bear raids? The short answer is their business model does not depend on a belief system—of solvency, liquidity, deleveraging, or risk management. All these firms have to do is not go bankrupt.

If you run a major investment bank, however, you
also
have to make sure you don't appear to be
remotely close
to going bankrupt. You needed a bigger margin of safety. Such is the fate of those who depend on the confidence of others.

Bear was perhaps the most colorful example, but it wasn't only a crisis of confidence that did in the investment banks; it was a crisis of
competence.

And yet, somehow, the investment bank CEOs all failed to realize this. It is inexcusable that this much leverage was applied to firms that relied on others' favorable belief in their solvency. It was unconscionable these firms had been purposefully put into a risk-taking position in extremis. That the CEOs blamed short sellers and rumors—but tried to exonerate their own horrific actions—serves only to emphasize not only their own failures, but their lack of comprehension of what
they themselves had done to their firms.
It was their own incompetent stewardship that purposefully and unknowingly placed these firms at such grave danger of destruction.

Imagine a patient being treated for a particularly aggressive form of cancer. The chemotherapy makes the patient's hair fall out, so he buys himself a Yankee baseball cap to wear. Unfortunately, the cancer is too far progressed, and patient succumbs to the illness. If you were the management of Bear Stearns, you would blame the Yankees for the death of this patient.

B
ear's failure contained harbingers of what other management teams would soon do also:

Schwartz was in many ways the fall guy for the failures of his predecessor, Jimmy Cayne, who famously spent much of 2007 and 2008 playing golf and bridge. Infamously, the
Wall Street Journal
reported Cayne also favored marijuana.
²
As Bear careened toward disaster, Schwartz got burned for Cayne's fiddling.

An investment banker by training, Schwartz was admittedly not an expert in the complex mortgage-backed securities that were crippling the firm. That was the purview of co-president Warren Spector. In the years leading up to Bear's fall, Cayne had reportedly given Spector free rein to run that side of the business (and it was a big side at Bear). Spector became the fall guy after those internal hedge funds blew up in the summer of 2007, and he was unceremoniously fired shortly thereafter.

When the crisis intensified in late 2007 and on into early 2008, Bear was being run by one executive who was in over his head, and another who had figuratively (and possibly literally) checked out. The
Wall Street Journal
reported that “repeated warnings from experienced traders, including 59-year Bear Stearns veteran Alan ‘Ace' Greenberg, to unload mortgages went unheeded.” Schwartz, most notably, “didn't want to unload tens of billions of dollars' worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.”
³
Any experienced trader will tell you to “cut your losers short and let your winners run.” That the corner office at Bear failed to grasp this is telling.