Russ Roberts

Cohan on the Life and Death of Bear Stearns

EconTalk Episode with William Cohan
Hosted by Russ Roberts
Buchheit on Google, Friendfeed... Gary Stern on Too Big to Fail...

William Cohan, author of House of Cards: A Tale of Hubris and Wretched Excess on Wall Steet, talks with EconTalk host Russ Roberts about the life and death of Bear Stearns. The discussion starts with how Bear Stearns and other Wall Street firms made money and how they financed their operations. The conversation then turns to the collapse of Bear Stearns's hedge funds in the summer of 2007 and how that collapse and the firm's investments in subprime mortgages led to the death of the firm in March of 2008. Cohan explains the role of borrowed money in the financial crisis and Bear Stearns in particular. The conversation concludes with the incentives facing Wall Street executives and the price they paid or didn't pay for the gambles they made with other people's money.

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Podcast Highlights
0:36Intro. [Recording date: September 22, 2009.] One year anniversary of end of Lehman Brothers, which many view as the beginning of the crisis, but it began March 17 when Bear Stearns was forced into a marriage with J.P. Morgan Chase, with the Fed and Treasury as matchmaker. Basics: Bear Stearns complicated creature. What does an investment bank like that do? How does it make its money and where does it get its funding from? Investment banks are in a surprising number of businesses, like most complicated, big companies. Asset management business--managing people's wealth; small brokerage business; investment banking business, meaning they raised capital for corporate clients, debt or equity capital; provided advice on mergers and acquisitions (M&A). Had very large business called fixed income sales and trading business, trade, underwrite, and sell securities, debt securities, among them being mortgage-backed securities--aggregation of people's home mortgages. Wall Street innovation in the middle 1980s that in the past decade became huge and profitable. Hedge funds. Added up to a 14,000 person firm, fifth largest on Wall Street. Mysterious: market clearing; role as intermediary for other firms. Opacity, complicated world, a lot of argot, language; disclosure minimal; can't figure out how they make money; not like selling soap and toothpaste. Other Wall Street firms enmeshed in long term trades on their books, firms on a global basis, interconnected. At the end, Bear Stearns was very short-term oriented in their financing of themselves--the very nature of banking in general. Banks borrow short, depositors' money which costs nothing to accumulate; risk for the bank is that when you want it, you can go to the ATM machine and get it. They count on the fact that not everybody does that at once. Occasionally everybody does want their money at once. In effect that's what happened to Bear Stearns, except at an institutional level, borrow short and lend long. They are not a commercial bank, so they borrow in the commercial paper market; but in the end because of their own credit problems, couldn't do that; so they borrowed in the secured lending market. Needed to borrow about $75 billion a night from firms like Federated Investments, Fidelity Investments, etc.--about 25 firms. In the end they said they weren't going to make those loans to Bear Stearns any more. Securing those overnight loans with the mortgage backed securities they were manufacturing and in the business of trying to sell, but by March of 2008, they could no longer sell those securities and had to keep them as inventory on its own balance sheet; and then in turn use those assets to secure the overnight lending it needed. Cycle fell apart.
9:00The securitized market is repurchase, also called the repo market; talked about that in podcast with Arnold Kling. Role for mortgage backed securities. Bear Stearns very vertically integrated; had a mortgage company that they owned, called EMC, making subprime loans to homeowners directly. Had their own online lending operation, called Bear Direct. How big at its peak? In the business of lending to high risk homeowners; holding on their own books, bundling and selling to others; slicing up into collateralized debt obligations (CDOs); funding their day-to-day flow of cash by repurchase--selling these securities to other investment banks with the promise that they will buy them back the next day or week or month. Technically not a loan, but it really is a loan. Complex, profitable but suddenly-not-profitable assets being used in all those ways. Not like an auto manufacturer. Mortgage-backed securities, 1980, Salomon Brothers; good idea, everybody rushes to copy. Bear Stearns very good at making money from mortgage-backed securities. Worried they wouldn't get enough supply of these mortgages, so vertically integrated with mortgage company and online mortgage company. Around the end of 2006, start of 2007, value of these securities began to fall, probably because the people who had borrowed to buy those homes were not in a position to borrow that money and probably shouldn't have. Political mandates in the 1990s; people who borrowed ended up unable to pay, so mortgages started to default, so mortgage backed securities based on those mortgages started to lose value. Bear Stearns viewed that as a buying opportunity--fatal mistake.
15:10Extraordinary story. Cultural norms interesting, but put those to the side. Move to the summer of 2007. Default rate starts to climb on those mortgages and market starts to realize these assets may not be worth as much as they thought, but not sure of size of reduction; don't know what default rate will be and also these instruments are complex, held in different pieces. Ratings agencies rated them as Triple-A, tranching system; anticipated some defaults but the top of the package, senior tranches, were insulated from the defaults. Default rates started moving up; rating agencies knew but surprised. False comfort that everyone was taking from the high degree of structuring. Read one of these documents--incomprehensible language, but false sense of security that you get from tranching. Conflict of interest; but it wasn't a secret that there was a conflict of interest. Some made up of second mortgages of people who didn't have the best credit rating to begin with; the senior tranch of that was rated AAA. Titanic analogy: ship that couldn't sink because if leak, damage would be limited to one area. No way that everybody will default; regional things could go wrong.
20:00Summer of 2007, first warning sign that Bear Stearns was in trouble came about when their two hedge funds were in trouble. Relationship between parent company and the hedge funds. Assumed these hedge funds were an integral part of Bear Stearns, but they actually weren't. Their total commitment to these billion-dollar funds was only $20 million, later went up to a $45 million stake; so the hedge funds' failure would seem to not have any impact on Bear Stearns because their stake so small. What happened? Decision by top management of Bear Stearns--called Bear Stearns Hedge Funds. Everybody wanted to invest in hedge funds, free money. People inside the firm wanted to be hedge fund managers and didn't want to lose them even though they had no experience. Also, had a lot of clients, investors who wanted to be invested in hedge funds. As hedge funds started to fall apart in June of 2007, liquidated in July 2007--investors and clients expected Bear Stearns to bail out the investors. Goldman Sachs bailed out some of their investors a few months earlier; Bear Stearns decided not to do that; investors lost $1.6 billion; but they bailed out the repo market. The hedge funds were in the repo market as well, using the hedge funds as collateral. In July 2007, management committee with Jimmy Cain dissenting--correct thought process--decided to become the overnight lender to the hedge funds because all the other lenders weren't lending. So, Bear Stearns the parent paid those lenders their money by and large and became the overnight financer to the hedge fund. That meant they were holding as collateral the crummy, toxic stuff which the hedge fund had bought. When liquidated at end of July, Bear Stearns ended up getting more of this on their balance sheets than they already had. In the fall of 2007, first loss in 84-year history, writing down the collateral they had just taken onto their balance sheet. Parent company initially only tangentially involved in the hedge funds. Take in money from clients; see opportunities every once in a while and borrow money to make trades they otherwise they couldn't make. The lenders are standard great names on Wall Street--Goldman, Chase, etc., same people everyone else is borrowing from. The hedge funds become defunct--the assets they are holding are worth only $.50 or $.30 on the dollar, so there is a meeting where all the lenders learn they are not going to get their money back from Bear Stearns. They lent believing the collateral was good, but it turns out it's not good; Jimmy Cain's answer: You paid your money, you took your chances. Poignant moment--this is a replay of 9 years before when Long Term Capital Management (LTCM), a similarly highly leveraged hedge fund--basically said it couldn't keep its promises, and Fed orchestrated a bailout of LTCM in which all these companies participated except Bear Stearns. Now Bear Stearns is trying to do the exact same thing; irony is it's their firm! Cain is the one who said we can't do this; you're big boys; we've supported this as much as we are going to, with $45 million on the line. But at that point the executive management team voted Jimmy Cain down and parent company became the overnight lender to the hedge funds, paying out all the other lenders, who got most of their money back.
30:54Bear Stearns lives for another nine months. During those 9 months, they are holding a lot of these mortgage-backed securities, essentially guaranteeing the holdings of their hedge fund, compensating the lenders; doing all that with their own borrowed money. Continued to be active in overnight short-term borrowing. House of cards, borrowing from Peter to pay Paul. Family with terminal illness. If Bear Stearns didn't know they were in trouble in the spring of 2007, they could no longer--short term borrowing less expensive than long term borrowing; but market would no longer provide them with longer term short term lending. Market didn't like their credit any more. Hadn't been a firm out of business since Drexel; firms got bigger and bigger, more entwined with other firms; now many too big to fail. The market was saying they thought they'd be there tomorrow but maybe not a month from now. Market buying puts, short term bets against a company's stock; turned out they were right. Did you ask them what they might have done differently? Chance other firms wouldn't play ball with them; but once that decision made, what might Bear Stearns have done differently? Afterword for the paperback version of the book, explored this with Alan Schwartz: basic conclusion maybe could have bought other business, but no choice but to have sold, and they didn't do that. Whole business plan of the firm had been heavily dependent on the fixed income group and the manufacture of these debt securities, which made tremendous money for a long time; at one time Jimmy Cain worth more than a billion dollars--didn't want to change their business plan. By the time they realized they had infected themselves, it was too late.
38:39Day to day basis: underlying cause of the crisis. The leverage, the amount of borrowing, one cause. How long had that got on. At the end Bear Stearns is leveraged from 30: to 50:1--that is, $97 out of $100 borrowed. People playing with other people's money; but why did other people finance those bets? Obvious thought in the short run if you are leveraged that way is to retrench, raise capital, lower the amount you have to borrow. Bear Stearns didn't do that; neither did Lehman Brothers, in the aftermath. Bear Stearns said they did, claimed their capital cushion was healthy, but it wasn't true. SEC guidelines. The leverage started getting out of control in June 2004 when SEC passed new guidelines for leverage on Wall Street, which Wall Street had been lobbying for since the 1999 repeal of the Glass-Steagal Act; they felt that commercial banks were now able to compete directly with them, and that was now the law. Banks regulated by the Fed could only have 10-12 times leverage; investment banks not regulated by the Fed but by the SEC lobbied for that change and got the SEC to agree to it. Quid pro quo: SEC was supposed to do a lot more monitoring, but unfortunately forgot to do that till it was too late. August of 2007. Executive committee of Bear Stearns compensation mechanism flawed: minimize the amount of capital they had in the firm because paid based on return on equity. Fatal flaw.
43:31Incentives. From the outside looks like Bear Stearns didn't want to kill itself, so why would they leverage themselves so much? When that leveraged, a small change in the value of your assets means you are insolvent--the value of your collateral is no longer enough to cover the value of your loan. That's what happened to the firms that didn't make it. Standard argument is they didn't want that to happen. Why wouldn't they take enough care? View: Those incentives weren't there because they were counting on being bailed out, and along the way they made an enormous amount of money and didn't pay much of a price. When it came to Bear Stearns, they didn't think about whether or not they would be bailed out. Not conceivable to them that anything like what happened could happen. Didn't think about it, which is fascinating in itself. Executive committee level didn't understand how risky their business plan was, let alone that the lenders would say they wouldn't do business with them anymore. The lenders were aware that it was their money on the line, but they kept lending; creditors protected and ended up getting most of their money back. Seems like bad incentive. Firms started going public; Bear Stearns in 1985. What had been the individual partners' money on the line became other people's money on the line. Cain with a billion dollars in equity in Bear Stearns, but over the years had taken much of it out and tucked it away, so he was essentially playing with the house's money. Said he was left with a "mere six hundred million." Working ordinary job for $35,000 a year; moved to New York to become a professional bridge player; now had everything he wanted. Cain not along. Rebonato podcast, Bank of Scotland bankrupt; claimed the executives lost a lot of money; but they didn't pay much of the cost. Paper gains; Cain agreed not to sell the stock and had to settle for hundreds of millions of dollars. Flaw on all of Wall Street. Equity participation; but what people aren't focusing on is that even if 50% of their compensation is in the stock, the other 50% is in cash; and that cash portion alone is many multiples of what most people would expect to make in a lifetime. Warren Spector, who buy political machinations of Cain forced to sell a good chunk of the stock; turned out to be a good deal. Incentives: if anything the stock is the cover rather than the stick or the carrot. Once upon a time they were in it with us; private partnerships, their net worth was on the line. Lazard, private partnership from 1848 until 2005, no capital to be in M&A. Any money you made, you made from your own intellectual capital. Wall Street used to be like Lazard till started going public, risky bets to max out the bonus.
55:02Really playing with each other's money; our money came into it as taxpayers. Damaging to democracy and capitalism. Other mistake: focusing on the firms whose bets didn't turn out. Merrill Lynch and Bear Stearns didn't plan on going out of business. Other firms rolled the dice and didn't go out of business. Goldman Sachs and J.P. Morgan Chase, did a lot of the same things. Goldman went longer-term, pulled back from the mortgage securities which turned out to be the result of that firm-wide decision in 2006. Should have been a signal to the market that some smart guys had changed their mind about it. Rest of Wall Street instead doubled down; for a while did better than Goldman. Goldman went longer term with financing; didn't want to give lenders a vote every night on whether to keep doing business with them. Big differences. Wall Street is not monolithic--it's a bunch of people making decisions based on the incentives they have, and that can lead to bad decisions. Wasn't the first time, but the tenth time in this situation on Wall Street. No reform of the system. What other episodes? September of 1987, crash, market went down 22% in one day, grown men crying they would never let it happen again--happened because of bubble from lending in high yield junk bonds. Another bubble that formed was Internet IPOs in the late 1990s. Bubble in emerging telecom debt; in East Asia; in Mexico. Deadly combination of financial innovation on Wall Street and the compensation system on Wall Street and the fact that they are using other people's money by being public companies has created this cycle of boom and bust. We haven't changed a thing about that. Traumatic experience.
1:00:30Interviewed colorful and extraordinary people. What's happened to those folks? Bear Stearns died; what happened to those folks? Their net worth has taken a hit, but not as much as you'd expect. Jimmy Cain officially retired, still playing a lot of bridge at the national level--net worth took a hit. Most other executives had been selling stock right along. Jimmy Cain had been also, but others selling much more. Warren Spector, fired August 2007, probably worth 3 or 4 hundred million dollars; Alan Schwartz, CEO at the end, probably about the same, maybe less, now senior executive at Guggenheim Partners, trying to recreate a mini-Bear Stearns. Ace Greenberg still at Morgan Chase; probably most aggressive seller of stock all along; supposedly writing a book about all this. Sam Molinaro has not found new work. Death order matters: order of the businesses failing; shareholders at Bear Stearns didn't lose as much as those at Lehman Brothers, who lost everything; creditors of Bear Stearns got bailed out at 100 cents on the dollar, versus the Lehman creditors who got 10 cents on the dollar. Many at Bear Stearns have gotten new jobs; not making as much as they were before and perhaps depressed, but they've moved on.

COMMENTS (23 to date)
Chris Funk writes:

Your comments regarding the incentives at play for senior executives are telling, and my friends and I have echoed them many times in our informal discussions.

Specifically, we have to consider the unbalancing effect of extraordinary compensation. When the compensation one receives for a handful of years of service as a CEO effectively sets one for life financially, it can sever the mutual-interest relationship between the employee and the employer, or between the owner/principal and the owned firm.

Of course, for psychological, self-esteem, and ego-related reasons, no CEO would want their firm to go bankrupt. However, what motivates the CEO whose financial life is secure? Is it simply the regard of one's peers? Or perhaps for a select few the desire to provide good jobs to as many people as possible?

In any event, extraordinary compensation creates a situation in which there are not sufficient incentives to be risk-averse, but rather substantial incentives to be risk-seeking.

Fundamentally, we misunderstand the ultimate nature of our competitive enterprise. The competitive enterprise isn't solely about self-service. We must all be stewards of the process to ensure its integrity and long-term sustainability. Burning down others' houses to build our own is expedient in the short term, but destructive to the process of building a viable community in the long term.

Thanks again for your insightful broadcasts.

Nethy writes:

Dr Roberts,

Thanks for having another go at this subject.

I listened to 0:05-00:12 several times. I still don't understand why Bear Sterns needed to be financed every day. Did they need financing in order to buy more mortgages to package (securatize?) and resell? If so, why couldn't they just stop producing these products once the cost of financing became too high, when they were forced to go to the secured debt market? If not, where did this financing need come from? I feel like I've missed something.

Gmar Hatima Tova

Bruce writes:

There is a famous bridge player named Jimmy *Cayne*. A quick google shows that the former CEO of Bear Stearns is the same guy.

Mikeikon writes:

So, would it be reasonable to conclude that limited liability is at the root of this issue?

It doesn't seem right to me that two people can get together and write a contract that absolves both parties from liability.

They could contract to divide the liability equally, or instead put it all on a single owner, but the ability to eliminate liability entirely seems distinctly counter to libertarian natural law.

I'd like to hear some more discussion about this.

Nethy writes:

Chris Funk,

Russ mentioned that he has further discussion of the role incentives/compensation plays in this market. I find these questions fascinating. Personally, I am worried about how executive pay has entered the public discourse. I'm not at all sure I want these decisions made at a political level.

Some people see incentives as a predictable process where individuals will optimise their compensation over time in a pretty predictable way. You need to make sure that they are not optimising for something which is not exactly in line with the interests of shareholders (eg a return on equity equation encouraging leveraging as discussed in this podcast). You then have to watch out for issues like already rich executives being insensitive to incentives (a $1/2b cushion is not too bad), but otherwise incentives work.

I think it's foolish to think of compensation as simply a quantitative measure. I am confident that incentives work and extremely confident that in market like conditions they work a sort of magic. But when you break it down to individual levels, incentives work in a complex way. There are many flavours of incentives and flavours of (predictable) reaction to incentives. There is a tendency (I think) to pretty much rely on arguments from first principles, and/or extrapolate widely from experiments relating to strengthening our confidence in first (or at least low level) principles. I would be more comfortable if we were relying on science based high level principles.

A TED talk by Dan Pink fascinated me. The talk discusses experiments where individuals perform clearly defined tasks better when financially incentivised and worse on tasks requiring creative or lateral thinking. It would be interesting to experiment with the effect of financial incentives on risk taking behaviour. I wouldn't be surprised if I was surprised. I think there is a quite a body of science pointing to different types of incentive (positive, negative, financial, social, esteem, etc.) producing widely different results depending on the specific application. IE one encourages risk minimisation, encourages productivity in clearly defined tasks, encourages creativity, etc.)

(video plays by default):

Warren Buffet seems to consider financially secure (very rich) managers (mostly CEOs of Berkshire Hathoway owned companies) an advantage. He constantly describes them as having the job they want for the rest of their life and he implies that he wants managers with a deep emotional connection to their business, the family business or the business they spent their life growing. He seems to detest private equity firms above all other structures precisely because they run the companies with no emotional connection to the idea. I thought many of his letters were very relevant to this podcast.

From Warren Buffet's 2008 letter to shareholders - Why derivatives are a problem

Indeed, recent events demonstrate that certain big-name CEOs (or former CEOs) at major financial institutions were simply incapable of managing a business with a huge, complex book of derivatives. Include Charlie and me in this hapless group: When Berkshire purchased General Re in 1998, we knew we could not get our minds around its book of 23,218 derivatives contracts, made with 884 counterparties (many of which we had never heard of). So we decided to close up shop. Though we were under no pressure and were operating in benign markets as we exited, it took us five years and more than $400 million in losses to largely complete the task. Upon leaving, our feelings about the business mirrored a line in a country song: “I liked you better before I got to know you so well.”

Improved “transparency” – a favorite remedy of politicians, commentators and financial regulators for averting future train wrecks – won’t cure the problems that derivatives pose. I know of no reporting mechanism that would come close to describing and measuring the risks in a huge and complex portfolio of derivatives. Auditors can’t audit these contracts, and regulators can’t regulate them. When I read the pages of “disclosure” in 10-Ks of companies that are entangled with these instruments, all I end up knowing is that I don’t know what is going on in their portfolios (and then I reach for some aspirin).

Perhaps the derivatives themselves are ok, the problem being that transparency is meaningless when a firm is involved with them.

Dr. Duru writes:

I am hoping you do a "part two" on this discussion. This podcast was focused on a lot of review of historical events, many of which we followed into the news.

I would be more interested now in hearing you fit these events into your theoretical framework of how these financial markets should be structured. For example, if there were no government regulation at all of these markets and no pro-housing government policies, etc..., would the incentive structures and potential financial rewards at these firms be any different? Would we still be where we are?

I hear disagreement about whether or not these I-banks counted on being bailed out by the government as cover for doing risky behavior. But here, Cohan actually seems to suggest that even access to public equity markets and debt markets ("other people's money") causes perverse incentives as well. How do we reconcile these things?

Another example, the I-banks had to lobby the SEC to be able to exercise the amount of leverage that they did. But I am surprised to hear you implicitly support regulation that would limit access to leverage. (I could be wrong on this!). Finally, the repeal of Glass-Steagall...shouldn't we have considered the elimination of this regulation a good thing under your theoretical framework?

Again, I would be VERY interested in getting the economic theory "part two" version of this podcast to clarify in my own mind what economic lessons you propose we get from all this.

NormD writes:

I consider myself an ardent believer in free markets. That said, what happened in these banks makes me extremely angry. Although it does not seem practical, I would love to see the entire management teams and boards of these large institutions forced to give up all gains made while "managing" their firms, somewhat like asset forfeiture in criminal law. I doubt that I am alone.

There is something problematic with the banking sector. At a high level, it's simple. Some people/organizations work hard/smart and earn excess money that they would like to store for the future and hopefully earn interest on. The earners want to transfer this excess money to people who will use it to produce value and out of this value, repay the loan with interest. The first problem is what happens if there is more money seeking to be lent that money being sought for loans. NPR's Planet Money quotes the IMF as saying the pool of money seeking to be lent is $83 trillion dollars. I doubt that there are enough borrowers to absorb this amount. So what does this imbalance mean? At a minimum I would guess is that money that cannot be parked in a loan should cease to exist. Fundamentally no one exists who is willing to pay that money back. The second problem is that "bankers" (I use the term very broadly) create all kinds of financial instruments, some extremely strange and complex, whose sole reason for existing seems to be to hold money with no backing real loans in such a way that people believe that the money still exists. The middlemen that create these instruments can extract huge fees for their shell game. The whole thing smells like a Ponzi Scheme.

Russ Roberts writes:

Dr. Duru (and others),

The next EconTalk is with Gary Stern on the topic of too big to fail. It's kind of a part II and it deals with some of the issues raised in some of the other comments.

Adam writes:

All the talk about the incentives faced by managers of publicly traded corporations reminds me of Manne's seminal piece, "Mergers and the Market for Corporate Control".

Ever since mergers and hostile takeovers became heavily regulated (and therefore very difficult to actually accomplish), there has been a lot less competition at the managerial level.

Ward writes:

There is a sort of a supressed premise in this discussion that by going public and eliminating the partnership format the banks became reckless. Can we find NO examples in the history of Wall Street prior to DLJ's offering of stock when reckless behavior occured and threatened the system?

My favorite nugget of Wall St history is the story of Jay Cooke whose firm financed the USArmy in the Civil War. Cooke was informed on Sunday night that the Northern Pacific Railroad was in default and he knew at that moment that his firm would not be able to buy back the bonds they'd underwritten in that failed venture and would therefore close its doors and fail. He did NOT MENTION THIS FACT to his dinner guest that night President Ulysses Grant. The Panic of 1873 ensued.

I hate government intervention but I fear its a fact of life. Are booms and busts as well?

emerich writes:

The rock-bottom line is that too-big-to fail has got to go. I've observed, and worked for, too many dysfunctional companies to believe that incentives inherent to the market will guide most managers to make consistently good decisions. There's plenty of scope for stupidity--in the short run. But companies that consistently make bad decisions eventually eliminate themselves, but only if the institutional framework (a fancy term for politics) permits it. In my opinion, that's the great strength of capitalism--habitual dumbness doesn't survive unless propped up. Over the past 25 years we've seen the crash of 87, the junk-bond/Drexel collapse, Barings, LTCM, dot-com, and the housing/mortgage product bubble. The excesses were and are self-correcting, but are often made much worse by exogenous rules, i.e., laws, regulations, and politics. In the latest fiasco, some major culprits were capital regs that encouraged securitization, government coercion to relax or eliminate prudential mortgage lending rules, and loose monetary policy.

Kevin writes:

Russ I won't get a chance to listen for a few days... do you ask him what's up with accusing you of disguising political rhetoric as economic analysis? If so, how does he explain that?

Josh writes:

Dr Roberts,

I really enjoyed the show specifically the topic. I did have one question though.

What role did the FASB decision to change the mark to model and mark to market account rules play in the fall of these giants? And, will it come back?

I have heard "The problem wasn't losing the money. The problem was having to write down the losses."

TheInterest writes:

Let's not forget the naked shorting affect on the take down of Bear Stearns. See more here. And checkout for more Wall Street hi-jinks.

Russ Roberts writes:


I am not convinced that writing down the losses had much to do with it. To me that's like blaming the thermometer for the temperature.


I think that just accelerated the process.

Jim writes:

I'm late with my comments here, but I've got a few.

A quick one, early on Cohan says that Bear needed to go to the -capital- market for daily financing. What he meant to say, or should have said is that Bear had to go to the -money- market. This is not just an odd bit of jargon, there are significant differences between the money market and the capital market that go beyond simply the differences in maturity.

In the discussion of the repo market, what does everyone have against the law? A repo is meant to be especially safe for the lender, because legally it isn't a loan, it's a purchase and a forward sale. If you don't come and buy the security back, I can sell it in the open market immediately to get my money back. If I'm not made whole, I litigate. This is not new stuff, and frankly Jimmy Cayne was right.

Another important topic that isn't touched on (in the podcast -- I haven't read the book) is that systemic risk and 'too big to fail' are not synonymous. One of the duties of the Federal Reserve System is maintenance of the payments system. The Fed exhibited legitimate fear for the soundness of the payment system, because no one really knew the size of the risk of Bear failing as a counterparty in billions of dollars of credit default swaps, and what that might do to the payment system. To make it clear, assume Bank A owes Bear $1 million, Bear owes Bank B $1 million, and Bank B owes Bank A $1 million dollars. These debts should net to zero for each of the banks, but once Bears enters bankruptcy, it could push Bank B into bankruptcy, who would then push bank A into bankruptcy. A disorderly Bear bankruptcy could have wrecked havoc with the larger banking system because there was no mechanism in place to net these contracts. By the time of the Lehman bankruptcy, these were better understood, and most of the Wall Street trading desks were trading that Sunday afternoon, at the behest of the Fed, trying to net as much Lehman exposure as possible.

Later, in the the podcast, the myth of Goldman grows in the remembering. It's true that they went short the MBS/ABS market earlier than most (although they may have been less candid with their customers). But when the liquidity crisis was at its height, they suffered as greatly as any, and looking at historical credit default swap spreads Goldman was in as precarious shape as everyone else. They may have been smarter than everyone else, but they were still an investment bank, leverage was their lifeblood, and liquidity their oxygen. Were it not for a timely investment from Warren Buffet, and the bailout, or rather honoring the derivative contracts, of AIG they likely could be out of business. (It is funny how Warren Buffet doesn't like derivatives -- until he does.)

Finally, can we lay off the populist rhetoric, and try to examine the breakdowns from, oh I don't know, an economic perspective? Why the marketplace for bank CEO's is inefficient? You've not shown that these men are guilty of anything other than preferring more to less, which is not that uncommon. You seem to think that above half a billion, the utility curve should not just flatten out but start dropping.

Anyway -- loved the podcast, sorry for the ramble, and I'll try to be more timely in my comments.

Russ Roberts writes:


On your point on the repo market, not sure I understand your point about litgating. Please elaborate. I thought if the assets depreciate, too bad. That's why you make money in the meanwhile. What role does litigation play? Bear faced litigation because they may have misrepresented what was in the assets when using client funds in the hedge funds.

I think of there being a difference between too big to fail and too connected to fail. It seems it is really almost always the latter and that's your point about systemic risk. But if we allow firms to interconnect without fear of failure, we are going to transfer even more money to Wall St the next time. See this week's podcast with Gary Stern.

On Goldman I agree with you completely. They were playing the same game. They played it a bit more conservatively, maybe, but only a bit and AIG's rescue rescued them.

On the populist rhetoric, I agree with your basic point. But i have no respect for them. They exploited a system that was rigged in their favor--again see this week's podcast with Gary Stern. That is human and legal. But I don't respect it. I have no problem with people making huge amoutns of money. And I usually respect people who make huge amounts of money. The CEOs and their fellow managers were taking risks with my (taxpayer) money. I understand their incentives, or at least some of them, and I'm not surprised how they responded. But it's an ugly game. How much of the rigging is just good luck vs. lobbying is another question.

George writes:

It seems you both have an issue with the amount of money investment bankers made. Isn't this just the flip side of the "Walmart workers don't earn enough" complaint? Why do you -- or does anyone -- know better that the market about how much value to allocate to these investment banking activities?

Jim writes:

I am not a lawyer, but I was under the impression that after liquidating the collateral, a repo lender who was not made whole could potentially sue to try to get whole, though that might be a fruitless exercise.

My opinion is that Jimmy Cayne was right to let the lenders take it on the chin. I'm sure that the lending documentation made it clear to these lenders that the legal counterparty was not Bear Stearns. Presumably there was a reason for that. These were adults who were well compensated (on both sides of the table) and should be experts in this field. It's outrageous to me that after the fact they should claim that they were misled.

Russ Roberts writes:


There are two issues on the last point you make. You are right. Cayne could have done nothing. The puzzle is why he did what he did.

On the legal problems, according to Cohan's book, when subprime started tanking, the head of the hedge funds, Cioffi, told investors that this was great because the fund only had 6% of their funds in subprime stuff and that there would be great buying opportunities. In fact, the funds had 60% of their assets in subprime. If that is true, then that is fraud and Mr. Cioffi, I suspect, will soon be in jail.

Russ Roberts writes:


You make an excellent point about the market knowing better than I do what to pay people. And if you have been listening to EconTalk for a while, then you'll know how much I agree with you. The problem is that Wall Street doesn't appear to be much of a market. Listen to this week's podcast with Gary Stern. If he's right, and I think he is, then Wall Street is playing with my money, taxpayer money, rather than the money of the participants in the market. Let's take the crony out of crony capitalism.

Chris Funk writes:


I think you've articulated the fears of many interested -- but under-eductated -- observers like myself: that Wall Street isn't much of a market.

Not having any formal economic training, I am more susceptible to the 'populist' arguments sneered at by so many economists, for one simple reason: I am finding it harder to believe that the market is operating as theoretically intended. Forces other than the market appear to influence the allocation of value for services and products.

The question on my mind is this: Is the system producing valid (i.e. optimally efficient) outcomes?

Of course, I have a healthy appreciation for how human bias affects our answer to that question. When our efforts have been rewarded, we are inclined to answer in the affirmative. When our efforts have been spurned, we are inclined to answer in the negative.

Chris Funk writes:

To put my thought more succinctly:

Those who are most capable of criticizing the market's systemic validity have the least incentive to do so.

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