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The Greatest Risk

Posted by Larry Doyle on December 21, 2008 4:56 PM |

There remain no shortage of developments in the economy, the markets, and on “the street.” While I could continue to write at length on a number of those topics, I think it is healthy to take a weekend break from the regular hustle and bustle. With a break in the show, perhaps we can take a walk backstage and I can share with you some insights into Wall St. that occurred back in the ’90s but didn’t fully play out until 2008.

Please allow me to set the stage. I joined First Boston (now Credit Suisse) in 1983. I was very fortunate to gain employment at First Boston (FOB) as it was one of, if not, the hottest shops on the Street at the time. FOB was very much a traditional “white shoe” sort of firm. Propriety was important in executing business, although I am sure there were some sort of improprieties that occurred behind the scenes. I was too young to get dragged into anything that pushed the envelope. Although the head of HR threatened to fire me 6 weeks into my tenure (I think she was just trying to scare me), for the most part my 7 year career there was wonderful. I learned the business and developed many great relationships.

I was recruited to join Bear Stearns by an individual for whom I worked with for almost 15 years. I was very hesitant to go to Bear Stearns because it always had a reputation for being an extremely aggressive firm in every regard. That said, the person recruiting me was the most principled individual with whom I ever worked on Wall St. and he and I continue to have a very close relationship. I felt that I was working as much for him, if not even more, than I was working for Bear. I admired and respected his values and integrity.

For those who have read my pieces, you have heard me stress how important it is to understand risk. On Wall Street,as in any business, there are all types of risk. For example, there is market risk, credit risk, interest rate risk, prepayment risk, and counter-party risk amongst others. For anybody involved in the markets, all of these risks are facts of everyday life, but they pale in the face of what many feel is the greatest risk of all, and that is “in never taking risk.” For without risk, there is no reward.

However, in my opinion, there is a greater risk that lurks everyday and for my money is massively mispriced, and that is reputation risk. When I say mispriced, I mean there is no premium high enough to jeopardize one’s personal and professional reputation.

There are plenty of CEOs and senior managers who will tell you how important reputations are, but talk is cheap, and actions speak volumes. Mind you, I have no personal vendetta against Bear Stearns. I had a great 7 years there and learned many valuable skills. In fact, I continue to have many close personal friends from Bear whom I highly respect. I harbor no ill will toward anybody with whom I worked at Bear.

On Wall St. seniority is achieved typically through a string of accomplishments, being profitable, and achieving soft goals as well. At Bear, there was no mistaking that seniority was strictly a function of profitability. That system put a real onus on management to be extremely diligent in overseeing the traders and salesmen. The envelope was ALWAYS being pushed.

Along with the mortgage business, Bear’s other large profit center was the clearance business. This business effectively served as the back office for smaller brokers. It was a very low risk, high return business that generated profitability based on the volume of business executed by clients. Bear’s clearance business profitability was envied on Wall Street.

Let me now introduce you to another firm, that being A.R. Baron. This firm was the ultimate “bucket shop” or “boiler room” operation. Baron cleared their trades through Bear. That clearance provided a level of respectability because settlement letters and trade confirmations would be sent to Baron clients on Bear forms. Thus, Bear was providing an air of respectability where none really existed. In short, Bear sold its reputation for Baron’s business. The Bear-Baron relationship got so big that business magazine Forbes devoted a cover and lead story to it. The magazine cover was a picture of a rusty bucket, symbolizing both Bear and Baron. To be perfectly frank, I did not feel good during that stretch about being a Bear employee.

Ultimately my manager and friend left Bear and shortly thereafter I left to join him at another shop. The story is not over, though.

In 1998, the largest hedge fund in the market was a firm known as Long Term Capital Management. They were massively over-leveraged when the Russian ruble was devalued which put the entire market into total disarray and blew up LTCM in the process. Their positions were so large though that a consortium of Wall St. firms at the behest of the NY Fed pooled their funds to bail out LTCM. Every shop on Wall St. committed capital with one exception, Bear Stearns.

Much as they pushed the envelope in their clearance business, Bear was so driven to protect its own profitability that they were willing to forsake their reputation and relationships with the balance of the Wall St. community at that time of crisis. Thus, Bear reaped the benefits of a calming market without risking their own capital, but they once again knowingly risked their reputation, while perhaps not appreciating it.

Maybe you do not need friends until you really need them.

Fast forward to the Spring of 2008. As the economic stress led to further stress on Wall St., Bear Stearns was faced with increasing liquidity pressure to finance its operations. While senior management scrambled to get funding from institutions both on and off Wall St., the Bear Stearns stock, which had topped out at app $175 a share, was ratcheting lower. The Bear employees owned app. 35% of the firm with the most senior managers owning app 10%. Panic was setting in as the firm scrambled to get funding. Conspiracy theories came flying out of Bear.

On that fateful Sunday evening last Spring when Bear’s management knew that the firm was in the hands of the Fed and the Treasury, the powers that be met at J.P. Morgan. Jamie Dimon, the CEO of JPM, had long envied parts of Bear Stearns and was prepared to pay app. $20 a share to take the firm. At that moment, Treasury Secretary Paulson told Dimon, “don’t bid so high.” Dimon thought he was getting a great buy at $20 but Paulson did not want to create moral hazard in a government brokered transaction. Paulson indicated to Dimon that $2, not $20, was a better figure and at that moment Bear’s management having no other options sold the firm. What has never been published in any paper but has been widely discussed on Wall St. is that Paulson was finally exacting the pound of flesh that everybody on Wall St. wanted for Bear’s unwillingness to cooperate in the LTCM meltdown.

Bear had long been praised as a great bond shop with superior risk management. Bear’s stock rocketed during the early part of this decade and was the envy of many. All that said, from my standpoint the market never accurately priced the degree of reputation risk embedded in the Bear franchise. That risk was ultimately the downfall for the firm.

Regrettably for our economy, too many companies in too many industries have also been so highly focused on profitability at the expense of long term franchise value. That “reputational” risk is easily covered during a bull market but now that the tide is going out it is more widely displayed.


Please join us Sunday evening for LD’s Dollars and Sense at NQ Radio at 8pm. We have plenty to discuss. Check it out at:

My radio show! – DON’T MISS IT!

Thanks also for all who joined in at our inaugural “Central Station.” I hope you enjoyed the ride as much as I.

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