BookReview: House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
by William D. Cohan, Anchor, March 10, 2009, B001NLL5WC

William Cohan covers the Bear Sterns collapse in this book. He covers the subject in great detail, and I got bored with the book. I've worked "on the inside" of the finance industry. In my experience finance people suffer from blind arrogance. Often the most simple math slips them by. If you didn't know anything about the industry, this might be a good book for you. It covers the concept of leverage and lending well, which is what undid Wall Street.

[k96] The key to day-to-day survival was the skill with which Wall Street executives managed their firms' ongoing reputation in the marketplace.

[k136] Sedacca referred to as the "ultimate Roach Motel." A vicious cycle of downward pressure on the value of mortgage securities, which had begun at least a year earlier, was reaching a crescendo and affecting the entire asset class, not just the most junior and riskiest mortgages--so-called subprime mortgages--but also the more secure, performing mortgages. The very word "mortgage" was now a synonym for "toxic waste," or, as one wag wrote, "Financial Ebola."

[k223] FOR ANYONE WILLING to listen to Sedacca in early March, the price of the credit default swaps for both Bear Stearns and Lehman Brothers was broadcasting a potentially catastrophic liquidity problem similar to that faced by Thornburg, Peloton, and Carlyle: Both Bear and Lehman had, respectively, approximately $6 billion and $15 billion of unsalable Alt-A mortgages on their balance sheets. Others, such as John Sprow, a bond fund manager at Smith Breeden Associates in Boulder, Colorado, had noticed that the Bear Stearns swaps "were off in a world of their own," and by January were twice the cost of similar protection that could be bought against the debt of Morgan Stanley, and four times that of insuring the debt of Deutsche Bank.

[k234] Sedacca explained how the cost of insuring the obligations of Lehman and Bear Stearns--the credit default swaps--had increased dramatically in a month. Insurance for the Bear Stearns obligations cost more than those for Lehman, meaning the market thought the risk of default for Bear was higher. The insurance premium for the Bear debt, which had been $50,000 per $10 million of debt for the first half of 2007 and then crept up slowly, had spiked up to $350,000 per $10 million of debt by March 5. "In my book, they are insolvent," he concluded. "I feel bad for all my friends that work there, but I did the Drexel Burnham stint and I saw my stock go to zero. Yes, it can happen. Quickly."

[k403] Wall Street operates on trust, and in a world of instant communication that trust can be eroded instantly.

[k457] During that second conversation, the Bear banker reported, the competitor said, "'We got the same call, and they basically said to us, "Don't tell your traders and don't get out of any counterparty agreements that you have. But what's your exposure to Bear Stearns?'" He says, 'What do you think I'm going to do? Of course I told my traders. I bought puts, sold short, and got out of everything I could possibly could get out of.' I was so blown away when the second guy told me about getting a call. This guy [is] just an incredibly well-respected risk manager on the Street, [so] I knew that this wasn't made up. Now the rumors were even there, okay. But imagine you're getting calls. I mean, what fucking institution with any sense in their head calls up and asks what's your exposure to one thing and then says 'Oh, but don't do anything about it'?" The outbreak of these significant rumors led to the huge increase in the purchase of the Bear puts--and also in their price. It also was not surprising that the cost of insuring Bear's obligations skyrocketed on March 10 to around $700,000 to protect against $10 million of debt for five years, an increase of fourteen times over the previous week and yet another sure sign that the vultures were circling with increased velocity.

[k739] Still, on the edition of Mad Money following the market's 417-point rally on March 11, host Jim Cramer responded to a viewer who asked, "Should I be worried about Bear Stearns in terms of liquidity and get my money out of there?" with a patented Cramer tirade: "No! No! No! Bear Stearns is fine. Do not take your money out! If there is one takeaway other than the plus 400, Bear Stearns is not in trouble! If anything, it is more likely to be taken over. Don't move your money from Bear. That's just being silly! Don't be silly!"

[k771] "So I don't know where the rumors started," Schwartz continued after the news flash. "Maybe I can just say this: I think that part of the problem is that when speculation starts in a market with a lot of emotion in it and people are concerned about the volatility, then people will sell first and ask questions later, and that creates its own momentum. We put out a statement--I did--that our liquidity and balance sheet are strong, and maybe I should expand on that a little." Schwartz's comments bring to mind the truism first penned by the financial writer Walter Bagehot, a former editor of the Economist, in 1873: "Every banker knows that if he has to prove that he is worthy of credit, however good may be his arguments, in fact his credit is gone."

[k1127] Around six on Thursday night the senior Bear Stearns executives gathered in Sam Molinaro's sixth-floor office. In attendance were, among others, Schwartz, Molinaro, Friedman, Begleiter, Upton, and John Stacconi, the treasurer of the securities company. "We go through the cash position, and there's a lot of questions as to how accurate is it," Friedman explained. "It's hand-scribbled on a piece of legal pad. The firm was not really set up--most firms are not--to do real-time cash accounting. You come in in the morning and you reconcile your bank accounts and you see where you stand, and try to put this all together. To try to do it on the fly in the evening was like scribbles. But the bottom line is $2.5 billion of cash.

[k1334] The SEC, not the Fed, regulated investment banks. As a result, investment banks could not borrow from the Fed's discount window and were permitted much higher levels of leverage on their balance sheets. For instance, the ratio of assets to equity capital in investment banks--one measure of leverage--often approached 50:1 during the middle of a quarter. (Before the ratio was published at the end of each quarter, investment banks would take the necessary steps to sell enough of the assets to get the leverage down to a more "acceptable" 35:1 ratio.) Commercial banks, by contrast, had leverage ratios of around 10:1.

[k1642] "The problem that Bear Stearns and other financials face is a great unwind of leverage," she wrote. "A company is only as solvent as the perception of its solvency. When a company that is leveraged over 30-to-1"--and here she was being kind, since Bear's leverage was often as high as 50:1 during a given quarter--"faces a crisis of liquidity and confidence of creditworthiness, that company will be unable to leverage its collateral and its leverage will be forced down to 1-to-l. [Bear Stearns's] equity could become worthless as forced sales create asset deflation, which could cause cannibalization of remaining capital. We are in a tenuous market environment and experiencing a true crisis of confidence. The Fed's action in providing JPMorgan access to funding essentially buys time for Bear's counter-parties to unwind their position and deliver. The great unwind of leverage that will occur will further depress the stock prices of financials."

[k1665] In an interview with Bloomberg, Standard & Poor analyst Diane Hinton, a ten-year veteran, said, "In a normal market environment, we would not see this kind of movement, but we are not in a normal environment. One rumor gets started and people get more nervous than they already are and it becomes a feeding frenzy."

Via Rob 12/19/2010