The world of finance is no stranger to metaphors. For instance, ‘toxic waste’ can describe ‘the lowest rated and potentially least liquid class of securitised sub-prime mortgage debt,’ and ‘sausage factories’ can be ‘the cynic’s definition of investment banks that packaged and sold bundles of pooled mortgage-backed securities,’ as Alan C. Greenberg mentions in ‘The Rise and Fall of Bear Stearns’ (www.landmarkonthenet.com).
The author, who had served as the CEO and chairman of the company, reminisces that as tens of billions of dollars of asset ‘values’ were disappearing, ‘meltdown’ became the analogy of choice to describe the unquantifiable consequences of the global financial crisis. “Like the power loss and surge that triggered the disaster at Chernobyl, the securities markets plunged by the fall of 2008, desperately rebounded, then plunged further – an irrational volatility that resembled hysteria.”
Much of the intensity during the final weeks of the 2008 US presidential campaign could be traced to the erratic behaviour of the markets and a free-floating anxiety about the precariousness of the economy, Greenberg recounts. “The rhetoric from both parties made the election choice seem to be as much about Wall Street versus Main Street as it was McCain versus Obama.” And that was a time when, as he frets, everyone – economists, politicians, the media, Joe the Plumber – had plenty to say, worthwhile or otherwise.
Extinct specie
Looking back at the now-extinct specie of investment banks, Greenberg observes that the classic model of the investment bank – Bear Stearns, Goldman Sachs, Lehman Brothers, Morgan Stanley, Merrill Lynch, and the legions of long-departed competitors – became unviable because no such institution could withstand the sort of run we witnessed.
“There will still be firms doing commission business, there will be boutiques that do merger-and-acquisition and advisory work, but never an institution that does the full line of investment banking services unfettered by the sort of regulatory oversight that exists within the regular banking system. That’s gone; it’s a failed plan.”
Conceding that the interdependent relationships between banks and brokerages and institutional investors strike most laymen as impenetrably complex, the author explains that the simple ingredient lubricating the engine is trust. Without reciprocal trust between the parties to any securities transaction, the money stops, he cautions. “Doubt fills the vacuum, and credit and liquidity are the chief casualties. Bad news, whether it derives from false rumour or verifiable fact, then has an alarming capacity to become contagious and self-perpetuating. No problem is an isolated problem.”
Managing risks
The book opens on a biographical note. “Sixty-one years ago I moved to New York and found work as a clerk at Bear Stearns, an investment firm that had 125 employees. Before I turned forty, I was running the place. At its peak, Bear Stearns employed almost 15,000 people. Along the way, my formal titles included chief executive officer, chairman, and chairman of the executive committee; my principal occupation was and continues to be calculating and managing risks.”
Anyone who invests money and neglects to calculate the risks at hand with a cold eye has no business being in our business, says Greenberg. Clarifying that, contrary to common belief, securities markets are not casinos and the last thing to depend upon is getting lucky, he adds that the best risk managers instinctively anticipate the fullest range of plausible outcomes.
The scene in a risk committee meeting, however, can be tough, when assessing if the proper hedges are in place to manage risk. Sample this, from a description of a high-voltage encounter at a ‘Monday meeting’ of departmental managers. “The priority was to move our inventory, especially our low-grade bonds, which were mostly mortgage-backed. The guys in the mortgage department would report our long positions, which from late 2006 on kept going up. Provided that the shorts also kept going up, our downside was limited – right?”
Apples and oranges
Going by that math, if the company were long $60 billion in mortgages and had $40 billion in short positions, the exposure would be $20 billion. But if it were long apples and short oranges, hedging wasn’t necessarily happening. That, alas, to a painful extent proved to be the case, the author confesses.
Multiple variables contributed to an extremely complex dynamic, yielding consequences not previously faced, he elaborates. “What if we’d gone long on mortgages while shorting stuff that didn’t have the same degree of risk, so when the longs went down, the shorts didn’t. In other words, what if, notwithstanding our best intentions, our exit strategy didn’t really provide an exit?”
In Bear Stearns’ decentralised business model, it was Warren Spector who headed the fixed-income department, and he insisted upon being 100 per cent in control. “He’d been tremendously successful and he didn’t want anyone encroaching on his turf. Interfering in his bailiwick would have been like ‘Mutiny on the Bounty’; I would have found myself in a rowboat,” writes Greenberg.
Not long after, when it proved harder to de-leverage the mortgage-backed holdings without absorbing huge write-downs, Warren’s team tried different sorts of hedges, the author notes. “It became downright frantic. They were covering the debt longs by shorting certain stocks, all the while foraging for new ways to hedge the longs. Those hedges worked for a while – until they didn’t. With so many other institutions in an identical squeeze, new strategies had decidedly brief half-lives.”
Suspended laws of gravity
In good times or bad, money is always looking for a happy home; or, more to the point, a happier home, the author muses philosophically. “Anyone with a dollar to invest wants to receive the highest possible return within his tolerable limits of risk. Depending upon the investor, over time that tolerance might very well fluctuate.”
He sees the history of financial booms and busts as a continuous narrative loop in which the laws of gravity are magically suspended until, like a roller coaster that’s momentarily crested, they vengefully kick back in. What amazes him more than any spectacle of boom-and-bust is our capacity as a species to witness speculative bubbles inflating and bursting – or, to have read about the most notorious case studies, such as tulipomania or the South Sea Bubble – and yet fail to remember the inevitable outcomes.
How do habitually cautious investors lose their bearings and forget what their risk tolerance is? To this question, the author’s answer is ‘greed,’ an innate appetite. “Charles Darwin figured this out. A five-year-old boy (or a grown man) can possess a very large assortment of marbles, many more than he can play with at any one time, and if the opportunity arises to acquire a few more without going to much trouble, he’s definitely interested. Someone earning an enviable 9 per cent steady return is invariably willing to fantasise about 10 per cent…”
Suggested study.
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