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Bear Stearns on the operating table
20 Aug 2007
Amid concerns about its future, Financial News studies the anatomy of the troubled US investment bank

If Bear Stearns is known outside its US home base, it is because the 83-year-old bank is now virtually synonymous with sub-prime troubles and associated with two disastrous hedge funds that left investors with nothing.

Somehow, Bear Stearns, a workhorse of Wall Street that achieved record profits by sticking to its knitting, has become an example of what happens when securities firms do not diversify sufficiently.

“A harsh view would be that the company at its core is a mortgage securities business with an equity servicing business,” said Deutsche Bank analyst Mike Mayo in April, referring to its concentration on mortgages and clearing for hedge funds.

Only seven years ago it was on a par in size and profitability with Goldman Sachs, Morgan Stanley, Merrill Lynch and Lehman Brothers, but today Bear Stearns is a fraction of its rivals’ size. Banc of America analyst Michael Hecht said that where Morgan Stanley had $850bn (€634bn) of assets and Merrill Lynch nearly $1 trillion, Bear Stearns has $425bn. Mayo ranks it fifth out of the five independent banks and 11th among big investment banks.

Michael Holland, head of investment firm Holland & Co, said: “The history of the firm is one of success in a quiet, almost prosaic way, and recent events are so out of character with the company’s history.”

But it is not just Europeans who may have trouble recognizing Bear Stearns. Even at home, the bank’s business, management and reputation have been rendered unrecognizable by misfortune and, some say, bad judgment. This month the bank released Rich Marin, head of asset management, and Warren Spector, its popular and powerful co-president, who oversaw Bear Stearns’ main businesses including markets, asset management and risk management.

Chief executive James Cayne’s conference call about the bank’s credit outlook unnerved investors, said Punk Ziegel analyst Richard Bove.

While Bear Stearns froze redemptions from two imploded sub-prime hedge funds, Cayne was giving interviews about his 20lb weight loss, his bridge-playing prowess, his golf score, and, most disturbing for some investors, his meeting with Citi’s Charles Prince, intended to reassure Prince that Bear Stearns could meet its obligations.

The bank then controversially raised money through two $2.25bn bond offerings to bolster its cash position from $11bn to $14bn within two weeks. Bove believed it should instead have sold between $25bn and $50bn in Treasury and agency securities to reduce liabilities on its balance sheet and reassure investors it could meet its obligations. Bear Stearns paid a high price on its bond offerings with an interest rate of 7.05%, 2.45% above that of five-year Treasury bonds.

Bear Stearns' chief financial officer Sam Molinaro said: “The reason we sold the bonds is that it’s not we felt we needed the cash, but we needed to open up the market for credit in our name. While this was an expensive trade, it was reflective of where spreads were for the investment banks at the time, and it was evidence that the investment community was willing to take our name for five years in the unsecured credit market.”

While the offerings showed that investors would continue to buy Bear Stearns’ debt, the price indicated the bank had fallen in their estimation. In a few weeks, its valuation fell to 1.2 times book value, the lowest since 1995, while the share price dropped 29% in two months. Although few believed Bear Stearns was in dire straits, sale rumors abounded and most observers believe it will probably seek a cash infusion from a Chinese or European bank to bolster the balance sheet.

But, at home, bankers, analysts and fund managers agree it has damaged Bear Stearns, which in a volatile Wall Street has until now been a paragon of stability. Alone among its rivals, it lost little on the dotcom bust because it did not develop its business in the sector to any size. It formed a special risk-management bootcamp called Fast (Financial analytics and structured transactions) that trained risk managers for years before they were let loose on trading floors.

Bear Stearns refused to use any of its money to bail out Long-Term Capital Management in 1998, perhaps presaging Cayne’s refusal to rescue the two sub-prime funds this year. Management tenures are measured in decades, rather than years: former chairman Alan “Ace” Greenberg spent 52 years with the group before handing over to Cayne, who became co-president 22 years ago and chief executive 14 years ago. Spector had over two decades with Bear Stearns; Alan Schwartz, the new president and investment banker, is a 31-year veteran.

The firm’s culture is suspicious of outsiders and change. One Ivy League-educated executive said he would never think of discussing his university education with colleagues and nor would others, “if they knew what was good for them”.

For many years the desired degree at Bear Stearns was not an MBA but what Greenberg called a PSD: poor, smart and a desire to be rich. In 2001 when Greenberg was asked if Bear Stearns would head in a new direction under Cayne as chairman, he replied: “I hope not.”

But, like it or not, Bear Stearns has changed. “They’re captives to the fate of the markets they’ve chosen to participate in,” said Holland.

• Markets: fixed income and equities

Warren Spector was among the founding members of Bear Stearns’ mortgage business and one of its best advocates. It was a move that, until recently, paid off for the bank. When its rivals were giddy about dotcoms, Bear Stearns favored fixed income. It may not have been a surprising choice for the bond house but it worked.

Fixed income accounted for 38% of Bear Stearns’ revenues, according to Banc of America securities analyst Michael Hecht. The group shifted its focus to mortgages and bonds after 2000: about 40% of its fixed-income revenues are thought to be mortgage-related, and mortgages and mortgage-backed securities accounted for 51% of Bear Stearns’ trading book by the end of the first half of this year, up from 42% at the end of last year, according to Hecht.

Bear Stearns’ involvement in sub-prime debt appears tiny, given the panic: as Sam Molinaro, chief financial officer, said, sub-prime accounts for about 3% of Bear Stearns’ mortgage business and 1% of total revenues. But the group is highly exposed to the mortgage market just as it has hit trouble: Deutsche Bank analyst Michael Mayo estimated that 15% of Bear Stearns’ revenues are mortgage related, compared with less than 10% at Lehman Brothers, Bear Stearns’ closest rival, and 5% at the other banks.

While 3% of that mortgage business is sub-prime, a great part is Alt-A, which Mayo believes could be the source of the next worry in the credit markets. Bear Stearns said this year it wants to continue to originate, securitize and distribute mortgages; given the credit problems and Spector’s departure, the business’s future is doubtful.

Bear Stearns has taken a contrarian view in its markets businesses: it increased its presence in equity derivatives and cash equities this decade as rivals were departing. Its customers are mainly institutional.

The equities business, in which revenues rose by only 16% between 2000 and 2006, is boosted by its top-ranked clearing business, which makes up 12% of revenues and helps Bear Stearns maintain a top spot among prime brokers. Equities brings in only 25% of capital markets revenues, compared with 57% for fixed income. Corporate equities made up only 22% of Bear Stearns’ trading book. The firm is also non-existent in commodities, said Mayo.

One former executive said Bear Stearns’ proprietary trading activities were negligible: “They don’t want to compete against clients in anything.”

When Spector left, employees were concerned the markets businesses would not be represented. Bear Stearns promoted Jeffrey Mayer, Spector’s co-head of fixed-income, to the bank’s executive committee to soothe worries.

Mayo said there are several ways for Bear Stearns to develop these businesses, including boosting commodities, growing domestic and international market share in equities and winning business from hedge funds. The bank should also diversify its fixed income products.

• International

While European M&A activity increased by 75% over last year’s levels and Asian mergers and private equity investments provide the fastest growing source of revenues for its rivals, Bear Stearns has developed only slowly.

Although it has been a presence in Europe for some time, much of that profitably, Spector was the prime advocate of boosting the international business and pushed it hard in the past two years. The bank employs about 1,000 staff in Europe and several hundred in Asia. The international business recently made sufficient money to run on its own steam. International revenue is up 30% this year and on track to reach 20% of total revenue, or more than double its level of three years ago, said Banc of America’s Michael Hecht.

But Bear Stearns’ international focus stands at 13% of revenues, behind rivals who long ago hit the halfway mark. With Spector’s departure, there were worries that overseas bankers would see their primary advocate gone; bankers and analysts agree this is where Bear Stearns could do most to boost market share.

• Advisory

With new president Alan Schwartz emerging from investment banking, Bear Stearns’ advisory business will come under increased scrutiny. Its investment banking business is smaller than that of its rivals and heavily focused on sectors, such as hotels and media and telecommunications, a specialist area of M&A chairman Lou Friedman. Only 14% of Bear Stearns’ capital markets revenues come from investment banking, and only 6% from M&A.

The bank is a lead arranger for financing for forthcoming leveraged buyouts and is at risk from failed deals, though to a lesser degree than its rivals. It is involved in an outstanding $23.2bn financing for Alltel, $21bn for Hilton Hotels, $17bn for Archstone-Smith Trust, $12bn for Chrysler, and $9.2bn for Cablevision. Hecht estimates the bank has $424m of leveraged loan and high-yield exposure.

Bear Stearns rarely hires from outside for its advisory business and, when it does, it seldom brings in teams. In 2002, Spector recruited Sergio Lires Rial from ABN Amro to co-head investment banking with Schwartz and oversee the capital markets’ financing activities. Rial left when his contract ended.

Where its rivals have thrived on revenues from private equity, Bear Stearns has played a smaller role with financial sponsors; it is an area in which Bove noted it needs to improve.

• Asset management

Wealth and asset management make up about a tenth of revenues and Deutsche Bank analyst Mike Mayo has called the $54bn asset management business “undersized”. Despite the implosion of two hedge funds this year, Bear Stearns’ wealth management revenues were up 34% in the second quarter against the first three months.

Although the problems with the funds were localized Bear Stearns’ refusal to bail out the funds and their collapse is seen as a black mark against the company as the funds’ problems caused redemptions in other asset-backed securities funds. The bank brought in Jeffrey Lane, an old hand from investment adviser Neuberger Berman, to head the asset management division and to restore confidence.

Mayo suggested hiring more brokers for the wealth management arm to develop the business.

• Prime brokerage

Prime brokerage is a business in which Bear Stearns has an international reputation. Until last year, it housed the operation within the equities division but it has been moved to the global clearing unit. For decades, it has been considered in the top three, along with Goldman Sachs and Morgan Stanley. The three banks are thought to control 66% of the market.

Prime brokerage appears to have emerged unscathed from Bear Stearns’ recent troubles. The business has margin balances of about $100bn, with “virtually no exposure to any of the types of collateralized debt obligations or collateralized loan obligations that have been problematic”. The clearing business had record months in June and July, according to Molinaro.

That does not mean that prime brokerage has not had its challenges. The bank moved the European head of prime brokerage to Asia as a chief administrative officer. In March, it hired Leonard Feder to co-head prime brokerage and increase the focus on Asia; he left after just two months in the role.

The bank had a legal setback when it was ordered to pay more than $160m for providing prime brokerage services to Manhattan Investment Fund, which committed fraud to hide its losses. The bank lent the hedge fund money to cover its trades and reclaimed its money later. The court said Bear Stearns should have been aware of the fraud and exposed it.

Brad Hintz, an analyst at broking adviser Sanford Bernstein, said last year he expected Bear Stearns’ margins to be hit by underspending in technology, its lack of scale outside the US and the size of its hedge fund clients. But he predicted Bear Stearns Stearns would hang on to its top-three spot.

Financial News and Information from Financial News Online US

Bear Stearns on the operating table
Financial News Online US - 19 minutes ago
“A harsh view would be that the company at its core is a mortgage securities business with an equity servicing business,” said Deutsche Bank analyst Mike Mayo in April, referring to its concentration on mortgages and clearing for hedge funds.


So they are borrowing billions to commit  Hedge Fund Fraud.
It just keeps getting better! 
Is that like payday lending?
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