25 Jul House of Cards by William D. Cohan
Because the proverbial you-know-what did not really hit the fan until September of 2008 (with the one week period that included the fall of Fannie Mae, Freddie Mac, Lehman Brothers, Merrill Lynch, and AIG), many seem to forget that in March of 2008, six full months prior, Wall Street lost one of its true gem stones: the illustrious Bear Stearns. Cohan’s House of Cards is not intended to walk us through every nook and cranny of the housing crisis, or even the systemic mess that took place across Wall Street. This is a 450-page play-by-play of the fall and rise of Bear Stearns in particular. I say “fall and rise”, because in a twist of literary genius, Cohan starts the book with a 150-page minute-by-minute description of the final weeks of Bear. It reads like a murder mystery thriller, partly because the suspense and drama is riveting, and partly because it was, well, a “metaphorical murder”, as the hubris of a few particular men, the incompetence of a slightly greater number of men, and the unfathomable selectivity of government decision-making brought down a Wall Street giant.
The book is hard to put down. I am quite certain that I have never read a 450-page book as quickly as I read this one. The behind the scenes look at JP Morgan’s decision to buy Bear Stearns that fateful weekend in March of 2008 was accompanied by enough back-and-forth action it would make your head spin. Cohan uses Paul Friedman, the COO of the Fixed Income Division, to lay out the narrative. Readers are given a look under the hood of a weekend from hell, wherein Jamie Dimon, the CEO of JP Morgan Chase (and arguably the most powerful banker in the entire world) several times changed his mind and re-negotiated the purchase of Bear, a company whose two options became: (1) Take whatever deal JP Morgan offers, or (2) Close your doors and turn off the lights.
How does it happen that a company whose book value was $84 per share is forced to accept $2 per share in a desperate attempt to stay alive? How can a company with $18 billion of cash in the bank (their own cash) at the time be on the brink of liquidation bankruptcy? Has the leverage of a deal ever been more one-sided than it was in this case? The answers are far more important than just what they meant to Bear Stearns, for they give us a light on an entire system that became dependent on what is commonly called “overnight funding”, and more technically “repurchase agreements”. When the creditors of Bear Stearns became petrified that the company was ultimately insolvent, despite their decent cash reserves and phenomenal free cash flows, the rest became completely irrelevant. In a financial system that inexplicably requires every domino to believe the next domino will also work, all it takes is one domino removal to bring a company (or, the world), to its knees. Such was the fate of Bear Stearns.
After walking through the historical record of JP Morgan’s purchase of Bear Stearns for $2 per share (moved up to $10 one week later as a result of one of the most comical attorney errors of all time, wherein JP Morgan signed an agreement guaranteeing all the bad debt of Bear Stearns, even if the shareholders rejected the deal!!!!!), Cohan leads us on a 250-page history of the firm, beginning with its infant stages prior to the Depression. The pathologies of the men who led this firm over the years (remarkably, in an entire century, you are only talking about three or four key people) are enough to write thousands of pages on, and you have to be as dysfunctional as I am to find this so entertaining (but I really do). For review purposes, I will skip the myriad of details in this company history, but will simply say that Cohan left me feeling like I have grown up with Jimmy Cayne, the bridge-playing non-college-graduating iconoclast who led this firm for decades. Cohan has a career as a biographer if he wants one, for this was meaty stuff indeed.
The questions that are germane as far as I am concerned are these:
(1) In March of 2008 the Federal Deserve announced a new and unprecedented facility for primary dealers to access the Federal Discount Window. Yet, to this day, no explanation has been provided whatsoever as to why the access to this window would not be available until March 27 (too little, too late, for Bear Stearns). Ideologues can debate until they are blue in the face whether or not this measure made sense at all, but readers are right to wonder why the timing was such that it was exactly on time for everyone else who lived off of repo agreements, and exactly too late for Bear Stearns.
(2) This is not so much a question as a statement of fact. Through no fault of their own that I can detect, the story of this Bear Stearns mess for the bondholders has got to be one of the most miraculous tales of good fortune I have ever seen. Stockholders saw Bear Stearns trading at $170 per share less than a year prior to their collapse, and ended up taking $10. Bondholders, who likely would have received well less than 50 cents on the dollar in a bankruptcy ended up recovering 100% of the par value of their bonds, all interest owed (and still accruing), and in one of the most ironic parts of this story, a 100% gain on stock purchased as well. For the week that Bear Stearns approved the $2 sale to JP Morgan, knowing that shareholders would fight to the death to avoid this pillaging, bondholders began buying the stock above the agreed upon value en masse, purely as a way to guarantee that the deal would happen (as they would acquire enough shares to out-vote the stockholders, and protect their huge debt position). The intent was always to lose money on the stock trade, but simultaneously guarantee that their bond deal got done. In a classic case of winning one every side of the trade, one week later JP Morgan upped their offer to $10 per share, not only giving bondholders their deal, but doubling the value of the stock they had been buying. Sometimes God has a sense of humor.
(3) Tremendous moral questions remain about the propriety of a system that stopped compensating Wall Street titans for advising on client capital, and began risking their own capital. Bear Stearns died for the same reason many other firms died, or nearly died, just six months later: Excessive leverage of their own capital base, with a seeming complete and total ignorance from the men running the ship as to what was going on. I believe JP Morgan will make billions of dollars on this trade, as a $29 billion FDIC back-up to the toxic assets they bought has that effect on deals. Had Bear repo dealers decided to keep Bear afloat a little longer, perhaps they could have de-levered, and reinvented, and lived to fight another day. But when the leveraging of your balance sheet becomes a business model replacement for your operational profit and loss, something has gone astray. Have we learned? More importantly, as my next review will cover, how in the world did Lehman Brothers not learn.
Kudos to William Cohan for a brilliant book. It is non-partisan, historically factual, and leaves the reader scratching their heads at what became of a legend. Life is humbling sometimes. Will the events that led to the fall of Bear Stearns also lead to a new paradigm on Wall Street, a paradigm that prices risk appropriately, that seeks to be paid (extravagantly, as far as I am concerned) for wise advice and capital allocation, or will we suffer through all of this once again? Those who feel that regulation alone can solve this problem underestimate the complexity of the system, and the depths of moral depravity. They fail to see the evolution of a shadow banking system. And they truly underestimate the moral hazard of “too big to fail” and global inter-connectedness. For decades and decades, Wall Street was villainized, and indeed, a bunch of villains existed. But they were demonized because they were making a bunch of money giving advice and allocating capital, and that demonization was wrongly directed. The 2008 demonization of Wall Street was clearly deserved, but not because of a failure to regulate; Wall Street changed. Firms like Bear Stearns that spent decades innovating, and providing the financing during times of municipal stress (see New York in the 1970’), or railroad bonds (see America during the 1940’s and 1950’s). A new era is coming indeed. What Cohan has helped us do is wonder out loud if the new era will look like the old one or not. It will be good for the whole world to have a strong Wall Street, and not one built like a house of cards.