House of Cards: A Tale of Hubris and Wretched Excess on Wall Street
by William D. Cohan, 2010
William D. Cohan* is a banker-turned-writer who has by now written three histories of different Wall Street firms: His first book was about Lazard Freres, his former employer, and his latest is about Goldman Sachs. House of Cards, though, is the tale of Bear Stearns, the first investment bank that was taken down by the crisis.
Bears Stearns’s collapse occupies an odd place in the narrative of the 2008 crash, having occurred in March, six months before the fall of Lehman Brothers, the subsequent panic, and the passage of TARP. At that time, nobody quite knew the enormity of the problem facing Wall Street, and there was hope that Bear Stearns’s collapse would be the nadir of the problem. The firm was the smallest of the major Wall Street investment banks—if there was going to be a casualty, it would make sense for it to be Bear Stearns.
So how does a Wall Street bank go bankrupt? Well, the same way Mike Campbell did: Gradually, then suddenly. The seeds of Bear Stearns’s collapse go back several years—and possibly, Cohan implies, several decades—but the proximate cause was the sudden grip of panic that seized the firm in March of 2008.
It’s hard to pinpoint a clear moment when this began, and Cohan does a great job illustrating the gradual erosion of confidence in the firm. As problems got worse and worse in the housing market, investors started to worry about Bear, which was known to have a lot of money invested in mortgage-backed securities. The price of a credit-default swap on Bear debt* had gone from $50,000 in the beginning of 2007, to $350,000 in March of 2008.
*Which, again, measures the risk that someone will default on that debt.
Of course, once people start to have doubts about a bank’s ability to repay loans, it only gets worse. Cohan’s book stresses the difference between capital and liquidity, and demonstrates just how fragile and important the latter is. At the start of March, Bear had an $18 billion liquidity cushion. But as investors began to question the bank’s ability to repay loans, hedge funds and other clients started to withdraw funds and counterparties started to demand more collateral. To meet these demands, the bank had to either liquidate assets that had lost most of their value, or dip into its own cash. In some cases, Bear refused to make margin calls that it felt weren’t justified, which only exacerbated fears that the bank couldn’t pay its debts.
As this panic spiraled, rumors and innuendo started to swirl around Bear Stearns like the bank was a slut at a Sweet Sixteen. Cohan relays one story about a hedge fund that asked Goldman Sachs to “novate” a trade it had with Bear. A novation is simply when one firm takes the place of another in a deal, but Goldman Sachs declined. The reason Goldman gave was to protect Bear: “If we start taking novations, people pull their business, they pull their collateral, you’re out of business,” said Gary Cohn, a co-president of Goldman. Of course, the message such a refusal sent to the hedge fund, and others on Wall Street, was that Goldman didn’t want to risk getting involved in a trade with Bear Stearns.*
*It’s stuff like this, where Goldman seems to be doing the right thing but ends up only undermining a competitor, that gives Goldman Sachs its reputation.
All these doubts culminated on Thursday, March 13, when, as Cohan puts it, “all…simultaneously lost confidence in the firm.” There was, essentially, a run on the bank, and the $18 billion liquidity cushion quickly vanished.*
*TIMEOUT: It’s worth pausing for a second to ponder just how a bank with over $350 billion worth of assets can rely on a liquidity cushion of “only” $18 billion. All of the big five investment banks—Goldman Sachs, Merril Lynch, Morgan Stanley, Lehman Brothers, Bear Stearns—had hundreds of billions of dollars worth of assets in 2008. Of course, at any given moment, most of those assets are tied up in long-term investments that are difficult, if not impossible, to sell off quickly.
As a result, all of the banks relied extensively on the “repo” market for day-to-day functioning. Now, at this point I’ve read about a dozen descriptions of the repo market, but it still doesn’t make total sense to me. Essentially, “repo” is short for “repurchase agreement.” In such an agreement, a seller sells assets to a buyer with an agreement to buy those assets back at a slightly higher price. Effectively, then, a repo is just a short-term loan with the assets as collateral. The investment banks were all relying on repo loans to finance their day-to-day deals.
The problem, though, is that the repo market is based almost entirely on trust. The deals are worked out so fast, and the terms are so short (usually about one day), that very little attention is actually paid to the assets being bought and sold. The collateral isn’t that important, the thinking went, if you are going to be repaid in 36 hours. Once doubt creeps in, as it did for Bear Stearns, other banks become wary of being exposed in these deals. If a company goes bankrupt, it’s not going to be around to repurchase the assets it just sold you. Obviously, such fears represent a vicious cycle, and Cohan’s book illustrates just how quickly this cycle swallowed Bear Stearns.
Overnight, the bank got an emergency loan from JPMorgan. Jamie Dimon, JPMorgan’s CEO, put the loan in grandiose terms: “We thought… about what obligation did we have to do the best we can to help the United States of America.” Of course, it wasn’t quite that selfless: The loan was actually backed up by a loan to JPMorgan from the New York Federal Reserve. In other words, JPMorgan did not provide any collateral or liquidity of its own. It mostly served as cover for the Fed, so as not to seem like a direct bailout.
Had this loan worked, one could perhaps applaud the Fed for its ingenuity. But it did not. Bear Stearns still couldn’t find any funding and clients were still withdrawing their money. If anything, the loan seemed counterproductive: If Bear Stearns needed an emergency loan orchestrated by the Fed, then obviously it was in trouble. Bear’s stock price fell nearly 50% the morning after the deal was announced.
The book then goes on to the story of Bear’s sale to JPMorgan. As the details of Paulson’s book hinted, the government is as prominent a character in this story as either of the two banks. Although the original loan offered to Bear had been for 28 days, Paulson called Bear’s CEO that weekend to tell him, “You need to have a deal by Sunday night.”
Paulson was, as usual, worried about instability in the markets if there was uncertainty about Bear, but it never seemed to occur to him that the Treasury Secretary cannot order a company to sell itself by a particular date. Perhaps even more disconcerting, Paulson essentially picked the price of the sale: When Dimon told Paulson that he was considering offering $4 or $5 per share, Paulson said, “That sounds high to me.” Dimon then offered $2 per share.*
*The price would eventually be revised up to $10 per share, though by then Cohan says that JPMorgan had already bought most shares of Bear for somewhere between $2 and $10. In January 2007, Bear’s share price had been $172.
Cohan relays these unsavory details with virtually no comment. He retains a storyteller’s objectivity and lets the facts speak for themselves. This style has its appeal, but I almost feel as if the implications of the government’s actions during this sale were so unprecedented that they are worth pausing over. Cohan does have sources offer perspective on the issues, but the complexity of his story often compels him forward without proper analysis.
Another small shortcoming of Cohan’s book is its structure. The book is divided into thirds: The first tells the story of Bear’s collapse, the second tells its history through its three longest-serving CEOs, and the third tells the story of the years leading to the collapse. The reasons for starting with the collapse are obvious—it is the most compelling part of the story—but the nonlinear structure makes it hard to trace the effects back to their causes.
Certain elements of the story only become clear later on. The tension between the firm’s two former CEOs, Alan “Ace” Greenberg and Jimmy Cayne,* came into play during the board’s decision to accept JPMorgan’s offer, but the decades-long source of that tension (which seems to have stemmed from Greenberg’s jealousy of Cayne’s skills at bridge) is only fully explored in the second section. Similarly, the story of Bear’s increased exposure to the housing market is never directly connected to the crisis of Bear’s final days.
*Jimmy Cayne is one of the more interesting figures I read about in all these books. He comes off as quite an arrogant, self-involved person, but he’s also refreshingly honest in his self-grandeur. Even his lies are so obvious that they’re hardly worth dwelling on.
Cayne, for example, pushed the board of directors to take Bear into bankruptcy instead of accepting JPMorgan’s offer. His motives are quite obvious: Cayne held millions of shares of Bear stock, and he wanted to get a better price than the $2 he was being offered. This sounds greedy, but it brings something into focus: A sale may have been bad for stockholders, but it was great for anyone who held Bear bonds, since bondholders would be paid back in full. This would not have been the case in bankruptcy, in which stockholders would have been better off but bondholders would have lost value. Who were Bear’s bondholders? It’s never made explicit, but it’s pretty obvious that most of Bear’s bonds were held by other Wall Street banks.
Of course, Cayne was also largely responsible for the firm’s demise. His hands-off management style—he missed many crucial days for the firm to attend bridge tournaments—led to a failure to anticipate the risks Bear was taking on. He also resisted calls to diversify the firm’s investments as it piled heavily into the housing market, and he forced out Bear’s head of bond trading, Warren Spector, just before the crash for largely personal reasons. Cayne himself was essentially forced down in January of 2008.
Cohan tells the story of this exposure largely through the story of the Bear Stearns Asset Management funds, or BSAM. In the early 2000s, Cayne and his head of fixed-income, Warren Spector, made a concerted effort to grow BSAM. Part of that effort consisted of setting up a hedge fund within that branch. The hedge fund was to be run by Ralph Cioffi, and it operated largely outside the rest of Bear and BSAM. Indeed, most of the money in Cioffi’s fund came from outside investors, not Bear itself, making it somewhat hard for outsiders to tell where the bank ended and the hedge fund began.
Initially, Cioffi’s results were great: The fund was profitable in each of its first forty months. The success earned Cioffi the privilege to be left alone by his bosses. Indeed, Cohan makes clear that Spector and Cayne were almost entirely ignorant of what Cioffi was doing. And what he was doing was investing large sums of money—most of it borrowed money—in the subprime housing market. As time went on, their leverage got higher and higher, and they maintained their faith in the ratings agencies: “I simply do not believe anyone who shits all over the ratings agencies,” Matthew Tannin, Cioffi’s partner at the hedge fund, told him.
Cioffi and Tannin are now infamous for being the only Wall Street traders to have been charged with fraud in relation to the financial collapse. Cohan does an excellent job of balancing both the evidence the SEC used against them in that case with the reasons for their ultimate acquittal. It’s easy to see why it would be troubling to find a personal email from Tannin in which he says, “If AAA bonds are systematically downgraded, then there is simply no way for us to make money—ever,” while at the same time he was reassuring investors that they were properly hedged.
But Cohan makes clear that Tannin and Cioffi were never certain that their investments were worthless. They were constantly debating the likelihood of downgrades and the prudence of selling—exactly what you’d want your investment advisors to be doing. Their conclusions turned out to be horrible, but it’s not a crime to be bad at your job.
What hurt Bear Stearns, though, was that as the hedge funds began to lose value, and as their exposure to the housing market became clear,* their repo funding began to dry up. Although Bear Stearns had only $45 million invested in the hedge fund—a paltry sum for a bank with hundred of billions of dollars in assets—the bank made the decision to step in as BSAM’s repo lender while the other lenders fled. This put the bank on the hook for billions of dollars of the hedge fund’s assets, which it lost as the hedge fund failed.
*Another reason for the allegations of fraud was the varying statements about how much exposure the firm had to the subprime market. At various times, the fund claimed to be fully hedged, or to have only a 22% exposure, when in reality it was more like 60%. Again, though, this was not so much an example of fraud as it was an example of how poorly Cioffi and Tannin understood their own investments.
Nevertheless, it’s hard to tell exactly how fatal a blow that decision was. Although the hedge funds failed in the summer of 2007, the repo markets for the bank itself didn’t start to freeze until February of 2008. Bear made other stupid decisions in that time, like choosing to bet against the subprime market by buying Alt-A bonds* that turned out to be just as worthless.
*Alt-A bonds differed from subprime in that they were not loans to borrowers with poor credit, but were instead unconventional (or “alt”) types of loans to otherwise worthy borrowers. These loans, however, turned out to be nearly as bad, since most of them were for second homes, or had interest rates that reset, or incredibly low down payments.
If Cohan fails to pinpoint a moment or a decision that did Bear Stearns in, that’s less a failure of storytelling and more a feature of the situation. Bear Stearns wasn’t done in by one rogue trader or one costly decision, but by a culture that developed over decades. There were CEOs who didn’t understand the risk they were taking, traders who didn’t understand the instruments they were buying, managers who valued growth above all else, etc. The surprise isn’t that this house of cards collapsed, but that it stood so long in the first place.
by Lawrence G. McDonald with Patrick Robinson, 2009
I had hoped that A Colossal Failure of Common Sense would be for Lehman Brothers what House of Cards was for Bear Stearns, an account of one bank’s collapse. This book even had the advantage of being written by a Lehman employee, who had a unique inside perspective.
Unfortunately, A Colossal Failure… is a colossal failure. It is a lousy, poorly written book with virtually no insights at all on the crash. The first half is completely irrelevant, unless for some reason you are incredibly curious about the life of Lawrence G. McDonald and his friends. McDonald comes off as incredibly unlikable, confirming every negative stereotype of Wall Street types, and none of the good ones.
And McDonald is a horrible writer. Just awful. The book is full of pointless, confusing metaphors and overwrought language. McDonald strains to make you understand that he feels your pain. And if you’re wondering who was at fault in the crash, it wasn’t McDonald or anyone he knew. Everyone McDonald worked with was a brilliant crusader for the forces of financial justice, undone by unseen foes at the top, like Dick Fuld. McDonald puts most of the blame on the mortgage originators, who he calls “bodybuilders,” for selling homes to people who couldn’t afford them. But his analysis is slightly more credible than a fortune cookie, and it reeks of rationalization.