On the fifth anniversary of the breath-taking collapse of Bear Stearns and its rushed, $2-per-share sale to JPMorgan Chase (NYSE:JPM), one obvious question to ask is whether a similar stunning unraveling could happen again today.
After picking through the rubble left in Bear's wake, the bank's demise could be boiled down to three main ingredients:
- High amounts of leverage.
- A reliance on short-term financing.
- Confidence-spooking principal trades.
If we want to be sure that a Bear-like collapse couldn't happen again, we'd want to be sure those three ingredients couldn't come together in such a way that the same type of implosion could occur.
Oops... too late
Unfortunately, we have an unsettling answer to both whether those conditions could be allowed to come together again and whether a Bear-like collapse could reoccur. That answer, in just four syllables, is "MF Global."
On Halloween 2011, the derivatives broker run by former Goldman Sachs (NYSE:GS) CEO Jon Corzine, declared bankruptcy. The proximate causes of MF Global's fall were eerily similar to those of Bear Stearns.
1. Highly leveraged? Check.
For the June 2011 quarter -- the last that MF Global would report -- its gross leverage (assets divided by shareholders' equity) was a dizzying 33-to-1. Just prior to its collapse, Bear Stearns' leverage ratio was 34-to-1.
2. Heavily dependent on short-term financing? Check.
At the end of the June quarter, MF Global had $18 billion in repurchase financing. This is a short-term, collateralized type of financing that often allows lenders to pull their loans with as little as 24 hours notice. These repo lines accounted for more than 40% of MF Global's financing.
In the years leading up to its demise, Bear Stearns typically had a quarter to a third of its liabilities in repo loans.
3. Trades that made lenders uneasy? Check.
For Bear Stearns, it was the bank's holdings of potentially toxic mortgage- and asset-backed securities that put its counterparties on edge. At MF Global, CEO Corzine, playing the part of trader-in-chief, constructed an outsized trade around the debt of European sovereigns including Spain, Portugal, and Ireland, right when the market was the most uneasy about the future of those economies.
Two giant elephants in the room
When considering whether there could be a repeat of Bear Stears though, most of us aren't immediately thinking about MF Global or other smaller brokers and investment banks. We're thinking about two of Bear's blood rivals: Goldman Sachs and Morgan Stanley (NYSE:MS).
But if we stack Goldman and Morgan and their current stats against Bear and MF Global, it's easy to see that they give the system a lot less to stress about.
The follow-up concern to this data, however, is that while Goldman and Morgan may have a lid on their balance-sheet risk right now, we still may have to sweat over the prospect that they could throttle it back up when wild optimism takes over again.
To some extent, this is a valid worry. However, in the rush to backstop the two investment banks during the worst of the storm, regulators allowed both Goldman and Morgan Stanley to convert into bank holding companies -- a designation that both helps the banks in terms of providing access to capital, and "hurts" them by requiring them to comply with much tighter regulations. To this point, both Goldman and Morgan recently passed both rounds of the Federal Reserve's annual big-bank stress testing.
Will this stop a dangerous ratcheting of leverage via here-today, gone-tomorrow short-term loans years down the road? As much as I'd like to say "yes," the regulatory will to crack down on risk taking wanes considerably when so-called animal spirits reign over the markets.
In other words, the market has little to worry about from Goldman and Morgan right now, but we have no guarantees for the future.
And then there's everyone else...
There are numerous other investment banks and financing operations roaming around today, from smaller investment banks like Lazard (NYSE:LAZ) and Evercore to high-octane asset managers like Blackstone (NYSE:BX) and Fortress Investment Group. None of these currently causes me to loose any sleep. But could any one of them decide that it's a savvy move to start levering up and investing in risky assets?
MF Global caught the world by surprise with its fall into bankruptcy -- and with $1.2 billion that went missing from supposedly safe-and-sound customer accounts, the collapse threatened to hobble futures markets. A decade before we were worrying about mortgage-backed securities, Long-Term Capital Management shocked the financial world and drew a Wall-Street bailout when its PhD-devised trading strategy blew up in its face.
To be sure, the magnitude of the financial-market meltdown that precipitated Bear's crash was unusually extreme. Yet the the world of finance seems to attract risk-taking cowboys the way a springtime picnic draws ants. With that in mind, let's not pretend to be too surprised the next time this happens.