Could Bear Stearns Fail?

Before readers get too excited, let me be clear: this post is to discuss what circumstances might lead Bear Stearns to cease to be an independent organization. It is not an attempt to forecast the likelihood of that taking place.

Despite their considerable prowess, investment banks are fragile organizations. It took only one major scandal to bring down Salomon Brothers, the king of Wall Street in the 1980s, and Bankers Trust, one of the top two derivatives firms. In each case, it took some years before the firm lost its independence, but in each case, a single event led to their downfall.

In Salomon’s case, a senior trader, Paul Mozer, was submitting false bids at Treasury auctions, claiming them to be on behalf of customers, so that Salomon could purchase more than the maximum normally permitted to a primary dealer. The tragic aspect of this situation was that the historically able CEO, John Gutfreund, for some unknown reason waited months after discovering and halting the fraud before notifying the Federal Reserve. The Fed, furious at the delay, demanded a full accounting from the directors in ten days. The executive team did not pass on the Fed’s stern letter to the board but merely mentioned an information request. With no report forthcoming, the Fed read the failure to comply as intransigence, rather than neglect. And with the press hammering at the story, creditors began to pull back from the firm (and as a highly leveraged bond firm, Salomon depended on the repo market). Gutfreund and his deputy Tommy Strauss resigned. John Meriwether (Mozer’s boss and head of the highly profitable bond arbitrage group) was forced to quit, even though he had told Gutfreund immediately when he had learned of Mozer’s misdeeds.

Now this scandal, which nearly led to the collapse of the firm in 1991 (it never recovered and was eventually sold to Citigroup) was the result of a single mistake: the failure to call the Fed and grovel a bit.

In Bankers Trust’s case, the underlying weakness was systemic, an out-of-control culture, but again it was a scandal that led to the demise of the firm. Bankers, along with O’Connor & Associates (later acquired by Swiss Bank) were the two biggest derivatives traders by a considerable margin. OTC derivatives were hard to value, and most customer buying them had no idea if the pricing was remotely fair. Bankers exploited this ignorance and charged very rich prices (to the point that O’Connor traders were upset, fearing they would burn customers and ruin the market for all).

The proximate cause was a lawsuit filed by BT client Proctor & Gamble, seeking to recover losses on derivatives trades, essentially claimed that BT had taken advantage of them. Normally, BT should have been able to win easily; the notion that a Fortune 500 company was duped is laughable on its face (if they lacked the competence to understand the products, they shouldn’t have bought them). But Business Week demanded that information found in discovery be unsealed, and they hit pay dirt: recordings of BT salesmen discussing “raping” customers. CEO Charles Sanford resigned; a former Fed official, Frank Newman, became the new CEO, but he lacked the force of personality and experience to have much impact on the firm. HIs one initiative, to diversify BT’s revenue sources, led directly to its demise: they became aggressively involved in emerging markets lending shortly before the Asian crisis in 1997, and the second leg down, the Russia default in 1998, led them to seek a buyer, which turned out to be Deutsche Bank.

So how do these case histories relate to Bear? They illustrate how little it takes to precipitate a fatal decline. They also demonstrate that Bear is not too big to fail. Bear is not on the list of the Bank of England’s 13 “large integrated financial institutions” that they consider to be particularly integral to the world financial markets. That’s probably as good a proxy as any as to who might be worth trying to save if things got ugly. And Salomon was one of the very top financial players at the time of its scandal, yet the Fed was willing to take it down (only Warren Buffet’s intervention saved the firm).

And one securities thinks it would merely take a serious fall in earnings for Bear to be at risk, not of collapse, but of takeover. From MarketWatch:

Bear Stearns unveiled a $3.2 billion rescue plan for its in-house High-Grade Structured Credit hedge fund after it was hit hard by mortgage-derivatives trades that went awry.

Before that, Bear had only invested $35 million in the fund and another more leveraged vehicle called the High Grade Structured Credit Enhanced Leveraged Fund and it hadn’t lent any money to them.

But now the bank has “meaningful exposure,” to one of the funds, analyst Guy Moszkowski wrote in a note to clients of Merrill Lynch. Bear Stearns is one of the leading players in the mortgage market, so the bank should be able to extract value out of the fund’s assets, given enough time, the analyst said.

However, Moszkowski estimated that if Bear Stearns loses half the amount of its loan, that would knock roughly $7 a share off its net earnings in a year. That’s about half this year’s forecast profit, the analyst noted.

He added that if such losses mount, Bear Stearns could become vulnerable to a takeover.

“If the firm is not able to resolve its position without a meaningful loss, we think the likelihood of a sale rises materially,” Moszkowski wrote in the note. “Bear Stearns would be a very attractive acquisition candidate for a large U.S. or global bank looking to materially improve its U.S. capital markets capability.”

The bank’s stock trades at 1.58 times book value, while most of its competitors trade at more than two times the value of their assets, the analyst noted.

Bear could be acquired for two times book value, or $185 a share, Moszkowski said. On Friday, the shares closed down $2.06, or 1.4%, at $143.75.

Bear has never seemed eager to sell itself, but would benefit from a greater global presence, Moszkowski wrote.

Note that Moszkowski’s intelligence turned out to be incorrect; Fitch reported (hat tip Tanta at Calculated Risk) that the $3.2 billion was a collateralized repo facility, “a product offered in Bear Stearn’s usual commercial activity,” meaning no meaningful increase in exposure to the hedge fund.

But the workout is still in play; the second, bigger fund with the junkier paper’s fate is still unresolved. So Bear may still have to step up to the plate. And even if it manages to close down these funds at minimal cost to itself, these meltdowns have sent chills through the entire CDO market. It’s a given that values of this paper will be cut, which means margins will be reduced. That will put pressure on hedge funds, which is likely to redound to Bear, the biggest lender to hedge funds.

So Moszkowski’s scenario may still come into play, just with a different precipitating set of events.

But that begs the question of who would be so rash as to purchase Bear. Investment bank acquisitions have a terrible track record, and Bear would be a particularly tough deal. It has the most sharp-elbowed culture on the Street, and also the highest payout on revenue production, a toxic mix to any acquirer (bringing pay practices in line with those of the new parent would lead to an exodus of the best talent). And its most attractive business, its number one spot in prime brokerage, appears almost certain to be on the verge of a cyclical, if no a secular, decline.