It is ironic that after so much bad news about corporate America several years ago, we continue to see trouble with corporations in that country.
Cobie LeGrange from Acsis, says that the last time round far more regulatory bodies were created aimed at making corporate America a safer place for investors, with accounting and its regulation top of the agenda.
As far as the accountants are concerned, they may be safe this time round, but maybe the people who make their money explaining risk, have their heads on the collective block, this time round.
I enjoy looking at financial fiascos, not because of the misery they create, but rather because I want to understand more about what created them in the first place.
It therefore goes without saying that the recent near demise of Bear Stearns has been a topic of interest. The investment bank was founded in 1923, and having made it through the great depression and numerous market crashes over the years, it seems sad that they have fallen pry to something as easy to understand as subprime mortgages and their effect either direct or indirect. Why is it that no one in the company could at least see what the risk was that they were assuming?
The business’s annual report for 2006 is publicly available (2007 is not, although one can obtain the SEC filings detailing some anaemic earnings numbers), and it contains numerous caption lines which they feel encapsulates the way in which they do business.
The front cover makes mention of “eighty three years of profitability” and “twenty years as a public company”, thus enthusing the support that they so visibly lack today.
There seems to be a good rule of thumb when it comes to investing: “If you don’t understand it, don’t invest in it” and maybe I should add to that “… and don’t be shy to say so, it doesn’t show a lack of intellect, it shows discretion”
By reading the 2006 Bear Stearns annual report, there is no doubt that the mortgage market is very important to them, and that they made lots of money operating in this field. To put a number to this, net revenues in the fixed income division were $4.19 billion in 2006, increasing their capital markets division net revenue to $7.32 billion.
This was by far their most impressive division in the company, a real money spinner.
But to understand how these transactions were executed and packaged, and what this ultimately meant for the inherent risk in the business, is another matter altogether.
There seems to be a maze of relinquished transactions, normal transactions and special purpose entities created to house mortgage backed securities. And although all of this seems to be above board according to the accountants and credit rating agencies, there lurked trouble in Bear Stearns which is only unravelling now.
A little deeper into the annual report there is a section which deals with financial instruments. Under “financial instruments owned”, Bear Stearns make mention of some $125 billion of instruments. These instruments would aid the business in funding, collateral and margin type activity on deals that they were involved in.
Of these is $7 billion worth of US government and agency debt. It might be low down on the risk barometer, but at least one knows it will pay the bills when called upon.
By casting one’s eye a little further down one realises that the business also committed $43 billion to “mortgages and mortgage and asset backed instruments”. That is a huge chunk of money to commit to one specific debt class, and although the yield in these must have been in excess to government debt, surely this is a risk to one’s business?
Of course an investment bank should make money and take on the risk to do so, but at what stage does the risk that they assume become a larger indictment on the financial system? The composition of instruments which they owned was put together by someone with more of an appetite for returns than for risk management.
So although shareholders benefited from this approach in previous years, 2007 was a time when they wished they had paid more attention to risk management. It is as if a horde of factors, which in previous years played in their favour, all of a sudden turned against them.
At listing, Bear Stearns traded for $4.45, and since then had seen the share price grow to beyond $150. So when the subprime mortgage fall-out started in the US, the company was punished with the rest of their brethren, and some investors took this as a chance to partake in bargain hunting.
The much respected Bill Miller from the Leg Mason value trust was one such a manager.
He beat the market in the US for 15 years until 2006, thus demonstrating skill which others lack in his field. Another manager who got in much deeper than Bill Miller was James Barrow from Barrow Hanley Mewhinney & Strauss, and both he and Joseph Lewis from the Travistock group lost huge amounts. Much to their dismay what seemed to be a value opportunity actually very nearly became a value trap.
Could all of this not have been avoided if some simple risk management was applied?
Of course the annual report details whole sections on risk management, but this clearly did not show the wood for the trees. Bear Stearns showed that making money was more important than using discretion. I don’t argue that investment banks shouldn’t make money, that is why they exist.
But when their actions can possibly lead to an indictment on the whole financial system, maybe this needs some more thought. Bear Stearns is the counterparty to $10 trillion of over the counter swaps. Bear Stearns might not be the largest, but their position in the financial food chain is certainly very important.
Their importance to financial stability was larger than their seen an unseen losses, and for this reason there was no choice but to rescue the business, regardless of any moral issues which might arise from this.
Regardless of their lack in understanding a very complex financial world, regulators very quickly put a rescue plan together for Bear Stearns.
Opportunity knocked at JP Morgan’s door, who subsequently offered to pay just $2 per share for Bear Stearns. A fire-sale price by any measure.
This evidently made investors very unhappy, and the offer needed revision. The accepted offer details a price of $10 per share for only 39.5% of the company, and a subsequent chance for survival under the Bear Stearns banner.