“There isn’t such a thing as reality when dealing with the global economy. There’s no vault under Madison Avenue. [Even if it was] adequately capitalized, that didn’t matter once the momentum began, the downward perception spiral became reality. It’s a classic run on the bank, via the Internet.” Although history will have the final say, the fall of Bear Stearns may have marked the beginning of one of the worst financial nightmares in history.  As it looks right now, this global recession rivals that of the Great Depression and even exceeds it in some measures.

Though few of the Wall Street’s gunslingers were around for the Great Depression, many draw comparisons between then and now. Bear was a respected financial institution with a theoretically sound balance sheet, by industry standards. Their fall demonstrates how easy it is for large companies to succumb to the pressures of leverage and short run profit fixation. What were the contributing factors in this downfall and how might it have been prevented?

Bear Stearns made the mistake of joining the MBS (mortgage backed security) party late, and it was a fatal misstep. Even as the presence of a housing bubble became evident to many analysts in early 2007, Bear continued to consume as many MBSs as they could. In the second quarter of 2007, both Bear Stearns and Lehman leapfrogged competition in underwriting mortgage backed securities (MBS). Lehman was first with 10.9% of the market, while Bear had 10.1% or $31.94 billion. As a multiplier to this, their portfolios had a strong coastal bias.

Even as Bear was becoming a larger player in the MBS market, they were cutting back on their other asset backed securities. While they moved up to second place in MBS market share, Bear was only tenth in ABS market share at 4.7%. Why would they do such a thing if? At this time, many analysts predicted a downturn in the housing sector. Even if Bear did not believe this, of course there would be some hedge in place to prevent total collapse should the housing sector become degraded.

As Bear Stearns revealed mounting losses in their MBS portfolios, credit markets began to seize up. The effect was viral, as lenders made several assumptions as a reaction to Bear Stearns. First, they assumed that Bear was insolvent and could not recover. Next, they associated banks with one another and assumed that many banks had toxic assets yet to be revealed. Credit stopped flowing, and many financial institutions were unable to meet short term liquidity requirements. Without creditors ceasing to provide short term lending to Stearns, they may have survived. As it stands, they helped instigate one of the more extreme periods of credit tightening in recent history.

So, now a more expansive question: how could an experienced and well respected financial institution miss the boat so badly? Stearns seemingly blind pursuit of the MBS reveals a fatal flaw. Stearns had no capability to adequately measure their risk. Instead of controls and traditional limits, banks have been increasingly reliant on quantitative models to indicate their level of risk. While models are an excellent tool to assess risk, they also present problems. You may have heard of this as the revolution of the “Quant.” Basically, a Quant is a person with a high grade graduate education in a hard science, such as physics or statistics that tries to solve financial market tendencies with equations. There are some great things that have come about as a result of these brilliant people, but success can sometimes create expectations that are not reasonable. When this happens, pressures build up that force people to push assumptions beyond their limits. As a result, causality is assumed in situations where there is none.

Without human judgment, the numbers that are produced by advanced mathematical models have no meaning. Modern financial institutions engage in layer upon layer of risk “management,” including hedging, derivative trading and other measures. Without a comprehensive understanding of the interrelatedness of these processes, a mathematical model may miss significant risk factors. Also, measuring this current risk is more reactive than proactive, and sometimes it is too late to make changes by the time true risk is derived. It is important for banks to take preventative measures to ensure that they avoid overly risky endeavors. Bear did not take these steps, and they paid the price.

So what is the moral of this story? Basically, there needs to be a new measure of risk for a financial sector that has eroded the public’s confidence to regulate themselves. Of course, there was the government implemented stress test but no one believes this will convince banks to become responsible. Even this measure has showed that several banks were in dire straits.

What is needed is a new comprehensive method for measuring and managing the risks inherent in complex financial securities. The New Finance will begin to debate what methods and approaches to use when attempting to create a new measure.

Karen Donovan, “Behind Bear’s Sale,” Portfolio.com, 18 Mar. 2008, 2 Mar. 2009.
Terry Peters, “MBS Up, ABS Down,” National Mortgage News, 30 Jul. 2007: 1.
Duncan Wood, “A return to nuts and bolts,” Risk, Sep 2008: 70.
Nicole Zerillo, “Bear Stearns’ silence adds to its downfall,” PRweek, 14 Apr. 2008: 4.

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