Baring Bear

by Steven M. Cohen  •  Mar 16, 2008 at 6:55 am

http://www.buyselljump.com/2008/03/baring-bear

In today's New York Times, Gretchen Morgenson, a thoughtful writer for its business section, speaks of only bad outcomes as the result of the Fed "bailing out" Bear Stearns. According to Morgenson and many other business commentators, market experts and economists, the risk of "moral hazard" resulting from the Fed's move outweighs any benefits that such a bailout could provide.

It is a compelling argument. Morgenson provides a laundry list of awful consequences, including more damage to an already declining dollar, further aggravation of runaway inflation, and a continuation of what she calls the "slow bleed" at banks and other financial institutions.

When looking at Bear's predicament, one can't help but consider what an unsympathetic candidate it is for any help at all, much less at the expense of taxpayers. Bear has long been viewed by Wall Street as overly aggressive, opportunistic to the point of abject selfishness, and not always acting on behalf of its customers before it takes care of itself. This view of Bear is nothing new and is shared by many in the industry.

And let's not forget that Bear recently took no action to bail out two of its own hedge funds, which ultimately failed and left the investors nothing. Even though these funds bore the Bear name, in effect its stamp of approval, the firm evidently cared little about reputational damage, but only about the bottom line.

Of course Bear is not alone in making that choice--just ask the principals at Carlyle Group, who last week let its nearly-eponymous hedge fund slip into oblivion. Even more surprising, perhaps, since Carlyle has had a reputation far more sterling than Bear's. But in these precarious times, evidently reputation and trust aren't worth preserving if it involves risking even a portion of the principals' vast wealth.

Even in its most desperate moments, Bear Stearns could not prevent the appearance of foolishness, even buffoonery, at its highest levels. According to newspaper reports, chairman "Jimmy" Cayne participated in the pivotal conference call sealing the firm's fate by phoning in from a distant bridge tournament. Cayne had already been made to look rather silly in recent reports suggesting he spends most of his time distracted by all sorts of extracurricular activities. Truly odd behavior for the firm's largest shareholder, arguably with the most to lose if the firm expires.

But the reality of the situation transcends even deeply-held philosophical objections to the Fed's involvement. Just as the Street has only begun to assess the ultimate value of the ongoing writedown of rotten mortgage-related securities, the counterparty trading risk of a Bear collapse is impossible to quantify at this point. However, it takes little imagination to assume that it would be a catastrophic hit to the financial system, one that should be avoided if at all possible.

There is merit to preserving the pieces of the firm that are functioning properly and retain value, such as the prime broker unit. And if there is other value there it should be preserved as well, which could mean splitting up the good parts from the junk. And perhaps within the 28-day lifeline period granted by the Fed through J.P. Morgan the firm will find a buyer for most or all of it.

By making these outcomes possible, the Fed hopes to avoid the larger catastrophe of a market meltdown, just as it did when it arranged for the bailout of Long Term Capital Management in 1998. It is hard to argue that this is a good thing and that the moral hazard argument is not compelling. Certainly the Fed cleaning up the mess may invite more reckless behavior in the future. But given the precarious state of things, it may have no other alternative.

Some of that moral hazard can be ameliorated. It is one thing for the Fed to guarantee J.P. Morgan against losses, but before any taxpayer money is actually spent, every penny of value, if any, ought to be squeezed out of the Bear corpse. To the extent that one or more buyers pony up to take over pieces of Bear, those proceeds must go into a fund as collateral for the government loan.

And if the shareholders are left with nothing--zero--it might not be such a bad thing, especially if such an outcome contributes to the Fed's objective of stabilizing the market. It can be argued that shareholders (and thousands of unfortunate employees) being wiped out may actually inhibit acts of moral hazard in the future. Investors will be served well if this sorry episode persuades managers to more carefully and realistically evaluate risk or suffer the ignominy of Bear's officers and directors.

It has been estimated that Jimmy Cayne's paper losses last week approached $300 million. Looking on the bright side, his schedule may soon be completely uncluttered, opening up a lot more time for bridge tournaments.

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