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For the other two installments of the three-part Wall Street Journal series, "The Fall of Bear Stearns," see


Wall Street Journal, May 27, 2008 feature (Part 1 of 3)


The Wall Street Journal

May 27, 2008




Lost Opportunities Haunt
Final Days of Bear Stearns

Executives Bickered
Over Raising Cash,
Cutting Mortgages
May 27, 2008


Twelve hours after agreeing to sell Bear Stearns Cos. for $2 a share, Alan Schwartz wearily made his way to the company gym for a much-needed workout.

It was 6:45 a.m., March 17, and Bear Stearns's chief executive had slept little since hammering out the ugly details of his fire-sale deal with J.P. Morgan Chase & Co.

When Mr. Schwartz, already dressed in his business suit, trudged into the locker room, Alan Mintz, still in his sweaty gym clothes, made a beeline for the boss.

"How could this happen to 14,000 employees?" demanded the 46-year-old senior trader, thrusting his face uncomfortably close to Mr. Schwartz's. "Look in my eyes, and tell me how this happened!"

Two and a half months later, Mr. Schwartz still isn't quite sure. To Mr. Mintz and others, he has blamed a market tsunami he didn't see coming. He told a Senate committee last month: "I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference."

But many who lived through the seven tense months before the deal say Bear Stearns imploded because it was at war with itself. Buffeted by the most treacherous market forces in a generation and hobbled by indecision, the firm's leaders missed opportunities that might have been able to save the 85-year-old brokerage.

Those missteps are expected to have a lasting impact beyond the people who once worked at Bear Stearns or owned its stock. Unlike Wall Street meltdowns in decades past -- from Drexel Burnham Lambert Inc. to Long-Term Capital Management -- the Bear Stearns collapse spurred direct intervention from the Federal Reserve. That step is likely to increase the central bank's role in solving future financial catastrophes and bring securities firms further regulation in the bargain.

[The Fall of Bear Stearns]
Today: Missed Opportunities. As the firm's fortunes spiraled downward, executives squabbled over raising capital and cutting its inventory of mortgages.
Part Two: Run on the Bank. Executives believed they were about to turn a corner, but rumors and fear sent clients, trading partners and lenders fleeing.
Part Three: Deal or No Deal? The Fed pressured Bear Stearns to sell itself, but a misstep in the hastily drawn agreement nearly scuttled the deal.

As shareholders prepare to approve the deal on Thursday -- at a price that angry investors forced up to about $10 a share -- interviews with more than two dozen current and former Bear Stearns executives, directors, traders and others involved in the action paint the first detailed picture of the fractious last weeks before the Fed helped underwrite J.P. Morgan's purchase of the trading powerhouse.

Months before regulators pressured the firm to sell itself, nervous traders futilely begged Mr. Schwartz and his predecessor, James Cayne, to raise more cash and slash Bear Stearns's huge inventory of mortgages and the bonds that backed them.

At least six efforts to raise billions of dollars -- including selling a stake to leveraged-buyout titan Kohlberg Kravis Roberts & Co. -- fizzled as either Bear Stearns or the suitors turned skittish. And repeated warnings from experienced traders, including 59-year Bear Stearns veteran Alan "Ace" Greenberg, to unload mortgages went unheeded.

Top executives resisted, in part, because they were concerned the moves would upset the delicate calculus of appearances and perceptions that is as important on Wall Street as dollars and cents. If Bear Stearns betrayed weakness, they worried, skittish customers would pull their money out of the firm, and other financial institutions would refuse to trade with it.

Instead of managing these fickle forces, though, a brokerage whose culture and fortune were rooted in the trading floor's steely manipulation of risk was swamped by them.

Early Warnings

[An August conference call fails to calm investors.]

An August conference call fails to calm investors.

An early harbinger of the debacle to come appeared the first Friday in August. Bear Stearns executives hosted a conference call that day meant to reassure investors. The brokerage's stock had fallen sharply after the late-July collapse of two internal hedge funds tied to subprime mortgages, home loans made to the riskiest borrowers.

Mr. Cayne and his top financial lieutenants touted the firm's strong cash holdings -- $11.4 billion, according to company officials -- and new longer-term borrowing agreements. They also pointed out that Bear Stearns itself actually had few subprime holdings. But executives' comments about the bleak state of the market for interest-bearing securities stoked investors' fears, helping spur a broad rout in stocks and driving Bear Stearns's own shares to a 12-month low of $106.55.

Later that day, word leaked out that Warren Spector, Bear Stearns's co-president and chief of the division that oversaw the two failed hedge funds, was being forced out by Mr. Cayne.

Amid the mounting bad news, a lifeline appeared: Mr. Schwartz, then Bear Stearns's co-president, and Henry Kravis, KKR's fearsome founder, had a conversation about the buyout firm possibly purchasing 20% of Bear Stearns.

By Sunday, Bear Stearns's sleek, black tower in midtown Manhattan bustled with activity.

About 8:30 a.m., a team from KKR assembled in the investment-banking department on the 43rd floor to begin dissecting the firm's books. Buying a piece of Bear Stearns was attractive to KKR as an entree into the lucrative brokerage business at a time when prices were cheap. For Bear Stearns, it was a chance to raise $2 billion or more in capital and gain a crucial seal of approval by putting an éminence grise like Mr. Kravis on its board -- a move Mr. Schwartz hoped would silence Bear Stearns's critics.

Within two weeks, though, the talks would fall apart because each side had concerns. Among other things, Messrs. Schwartz and Cayne feared a deal might turn off Bear Stearns clients that competed with KKR.

While Bear Stearns's mortgage team fielded questions from KKR that Sunday, the firm's risk officers were meeting in the sixth-floor executive offices with staffers from the Securities and Exchange Commission. The regulators had traveled from Washington to make sure Bear Stearns had access to the day-to-day loans it needed to fund its trading operation. After scrutinizing the firm's $400 billion balance sheet well into the afternoon, the regulators agreed to reconvene with Bear Stearns managers for daily briefings until the market crisis passed.

Elsewhere in the building that afternoon, Bear Stearns's board was deliberating over Mr. Spector's resignation. Not everyone was convinced it was the right move -- including Mr. Schwartz, who had expressed his objections privately to Mr. Cayne. But Mr. Cayne was adamant.

The collapse of the hedge funds had exposed the then-73-year-old CEO to criticism inside and outside of the company for being disengaged and for brushing off warning signs. Early on, he seemed unconcerned. Mr. Cayne said the funds weren't Bear Stearns's money: It belonged to big institutions, wealthy individuals and lenders who all knew the risks going in. Soon, though, the lenders forced Bear Stearns to extend one of the portfolios $1.6 billion of its own money to keep it afloat.

A glib and gruff former scrap-iron salesman from Chicago with a penchant for cigars, golf and cards, Mr. Cayne had often taken off Thursday afternoons and Fridays that summer to play golf near his New Jersey vacation home. In mid-July, when the funds were melting down, both he and Mr. Spector had spent more than a week in Nashville, Tenn., competing in a bridge tournament. Mr. Cayne, who declined to be interviewed for this article, was said by people close to him to be particularly angry that Mr. Spector, who with his partners won the event, had been away from the office at such a sensitive time.

Bear Stearns's board -- 12 men largely handpicked by Mr. Cayne -- approved Mr. Spector's departure. Mr. Schwartz, a longtime investment banker more accustomed to rubbing shoulders with clients like Walt Disney Co.'s Robert Iger than to monitoring trades or capital levels, was named sole president.

Messrs. Spector and Schwartz had been promoted to co-presidents and co-chief operating officers in 2001. Mr. Cayne, the CEO, had leaned on them to keep their divisions running smoothly.

Now, Mr. Schwartz, a former star pitcher at Duke University, had to carry a heavier burden. At age 57, he had little experience in the bond and mortgage businesses that made up an outsized share of Bear Stearns's revenue. But he decided to manage the firm's capital-market division himself rather than hiring a replacement for Mr. Spector.

Mr. Schwartz moved to tighten oversight of the company's trading. He also began keeping daily tabs on the bond markets. Several times a week, he sat down with traders who had bet a lot of the firm's money, questioning them about strategy and results.

In the weeks after rejecting KKR's approach, Bear Stearns received other offers of capital. J. Christopher Flowers, a former Goldman Sachs Group Inc. partner, had met with some of Bear Stearns's senior managers about the possibility of taking a 20% stake. But the meeting left Bear Stearns's representatives concerned that Mr. Flowers simply was trying to gauge their desperation. The next day, they told the Flowers team they weren't interested.

Instead, Bear Stearns executives began working on what Messrs. Schwartz and Cayne saw as a more compelling option: a joint venture with Citic Securities Co. They reasoned a deal with the Chinese investment bank would bring in money and help increase Bear Stearns's miniscule presence in Asia. Smarting from criticism of his hands-off style, Mr. Cayne spent the Labor Day weekend on a whirlwind trip to Beijing to discuss terms with Citic executives.

Into early autumn, the mortgage market continued to slump. Housing prices had plunged, and most major financial firms were slashing the value they placed on holdings backed by home loans.

Bear Stearns -- with its immense stockpile of mortgages and related securities -- was particularly vulnerable. Despite months of price declines, those holdings were valued at about $56 billion -- a large portfolio for a firm its size. Still, SEC staffers -- who now were phoning in for weekly Wednesday-evening conference calls with the firm -- appeared comfortable. By Thanksgiving, some senior regulators were calling in less frequently.

'We've Got to Cut!'

['Ace' Greenberg argues to dump mortgage inventory.]

'Ace' Greenberg argues to dump mortgage inventory.

Inside Bear Stearns, though, skirmishes about its mortgage holdings at times grew heated. Some veteran traders insisted that Tom Marano, the head of mortgages, needed to trim his portfolio. Among them were Wendy de Monchaux, who as head of proprietary trading invested Bear Stearns's own money, and Steve Meyer, co-head of stock sales and trading.

"Cut the positions, and we'll live to play another day," Ms. de Monchaux said often, invoking one of the firm's venerable maxims. But Mr. Schwartz, still boning up on the details of the mortgage markets, urged caution.

For some of the assets, the market was frozen, Mr. Schwartz reasoned, so selling was out of the question. On others, he had mixed feelings. He didn't want to unload tens of billions of dollars worth of valuable mortgages and related bonds at distressed prices, creating steeper losses.

Mr. Schwartz believed the portfolio at least should be better protected from further price declines. Spearheaded by Mr. Marano, a bearded 46-year-old trader with a Grateful Dead tattoo on his right shoulder, the mortgage team unfurled a hedging strategy known as "the chaos trade."

The trade was a deeply pessimistic bet -- essentially a method for making money if the mortgage and financial markets cratered. The traders bet that the ABX, a family of indexes made up of securities backed by subprime mortgages, would fall. They made similar moves on indexes tracking securities backed by commercial mortgages. Finally, they placed a series of bets that the stocks of major financial companies with exposure to mortgages, including Wells Fargo & Co., Countrywide Financial Corp. and Washington Mutual Inc., would decrease in value as well.

Late in September, with Bear Stearns and other financial stocks rallying, members of the firm's executive and risk committees gathered in Mr. Cayne's smoky, dark and secluded sixth-floor offices to discuss the hedges. Negotiations for Allianz SE's Pacific Investment Management Co. to take a nonequity stake of as much as 10% in Bear Stearns had recently fallen apart. That cost the brokerage a chance for capital and a coveted endorsement of Bear Stearns's creditworthiness.

Mr. Cayne had just returned from the hospital where he'd been treated for an infection, and he looked thin and drawn. Mr. Greenberg, the firm's storied trader and former CEO, took center stage. As head of the risk committee, he had been reviewing the Wells Fargo and other negative stock bets. He wasn't happy. The financial-stock hedges were too risky, he warned, and should be closed out immediately. Moreover, he wanted the mortgage inventory slashed.

"We've got to cut!" Mr. Greenberg demanded. Ms. de Monchaux and Mr. Meyer concurred.

Oklahoma-bred and Missouri-educated, Mr. Greenberg was the embodiment of the "PSDs" -- poor, smart employees with a deep desire to get rich, upon whom the firm had been built. Mr. Greenberg, who ran the firm for 15 years before Mr. Cayne nudged him aside, was known on Wall Street for his voluminous memos, in the voice of a fictional character, urging traders on issues large ("it doesn't pay to get too arrogant") and small (save paper clips to cut costs).

But it was Mr. Greenberg's trading style that had most defined Bear Stearns: Sell losing trading positions -- quickly. Mr. Greenberg still recalled what his father, an Oklahoma City clothier, told him: "If something isn't moving, sell it today because tomorrow it will be worth less."

The hedges had made close to half a billion dollars and stood to make more as the stocks continued to fall. But since they had first employed the chaos trade, Mr. Marano and his team had been hectored almost daily by complaining phone calls from colleagues. Some of Bear Stearns's more superstitious traders even objected to the strategy's name: They were tempting fate by invoking chaos.

Faced with the fierce divide among his top executives, Mr. Schwartz, who was generally supportive of the chaos trade, decided to abandon it. He wanted specific pessimistic plays that would offset specific optimistic bets, rather than the broader hedges Mr. Marano had employed. Frustrated, Mr. Marano ordered the trades undone.

As October dawned, Messrs. Cayne and Schwartz had high hopes that a deal with Citic would bolster Bear Stearns's fortunes. On Oct. 22, Bear Stearns announced a joint venture in Asia that included a $1 billion cross-investment between the two companies. If regulators approved, Bear Stearns could count on getting $1 billion in the first half of 2008. But it would spend the same amount over a longer period for a complementary stake in Citic.

Investors weren't impressed. Bear Stearns shares rose meagerly but backtracked days later.

Over the next few weeks, Bear Stearns's competitors disclosed losses from bad mortgage-related bets. Merrill Lynch & Co. announced a loss amid write-downs of $8 billion; Morgan Stanley revealed losses of nearly $4 billion.

To outsiders, it was beginning to look as if Bear Stearns had navigated the crisis relatively deftly. Inside the firm, that view wasn't as prevalent. Its mortgage holdings were still hefty, and its bond business was reeling.

The firm continued to explore ways to raise money, hiring investment banker Gary Parr of Lazard Ltd. to try to bolster the firm's prime-brokerage business, which handled trading and lending to hedge funds and other big clients. Mr. Schwartz had also discussed a merger with hedge fund Fortress Investment Group.

Neither effort would bear fruit.

Time to Move On

[Alan Schwartz tells James Cayne he needs to step down as CEO.]

Alan Schwartz tells James Cayne he needs to step down as CEO.

In late November and early December, tension mounted as Bear Stearns executives contemplated a bonus pool down significantly from a year earlier. Executives in the stock division blamed their counterparts in bonds.

"Why should we pay those guys anything?" Mr. Meyer, the stock sales and trading executive, at one point demanded in a compensation meeting.

Things only got testier when Bear Stearns announced abysmal fourth-quarter results on Dec. 20. Dragged down by a drop in the value of its mortgage inventory, the company reported its first quarterly deficit since it opened for business in 1923. The bond division, always the firm's cash cow, had a loss of $1.5 billion for the quarter.

At lunchtime the next day, as employees prepared for the holidays, Bear Stearns received bleak news. An email from Pimco, the influential bond fund, said it had become uneasy about the financial sector in general. And the fund wanted to immediately unwind several billion dollars of trades it had agreed to with Bear Stearns.

"This doesn't make any sense," Jim Egan, Bear Stearns's co-head of global sales, said in a hastily arranged conference call with William De Leon, a Pimco risk manager, and William Powers, a Bear Stearns alumnus and Pimco managing director. How could a snap decision throw cold water on such a longstanding relationship with such little warning? If Pimco planned to take such drastic action, Mr. Egan and his colleagues added, the decision should be made "corner office to corner office."

Messrs. De Leon and Powers ultimately agreed to hold off on dramatic moves until January, when they'd have a chance to sit down with senior Bear Stearns executives. But before hanging up, Mr. Powers issued a stern, if familiar, warning: "You need to raise equity," he said.

Many Bear Stearns veterans began pushing hard for Mr. Cayne's ouster, arguing the firm needed a more engaged leader. The dissatisfaction had been building since the summer. It grew after a Nov. 1 story in The Wall Street Journal documenting Mr. Cayne's frequent absences from the office for golf and bridge during the worst of the summer's hedge-fund crisis. The article also mentioned that Mr. Cayne had used marijuana in the past. He told employees in an email the same day that he hadn't "engaged in inappropriate conduct."

Mr. Schwartz was reluctant to push Mr. Cayne out. He had led the company through some great years, Mr. Schwartz believed, and could be trusted to step down on his own.

"Stand calm," he told the protesters. "We've got it under control."

Several top managers began joking that they should hold a sit-in in Mr. Schwartz's 42nd-floor office until he agreed to unseat Mr. Cayne as CEO.

Investors were growing impatient, too. Bear Stearns's fourth-largest shareholder -- Bruce Sherman, chief executive of money manager Private Capital Management Inc. -- was agitating for a change at the top.

Shortly after the New Year, Mr. Schwartz stopped by Mr. Cayne's office. The pressure inside and outside of the firm for his departure had become too great, he told his boss. It was time to move on.

Write to Kate Kelly at kate.kelly@wsj.com1

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