Sunday, 27 January 2008 12:30

Is this the Breaking of the Bear? Featured

How we got started

Anybody who follows my blog knows that I am extremely bearish on the global macro environment, particularly risky and financial assets. As I see it, the Doctor(s) FrankenFinance are constantly percolating econo-alchemical brews such as that of the ongoing “Great Macro Experiment,” eliciting undulating waves of joy and elation from amateur speculators such as myself while simultaneously creating risk/reward traps that many a financial and real asset concern may never escape from. While discussing with my team how best to move forward to find a target of our “Macro Experiment” victim analysis in the financial sector, I was queried as to what to look for in creating the short list. Evaluating investment banks, like evaluating the monolines, is not necessarily a straightforward endeavor. No matter how you do it, someone is going to disagree. This is what makes what I do so appealing. All I have to answer to is performance. I just need a profitable result in order to be successful. No corporate politics or conflicts of interests to get in my way. In the end, absolute return is the ultimate criteria, and not whether it is accepted by the ivy league or academia, industry practitioners, sponsors, clients or whether or not XZY bank has been doing it differently for the last 25 years. Investing for your own account enforces a certain code of realism that, at times, may not be shared by others. So, I used that realism as my strength and my focal point to guide the creation of a short list, the ultimate target, and the valuation/risk analysis methodology. I simply said, in the REAL world where I would have to make some money from some REAL assets,throwing off REAL cash flows and REAL market transactions? Using this “Reggie REALity Engine” (so to speak) to power the analysis proved very enlightening. We found banks that counted spread guesstimates as assets. We found banks that could not afford to keep their best employees. We found too many banks that faced insolvency in the very near future. We found a lot. To keep this story short, let’s just say we used the engine to find that truth that nobody really wants to hear. That truth as marked to reality. This resulted in a short list of 2 firms. The first one is Bear Stearns, which we will delve into here. The second one is what I call, “The Riskiest Bank on the Street”, and the blog post and analysis will be out in a few days. Using a Sherlock Holmes style of forensic analysis, we have tried very hard not to leave anything out of our scope of analysis. In the case of Bear Stearns, it was not easy since very little info was available outside of the plain vanilla 10Q, 10K, etc. They also volunteered very little information. Much of this is investigative analysis and it would be much more detailed if we had access to the Bear Stearns inventory. We wrote to Bear Stearns’ investor relations department asking for more information on the company’s exposure to risky assets and their breakup. So far, no word back. No need to be concerned for my health, I’m not holding our breath…

Alas, as I stated earlier, it is that truth that no one wants to hear. So if you are one of those "no ones" that don't want to hear the truth, cover your ears, cause here we go...

Bear Stearns is in Real trouble

Bear Stearns will soon be, if not already, in a fight for its life. It is beset with the possibility of a criminal indictment (no Wall Street firm has ever survived a criminal indictment), additional civil litigation, and client defection and alienation. Despite all of these, the biggest issues don't seem all that prevalent in the media though. Bear Stearns is in a real financial bind due to the assets that it specialized in, and it is not in it by itself, either. For some reason, the Street consistently underestimates the severity of this real estate crash. If you look throughout it appears as if I have an outstanding track record. I would love to take the credit as superior intelligence, but the reality of the matter is that I just respect the severity of the current housing downturn - something that it appears many analysts, pundits, speculators, and investors have yet to do with aplomb. With a primary value driver linked to the biggest drag on the US economy for the last century or so, Bear Stearn's excessive reliance on highly "modeled" and real asset/mortgage backed products in its portfolio may potentially be its undoing. This is exacerbated significantly by leverage, lack of transparency, and products that are relatively illiquid, even when the mortgage days were good.

The last year at the Bear hasn’t been a good one – a quick recap

Bear Stearns Companies Inc (BSC) has been at the forefront of the ongoing subprime mortgage crisis and has been considered the main trigger for the credit turmoil with the failure of its two hedge funds in July 2007. These failures marked the beginning of credit turmoil and severely tarnished the company’s reputation. Bear Stearns also has significant exposure toward the troublesome mortgage securities as compared to its peers in terms of the equity of the company. Bear Stearns specialized in mortgage related securities, at a time when real estate (both residential and commercial) and real estate related credit, experienced a severe bursting of a prolonged and historically unprecedented bubble. If historical mean values are any indication of future trends, we are just in the very beginning of a very steep correction in both residential and commercial real estate values. This bodes quite ill for the Bear.

Bear Stearns has a Level 3 assets (see Banks, Brokers, & Bullsh1+ part 1 ) worth $27 billion, investments in SIVs of $41 billion, and off balance sheet SIVs of $21.3 billion. Furthermore, Bear Stearns has counterparty credit exposure (Banks, Brokers, & Bullsh1+ part 2 ) towards Ambac which recently was downgraded from AAA to AA by Fitch Rating Agency. I have written extensively on Ambac – material that was quite controversial, and in hindsight highly prescient. I feel I have a handle on this company's situation, and it is not as positive as management and investors would make it out to (see Ambac is Effectively Insolvent & Will See More than $8 Billion of Losses with Just a $2.26 Billion of Equity, Follow up to the Ambac Analysis, Monolines swoon, CDOs go boom & I really wonder why the ratings agencies are given any credibility, Ambac Management Should Read Blogs More Often, Ambac Now Has a Municipal Bond Issue to Worry About - I'm not going to say I told you so! , and Download a "Window" into Ambac's Problems). Faltering counterparties have further aggravated the company's credit position. Bear Stearns' 5 year CDS spread is also widening significantly, following concerns that the company will need to take additional write down on assets in the coming quarters. The deteriorating US credit situation has negatively impacted almost all the banks and brokers alike with $133 billion of asset write downs to date, with two of the biggest names in the industry, Citigroup and Merrill Lynch, leading the pack. We believe the amount of write downs taken by Bear Stearns as compared to other big investment banks seems insufficient. Moreover, the selling of stakes by some of the top executives at Bear Stearns validates the trouble at the company is far from over and is likely to get worse.

Back to the Basics: The Customer is Always Right

Bear Stearns’ most visible problem is probably its most basic as well. It has alienated its customer. With ex-clients lined up in court trying to reclaim their money from what was once their trusted advisor, to clients cooperating with the government in pursuing a federal indictment (no Wall Street firm has ever survived a criminal indictment), it is apparent the main source of revenue (the customer) is a tad bit disenfranchised with the Bear. This is a short and simple point, but it is probably the most poignant and underappreciated as well.

Money Making Talent Caught in a Bear Hug: Show Me the Money?

Would Bear Stearns be able to entice me for a gig (that is, assuming I am a hot commodity and I knew what I was doing with this finance and investment stuff)? Probably not, and this is how many worth their mettle will feel given the Bear’s current situation.

One of the key points that we have observed in the case of Bear Stearns is that compensation expense as a percentage of revenues has increased to 57.1% in 2007 compared to 47.1% in 2006. This was despite the compensation expenses coming down to $326 million in Q407 from $664 million in Q307 and $1,052 million in Q406. In addition, the executive committee has decided that they will receive no compensation this year (last year they made $156 million, or 3.6% of total compensation expense).

Now, if I compare this to some of Bear’s key competitors, the average increase for other investment banks’ compensation expense is in the range of 20-21% with Lehman Bros. giving a 10% increase, Goldman Sachs 23% and Morgan Stanley increasing the compensation expenses by 19%. In this scenario, it is likely to be extremely difficult for Bear to attract, and more importantly retain, people who will be able to make real money (and in the past have made real money) for them. This is a point that can’t be overemphasized. Intellectual capital service organizations, such as investment banks and consulting firms, have only their as a primary, yet highly competitive resource, with financial capital being a commodity that is normally (although not the case recently) relatively easy to come by. Without competitive human capital, any services entity, be it an investment bank, investment fund or consulting firm is doomed to failure. Wall Street has created an environment where human capital is simply paid for, it flocks to the highest bidder with the highest cache in terms of stature and potential for future payout. Currently, in my opinion, Goldman Sachs takes this pole position here (although we feel they have some skeletons sporting big bones in their closet), with Bear Stearns at the rear in terms of major US investment banks. Without adequate financial capital to bid for and retain the human capital necessary to compete, Bear Stearns will find itself in a downward spiral that is self-reinforcing – the worse its performance, the harder it will be to attract and retain money makers, hence degrading its performance relative to its peers.{mospagebreak}

Insider Trading

The company's top employees sold stocks worth over $20 million in December 2007 alone. In fact, before resigning recently, Bear Stearns Chief Executive James Cayne sold $15.4 million of stock in December 2007. Cayne exercised and sold 172,621 shares of stock vested under a capital accumulation plan according to a filing with the SEC. However, Cayne still owns 5.6 million shares, or about 5% of the company.

In addition, in a Form 4 filed with the SEC, Bear Stearn’s President, Alan Schwartz reported he exercised options December 21, 2007 at no cost as part of a compensation plan and sold 67,900 shares the same day for $89.01 apiece. Further, An Executive Vice President exercised options for 102,408 shares of common stock according to a SEC filing. The bank’s Treasurer exercised options for and sold 25,927 shares of common stock in the same month.

Despite these negative developments, Bear Stearns has managed to find investors. British financier Joseph Lewis owns 9.6% of Bear Stearns. He has acquired nearly 2 million more shares. In September 2007, Mr. Lewis had become the single-biggest investor in Bear Stearns, acquiring shares soon after two Bear hedge funds collapsed because of bad bets on securities backed by mortgages. He spent some $860 million to buy 7% of the company when the stock was trading at more than $100 a share. However, with the stock's fall, Mr. Lewis has a paper loss of well into, if not over the $100 to $185 million range (depending on the effectiveness of his hedging, he owns at least 706k puts on BSC stock). The latest SEC filing said Mr. Lewis has spent about $1.19 billion to buy Bear shares, spending an average $107.31 each. Also, in October 2007, Bear Stearns and Beijing investment bank CITIC Securities Co. agreed to invest about $1 billion each for minority stakes in one another. The companies agreed that CITIC's resultant ownership in Bear Stearns can be expanded to as much as 9.9%, and Bear's combination of convertible-securities holdings and five-year options in CITIC could, over time, amount to about 7% of the Chinese investment bank. These investors obviously have an outlook on the bank that is contrary to mine, and would obviously be on the opposing side of any trades that took place.

December is the window for executive option exercise (known as the CAP plan), in which management has a history of selling stock which immediately vests. This would explain the raft of selling activity. This does not explain the dearth of buying activity though, particularly since the stock is at such an extremely low price, historically. If anything, management/insiders should be recording net purchases, not net sales. That is, unless they don’t have confidence in the stock. This latter view is complemented and bolstered by a more forensic view of insider transactions…

Director Selling On Weakness/5% Owner Buying: A director of Bear Stearns (BSC) who was an aggressive buyer of stock in the spring of 2007 sold more than a quarter of his holdings at a steep loss as the year came to an end (most likely attempting to take advantage of the tax loss, but also showing little confidence in the potential for gain in the stock - particularly considering these are short term gains and losses. In the meantime, a British billionaire has increased his stake in the $9.9B market cap financial service firm, purchasing stock recently at a high premium through options transactions, and accepting a paper loss of up to $185 million. ·Director Paul "Tony" Novelly sold 50K shares at $86.78 on December 28th, decreasing his holdings to 125K shares. Novelly's holdings are controlled by St. Albans Global Management, a hedge fund set up to handle his investments, and he holds an additional 3.5K shares of restricted stock, which were awarded for board service. The sale by Novelly, a director of BSC since 2002, represents a drastic reversal of sentiment for him. In March 2007, he purchased 50K shares at an average price of $148.32, buying as the stock began to retreat from an all-time high. From January 2006 to March 2007 (including the aforementioned buys), Novelly purchased 106.4K shares at an average price of $129.78, investing more than $14.6M. Novelly also purchased 35.7K shares at an average price of $84.04 from March 2004 to May 2005, investing a little more than $3.5M. Novelly is the chairman and chief executive officer of privately held, Missouri-based Apex Oil Company, Inc., which engages in wholesale sales, storage, and distribution of petroleum products including asphalt, kerosene, fuel oil, diesel fuel, heavy oil, gasoline, and marine bunkers. He also serves on the board of Boss Holdings Inc. (BSHI), a micro-cap maker of work gloves, rain gear, pet care products, and balloons. · Joseph Lewis disclosed on December 26th that he now owns 11.05M shares of BSC, or a 9.57% stake, up from 9.253M shares, or an 8.01% stake, disclosed on December 7th, and up from 8.1M shares, or a 6.97% stake, disclosed on September 10th. Lewis has paid more than $1.186B, or about $107.31 per share to build his stake and become BSC's largest shareholder. A series of options transactions saw Lewis paying upwards of $110.00 per share for BSC on December 21st, when the stock traded in a range of $87.63 to $92.31. As a result of his buying, Lewis is now BSC's largest shareholder, moving past Putnam Investment Management and Private Capital Management, which own stakes of 6.05% and 6.0% respectively. Chairman & Chief Executive Officer James Cayne owns a 5.82% stake. In his Schedule 13D filing, Lewis said he acquired shares of BSC for "investment purposes." He also disclosed that Aquarian has additional long exposure to 791.5K shares via call options and additional short exposure to 706.5K shares via put options.

Insider Transaction Analysis for the Past Year

Book Value, Schmook Value – How Marking to Market Will Break the Bear’s Back

Okay, I’ll admit it. I watch CNBC. Now that I am out of the confessional, I can say that when I do watch it I hear a lot of perma-bulls stating that this and that stock is cheap because it is trading at or below its book value. They then go on to quote the historical significance of this event, yada, yada, yada. This is then picked up by a bunch of other individual investors, media pundits and other “professionals,” and it appears that rampant buying ensues. I don’t know how much of it is momentum trading versus actual investors really believing they are buying on the fundamentals, but the buying pressure is certainly there. They then lose their money as the stock they thought was cheap, actually gets a lot cheaper, bringing their investment down the crapper with it. What happened in this scenario? These investors bought accounting numbers instead of true economic book value. Anything outside of simple widget manufacturers are bound to have some twists and turns to ascertain actual book value, actual marketable book value that is. This is what the investor is interested in, the ECONOMIC market value of book, not what the accounting ledger says. After all, you are paying economic dollars to buy this book value in the market, so you want to be able to ascertain marketable book value, I hope it sounds simplistic, because the premise behind it is quite simple – How much is this stuff really worth?. The implementation may be a different matter, though. I set out to ascertain the true book value of Bear Stearns, and the following is the path that I took.

Increasing foreclosures, declining housing prices having an impact on the marking of ABS & MBS Inventories

Bear Stearns $46 billion of MBS and ABS securities portfolio includes 5.5% ($2.55 billion) of the subprime mortgage related securities as of November 2007. Five hundred million of the $2.55 billion subprime exposure is of the vintage year 2007, which is most likely to be negatively impacted by the credit turmoil. The defaults witnessed in the vintage years of 2006 and 2007 assets have been highest, consequently these assets are likely to be further written down. Bear Stearns has $1.1 billion of Investment Grade (IG) subprime securities and $200 million of Below Investment Grade (BIG) securities. Bear Stearns also has $750 million of ABS CDO exposure, the structured finance products that has been the bane of the recent credit turmoil. As of December 20, 2007, Bear Stearns MBS & ABS related securities declined to $43.6 billion of which $15 billion consist of CMBS portfolio.

Losses Base Case Optimistic Case Worst Case
Subprime mortgage loans 0.13 0.08 0.25
IG subprime securities 0.11 0.06 0.28
BIG subprime securities 0.10 0.05 0.15
ABS CDO 0.38 0.19 0.56
Total Losses 0.71 0.37 1.24

The slow down in the housing and commercial real estate markets owing to slump in the demand has exerted pressure on the valuations of the ABS/RMBS and CMBS portfolio. In addition, the sharp correction in housing prices witnessed across almost all the states in the US is further worsening the situation. Rising inventories of housing attributable to rise in foreclosure activity, REO sales, existing homeowner sales, and new inventory from homebuilders will further put pressure on the values of this portfolio. In the last one year, housing prices have declined at an average of almost 7%, while the foreclosed housing inventories have risen by almost at an average of 20% in the US . The continued weakness in the US housing market will further worsen the situation as the demand for such papers continue to wither away.

Nationally, for the past several weeks, inventory has increased by 1.56% and median pricing has decreased by 7.6%. The graphs below show the liklihood of this trend not only extending for some time, but deepening as well.

Affordability is at an all time low, with many areas totally out of the conforming loan limit guidelines considering JUST THE MORTGAGE...

Percent Income: The percentage of the local median family income required to make payments on the mortgage for a median (sale) priced single family home given a 20% down payment and a 30-year fixed rate loan at prevailing rates.


Prices have significantly outstripped rents...


Lenders are showing increasing defaults...


REOs are at record levels... Index spread from 100 as of 4/6/2007, source:


Residential Price Movement Expectations are decidedly and sharply downward

Shiller housing forecast

As noted in the precursor to this article, BSC’s exposure to RMBS will cause it to sustain at least several quarters of underperformance, as the real asset devaluation will most likely last for years. The chart above show the extent of the most recent real asset bubble, and how far prices have to correct to come anywhere near mean historical values. Even at this point in the bubble burst, we are at twice the level left over by the US Gold Rush!

Commercial price movement expectations fare no better

Commericial Rents

Their exposure to CMBS will not fare much better, with the spread between in place retail/office commercial rents and renewal rents already negative, yet still considerably above the rate of average leases expired in ’06. This spread will revert to mean and narrow, causing pain to some market participants and CMBS holders.

The aforementioned macro factors have manifested themselves in the first of many net negative declines in revenues and profits for Bear Stearns. As mentioned earlier, we are in the beginning stages of this real asset bursting of the bubble.


Level 2 and Level 3 Assets – Model Risk

Model risk, or the risk of the bank living in a spreadsheet in lieu of the market, has already reared its head in the summer of ’07 with the blow up of two of BSC’s hedge funds, which have left them in litigation with their own customers. Basically, many of the assets of the fund were levered highly, and valued based upon modeled cash flows from assets, and not from the actual tradable value of the assets. This is fine, until you need to liquidate by selling assets. As luck would have it, they found no market they felt was acceptable and were forced to market value down significantly, approaching zero. It has also manifested itself more recently in the recent announcement that they will be moving at least 7 billion dollars to the level three (the most BullSh1+) category. Bear Stearns has recently announced another hedge fund blow up, which doledout significant losses to investors and is attempting liquidation. For my laymen’s plain English take on level 1, 2, and 3 asset accounting, see the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk,).

Level 3 Assets at 231% of Total Equity; Amongst the Highest on Wall Street

Among the top investment banks, Bear Stearns has one of the highest exposures to the riskier class of assets. The company’s exposure to Level 3 assets further increased by $7 billion to $27 billlion as of 30 November 2007, representing almost 229% of its equity, as compared to 70% for Merrill Lynch for the same period. Bear Stearns also has a $43.6 billion of MBS & ABS inventories of which $15 billion is in the CMBS portfolio. In addition, Bear Stearns is exposed to riskier assets through its arrangements with Special Purpose Investment Vehicles (SIVs) having assets totaling $41 billion, of which $37 billion comprises Mortgage Securitizations.

Considering the assets which makeup the Level 2 and Level 3 assets such as distressed debt, non performing mortgage related assets, MBS, Chapter 13 and credit card receivable which are likely to decline in value, our default probability ranges from 2% to 20% in the base and worst case scenarios. Moreover, considering the addition of $7 billion from level 2 to level 3 assets in 4Q 07, we have conservatively assumed a base case default probability of 2% on the Level 2 assets.

Base Case Default Assumptions Losses (US$ bn)
Level 2 2.0% 1.8
Level 3 10.0% 2.0
Total   3.9
Optimistic case Default Assumptions Losses (US$ bn)
Level 2 1.0% 0.9
Level 3 5.0% 1.0
Total   1.9
Worst case Default Assumptions Losses (US$ bn)
Level 2 4.0% 3.6
Level 3 20.0% 4.1
Total   7.7
Bear Sterns Companies Inc          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Balance as of August 31 '07
Financial instruments owned, at fair value        
Non-Derivative trading inventory 26.8 85.7 14.6 - 127.2
Derivative trading inventory 2.2 101.3 2.0 (90.9) 14.7
Total FI owned at fair value 29.1 187.1 16.6 (90.9) 141.9
Other Assets 0.7 0.9 3.7   5.3
Total Assets at fair value 29.8 188.0 20.3 (90.9) 147.2
As of November 30,2007          
In $ Billion Level 1 Level 2 Level 3 Impact of netting Total
Total Assets at fair value 29.8 181.0 27.3 (90.9) 147.2
Included in level 3 category are distressed debt, non-performing mortgage-related assets, certain mortgage-backed securities and residual interests, Chapter 13 and other credit card receivables from individuals, and complex and exotic derivative structures including long-dated equity derivatives.  

The company quoted in its 4Q 07 conference call "While we haven’t completed the review for the 10-K disclosure, it is anticipated that the amount of Level 3 assets will increase by approximately $7B when compared to August 31 amounts"{mospagebreak}

Unique method of hiding risk: Special Purpose Investment Vehicles (SIVs) and other things of Myth and Mysticism

The regular readers of realize that in many financial and/or real asset companies, if you dig past the regularly perused and published financial documents and bother to really look under the hood, you are bound to find things that really contradict what the income statements and balance sheets convey. One of the most glaring examples of this is our forensic analysis of the Lennar, the nation’s largest home builder. As luck had it, they actually forgot to put about 40% of their recourse debt in their financial documents and had it sitting in Joint Ventures, formed as special purpose vehicles off balance sheet. No need to fret, though. We tapped them on the shoulder and reminded them of the few billion dollars of liability that they misplaced, ala Enron from the 90’s.

This funny money style of bookkeeping is known as > - Any form of accounting that does not follow principles of conservatism. While there are many methods by which financial statements can be fudged, it always comes down to inflating revenue or hiding expenses. Any method that boosts profitability through accounting tricks eventually catches up with the company. As soon as it does "poof", past profits disappear like magic (hence the name "voodoo accounting").

In the investment banking industry, Voodoo magic take the form of VIEs, variable interest entities. For those who actually have a life and don’t spend all of their time reading the fine print of SEC and GAAP reports, VIEs are special purpose (single purpose shell) companies that have one or both of the following characteristics:

1.The equity investment at risk is not sufficient to permit the entity to finance its activities without additional subordinated financial support from other parties, which is provided through other interests that will absorb some or all of the expected losses of the entity.

2.The equity investors lack one or more of the following essential characteristics of a controlling financial interest:

a.The direct or indirect ability to make decisions about the entity's activities through voting rights or similar rights

b.The obligation to absorb the expected losses of the entity if they occur, which makes it possible for the entity to finance its activities

c.The right to receive the expected residual returns of the entity if they occur, which is the compensation for the risk of absorbing the expected losses.

So, if I may take license to grossly oversimplify this subject, this is what the I-banks use to put assets and liabilities off the books, thus giving the appearance of a higher ROI/ROA (since the ”I” [investment] and the “A” [assets] are not readily discernable on the books (at least for a simple man such as myself), but the “R” [return] is). Now, if you glance at the VIE chart below, you can see that the VIE assets are not exactly Treasury Bills and cash equivalents:

·Energy assets – can get pretty esoteric and are definitely not straightforward to value and trade,

·CDO’s/CLO’s – these have been in the popular media enough where I don’t need to explain,

·distressed debt – risk aversion has caused spreads to widen significantly (actually, they’re just reverting back to mean) leaving those who bought on narrow spreads holding the bag,

·and mortgage securities – need I say more...


This stuff is:

1.Illiquid and hard to trade;

2.Not very transparent price wise and subject to EXTREME model risk, and;

3.Three out of four of the bullet list are considered toxic sludge by today’s market, which is trending down in liquidity and up in risk aversion.

Far be it for me to proclaim myself the grand arbiter of all things fair and equal, but it damn sure seems like cheating to me if a company is allowed to stuff these things away off balance sheet. Since everyone doesn’t read my blog, and most other people have a life, how in the world would the average retail or even professional investor know that these exist, where to look for them, how to value them, and how to adjust for and quantify risk. The company definitely wasn’t very forthcoming. I will send them a copy of this blog post and ask for further clarification.

In my Voodoo piece on Lennar as well as the very definition of Voodoo accounting itself, it is made it clear that shenanigans like this often come back to haunt the companies that play them, ala Enron. Well, investment banks are no exception. The value of the assets in the Bear Stearns VIEs have decreased by 18%, but the maximum exposure to risk from these entities has actually increased by 16.5%. The increase is in both absolute terms and in proportion to the VIE assets. Uh, Oh!!! I shouldn’t have to remind my astute readers that, CNBC perma-bulls aside, the macro environment that spawned that 18% loss in the VIEs is not only still here but getting significantly worse, and on a global scale. Simply glance at the residential and commercial graphs above, or the global risk asset sell offs of the recent weeks as a reminder.

Bear Stearns also owns significant variable interests in several VIEs related to CDOs & CLOs for which the company is not the primary beneficiary and therefore does not consolidate these entities into its books. In aggregate, these VIEs had assets of approximately $21.3 billion and $14.8 billion as of August 31, 2007 and November 30, 2006, respectively. On August 31, 2007 Bear Stearns estimated maximum exposure to loss from these entities to approximately $194.0 million.


Counterparty Risk

In $ million   OTC Derivative credit exposure ($ million)      
The table summarizes the counterparty credit quality of the company's exposure with respect to OTC derivatives  
Rating(2) Exposure Collateral (3) Exposure, Net of Collateral (4) Percentage of Exposure, Net of Collateral Total exposure a % of Total assets Net exposure as a % of Total assets Net exposure as a % of equity
AAA 3,369 56 3,333 42% 0.8% 0.8% 25.6%
AA 6,981 4,939 2,153 27% 1.8% 0.5% 16.6%
A 3,869 2,230 1,784 23% 1.0% 0.4% 13.7%
BBB 354 239 203 3% 0.1% 0.1% 1.6%
BB and lower 1,571 3,162 322 4% 0.4% 0.1% 2.5%
Non-rated 152 223 94 1% 0.0% 0.0% 0.7%
  16,296 10,849 7,889 100% 4.1% 2.0% 60.7%
(1) Excluded are covered transactions structured to ensure that the market values of collateral will at all times equal or exceed the
related exposures. The net exposure for these transactions will, under all circumstances, be zero.    
(2) Internal counterparty credit ratings, as assigned by the Company’s Credit Department, converted to rating agency equivalents. (3) Includes foreign exchange and forward-settling mortgage transactions) as of August 31, 2007

Quantifying Counterparty Credit Risk

After incorporating the exposure to Level 2 and Level 3 assets (see Banks, Brokers and Bullsh1+ part one for model risk and part two for counterparty risk, both a direct tie-in here) and taking into consideration all other off balance sheet items that the bank has, as well as marking for counterparty risk, we are getting a weighted average fair price… Wait, I’m getting ahead of myself. Let’s run through the assumptions, findings and relative risk marks that are necessary in quantifying the increasingly dangerous level of counterparty risk prevalent in Bear Stearns business, particularly considering today's macro environment.. We have performed a forensic sensitivity analysis of the $46 billion of MBS and ABS inventory, $7.8 billion of counterparty credit exposure and $181 billion and $27 billion of level 2 and level 3 assets. Some of these securities have been effectively downgraded, and others leave BSC holding the bag with either actual counterparty default (whether technically declared or not) or the significant possibility, therein. Two examples counterparty risks marked to reality are ACA, who is very close to being placed into receivership (and very well be by the time you read this), and Ambac Financial, who just lost their faux AAA credit rating from Fitch Rating Services, thereby devaluing all insured instruments below AA negative ratings watch. Even before the technical loss of the rating, we factored in a significant devaluation here due to the extensive research we performed in this area. Whether or not Fitch nominally lifted the AAA designation, we knew Ambac was far from a AAA risk and would be foolish and inaccurate to value BSC inventory as if it were. BSC has $2.2 billion of exposure to Ambac, of which $1.6 billion is directly affected by a downgrade and devaluation due to the loss of their AAA credit rating (all insureds below AA neg. watch are affected). On January 8, 2008, Moody's Investors Service downgraded the ratings of 46 tranches issued by Bear Stearns in 2006 and placed under review for possible downgrade the ratings of 11 tranches from eight Alt-A deals issued by Bear Stearns in 2007. The ratings of 24 tranches were downgraded to junk status, while 13 others had their ratings lowered but remained above junk status. In addition, the nine tranches already considered as junk status were cut further. Moody's said it took its action based on higher-than-anticipated rates of delinquency, foreclosure and banks owning real estate relative to credit-enhancement levels. This is directly related to the work that we did with Ambac and MBIA (see Insurers and Insurance), for Ambac insures quite a few of these tranches and we find the leverage and exposure for Ambac to be a disaster waiting to happen. There is also a direct connection to the model risk (of which Bear Stearns has significant amounts) and counterparty credit risk that was loosely described in the Banks, Brokers and Bullsh|+series (Banks, Brokers, & Bullsh1+ part 1 for model risk, and Banks, Brokers, & Bullsh1+ part 2 for credit risk).

The company in its previous quarter’s earnings call also mentioned that it has considerable investment in the troubled bond insurer ACA Capital Holdings. ACA Capital’s bond insurance unit has been under consideration to be taken over by the Maryland insurance administration owing to the troubles faced by the bond insurer. The company was recently downgraded to junk territory by S&P, resulting in a cash shortage for the company. ACA recorded a $1.04 billion loss in third quarter owing to recent turmoil in the credit market. A substantial exposure to collateralized credit obligations with a significant amount of asset-backed or mortgage-related debt obligations contributed to the company's third quarter loss. The relationship between the types of assets Bear Stearns holds in its inventory, the current default rates, the litigious liability exposure, the precarious situation of the mononlines (actually, the multi-lines, since the only ones that are in trouble are the ones that strayed from their knitting) and where my research says the underlying must move price wise to achieve equilibrium, just may cause Bear Stearns to enter into a spiral where no amount of PRUDENT capital may be able to rescue it. Bear Stearns has a lot of fine businesses, but they are tied through the parent company with businesses that are headed for a death spiral. For more on my findings of how the flaws of this monoline turned mult-line business model will reverberate throughout Wall Street and Main Street, start with A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton, then follow the articles in Insurers and Insurance).

More on Credit Exposure

Default assumptions  
Base Case  
AAA 5%
AA 7.5%
A 10%
BBB 15%
BB and lower 20%
Non-rated 25%
Assumed protection on defaults 19%
Base case  
AAA 0.14
AA 0.13
A 0.14
BBB 0.02
BB and lower 0.05
Non-rated 0.02
Total 0.51
In $ billion  
Total Base case losses 0.51
Total optimistic case losses 0.19
Total worst case losses 0.97

-To analyze the counterparty credit exposure of $7.8 billion (net of collateral), we have initially assumed a default protection of 25%. After the recent events involving ACA, whom BSC has significant exposure, and Ambac financial, who insured several $2.2 of BSC deals from BIG up to AAA ratings and effectively caused the downgrade devaluation of $1.6 billion of AA neg. watch and lower securities over the weekend; we reduced the assumed effective default protection to 19%, since (and as) we predicted in our Bank, Brokers, and Bullsh1+ series (part II), BSC and the Wall Street banks in general, will have significant counterparty credit issues over the next 8 to 12 fiscal quarters. In the base case, the default rates range 5% to 25%, and in the optimistic scenario 0% to 20%, and in the worst case scenario, 10% to 35%. For more, see our work on Ambac and MBIA.

-On the exposure to the level 2 and level 3 assets of $181 billion and $27 billion, we have we have assumed a recovery rate of 50% on level 2 assets and 25% recovery rate on level 3 assets. Again, we have been very realistic in assigning the default rates on these asset categories: under level 2 assets the default rates range from 1% to 4%, while in the level 3 assets, which are more troublesome, it ranges from 5% to 20%.

The high volatility of the public markets combined with the low transparency, minimal liquidity, and questionable solvency of the participants in the OTC markets make a dangerous brew for companies such as the highly leveraged and exposed Bear Stearns. Note: worst case and optimistic case scenario charts are not included due the space and formatting limitations of the Blog format, see pdf download for full scenario analysis.

Counterparty credit exposure towards Ambac a serious concern

Bear Stearns counterparty credit exposure is also an area wherein the failures can seriously have serious incremental impact. The company has a net of collateral exposure of $7.8 billion of which approximately 8% are BBB rated and lower. The company’s bonds are also exposed to the counterparty credit risk as the bonds are guaranteed by the troubled bond insurers such as Ambac, MBIA and ACA capital. Credit Default Swaps (CDS) attached to banks and securities brokerage firms increased amid concerns that losses from subprime mortgage delinquencies will worsen if bond insurers, which have guaranteed securities held by banks and brokers, lose their AAA ratings. On January 18 2007, Ambac was downgraded from its top AAA grade by Fitch Ratings after it dropped its plans to raise new equity. Moody's Investors Service and Standard & Poor's are also reviewing the bond insurers, throwing doubt on the ratings of the $2.4 trillion of debt guaranteed by them. The ratings downgrade will further expose Bear Stearns’ counterparty risk. Bear Stearns’s has an exposure towards Ambac of $2.2 billion, of which $1.62 billion is directly downgraded as a result of Ambac's downgrade.

In our analysis of the counterparty credit risk, we have assumed a 75% probability of further downgrade and 22.5% probability for the portfolio insured by Ambac as there is likelihood of future downgrade of ratings and default. For the remaining counterparty exposure, we have assumed our default probabilities on the basis of ratings. In our base case, we have assumed our default probability in the range of 5% to 25%, in optimistic case – 0% to 20%, and in our worst case scenario – 10% to 35%. Consequently, we believe Bear Stearns is exposed to potential losses of $1.96 billion in our base case scenario owing to the failure of counterparties honoring thier contractual obligations.

Portfolio exposed towards Ambac is $2.2 billion

Bear Stearns portfolio insured by Ambac Ratings
Issuer Net Par Exposure ($ mn) A AAA BIG Grand Total
The Bear Stearns Companies Inc. $88   $88   $88
  $104   $104   $104
  $117   $117   $117
  $125   $125   $125
  $136 $136     $136
  $140     $140 $140
  $144     $144 $144
  $151     $151 $151
  $171   $171   $171
  $202     $202 $202
  $245 $245     $245
  $261 $261     $261
  $337 $337     $337
Total $2,220 $978 $605 $638 $2,220


Increased risk perception reflected from the widening of CDS spreads

The perception of the credit quality has been under serious doubts as the CDS spreads continue to widen for brokers and banks in the US. CDS spreads on companies such as Bear Stearns and Merrill Lynch continue to rise. Bear Stearns’ one-year CDS spreads are rising and are trading at 344 basis points, while five- year contracts costs 249 basis points as compared to Lehman Brothers’ which trade at 192 basis points and Goldman Sachs’ which trade at 102 basis points. Among the US investment banks and brokerage houses, Bear Stearns is witnessing the largest widening of spread in its contracts. Bear Stearns CDS spread has significantly widened in the last few months.

US Brokers 5 yr CDS spread
Source: Bloomberg
Bear Stearns 1 year, 3 year, 5 year and 10 year spreads
Source: Bloomberg

After Citigroup and Merrill Lynch, it’s now Bear Stearns’ turn to writedown more assets

Driven by the implosion of the US asset securitization market, the US housing industry saw writedowns and credit losses of $133 billiion, and still counting. Merill Lynch, leading the pack, has thus far written down assets worth $24.5 billion, followed by Citigroup, which has written down $22.1 billion worth of assets. J.P. Morgan Chase also written down $1.3 billion attributable to subprime losses. The meltdown in the US asset securitization market has its repercussion on the entire global financial systems with banks in Europe and across Asia reporting huge writedown of assets. European Banks such as UBS are anticipated to report huge writedowns in their fourth quarter results, totalling $14.4 billion, while HSBC has reported writedown and credit loss worth $10.7 billion. However, Bear Stearns which has so far written down $700 million and $1.9 billion in 3Q 07 and 4Q 07, respectively seems to have inadequately written down its assets taking into consideration the level of exposure it has toward the risky assets. Bear Stearns was the Street's, and the world's, fixed income mortgage derivative leader yet it actually came in close to last place in writing down the value of its mortgage derivative assets. Something just doesn't smell right... We are likely to see the company writing down more far more assets in the coming quarters.

Total writedown and credit losses


Source: Bloomberg

Banks and Brokers write-downs Write down Credit Loss Total
Merrill Lynch 24.5   24.5
Citigroup 19.6 2.5 22.1
UBS* 14.4   14.4
HSBC 0.9 9.8 10.7
Morgan Stanley 9.4   9.4
Bank of America 7 0.9 7.9
Washington Mutual* 0.3 6.2 6.5
Credit Agricole* 4.9   4.9
Wachovia Bank 2.7 2 4.7
JP Morgan Chase 1.6 1.6 3.2
Canadian Imperial (CIBC)* 3.2   3.2
Barclays* 2.7   2.7
Bear Stearns 2.6   2.6
Royal Bank of Scotland* 2.5   2.5
Deutsche Bank 2.3   2.3
Wells Fargo 0.3 1.4 1.7
Lehman Brothers 1.5   1.5
Mizuho Financial 1.5   1.5
Other Canadian Banks 1.4 0.1 1.5
National City 0.4 1 1.4
Other Japanese Banks 0.8 0.4 1.2
Credit Suisse 1   1
Nomura Holdings 0.9   0.9
Societe General 0.5   0.5
Total 106.9 25.9 132.8

* includes losses the company expects to report in the upcoming quarters{mospagebreak}

Deteriorating financial performance reflected by the last two quarter results

The turmoil in the credit markets and the Bear Stearns exposure towards subprime RMBS/CMBS and CDO investments negatively impacted the company’s performance in the last two quarters. The company reportedly wrote down $1.9 billion of assets, $700 million more than announced in November 2007. The higher-than-anticipated write downs, poor investment banking results and weaker equity trading revenues saw Bear Stearns report a huge net loss of $6.90 per share significantly below the market expectations. Bear Stearns capital markets segments reported negative revenues primarily due to net inventory markdown in the fixed income business. Revenues from the fixed income business were a negative $1.55 billion, driven by the $1.9 billion of writedowns. Even after excluding the writedowns, Bear Stearns fixed income revenues were a dismal $355 million, significantly lower than 4Q 06.

In addition, the institutional equity and the investment banking businesses also witnessed decline in revenues. Institutional equity business witnessed a decline in revenues owing to weaker performance in the structured finance products. The investment banking revenues were also under pressure reporting a fall of 38% owing to lower high yield underwriting revenues resulting from difficulties in the fixed income and capital market environment. However, the growth in revenues in the Global Clearing Services and the Wealth Management segments helped offset the decline in revenues witnessed in the Capital markets segment.

Net income before tax (in US$ million)and y-o-y growth
Source: Company data

Wealth Management revenues to be under pressure

The failure of the two hedge funds of Bear Stearns have left the investors stranded, frustrated, and more importantly, losing money. More and more investors are suing Bear Stearns as they believe that the company misled them about the funds performance. The funds, the High Grade Structured Credit Strategies Fund and the High Grade Structured Credit Strategies Enhanced Leverage Fund, sought sanctuary from creditors by invoking jurisdiction defenses allowed by off shore domiciles after investing heavily in CDOs backed by subprime mortgages. Barclays PLC is suing Bear Stearns and two of its fund managers, as the collapse of the funds resulted in huge losses for Barclays. We believe all this legal actions will estrange Bear Stearns existing as well as potential clients putting undue pressure on the company assets under management (AUM) growth. In the asset management business, total AUM declined to $44.6 billion, compared to $57.8 billion in August 2007 and $52.5 billion at the end of the November 2006. The decline was primarily due to the $8.8 billion transfer of assets related to the spin out of O'Shaughnessy Asset Managemenint and poor performance. However, we believe the reputation hit taken by the company will put the company under pressure to generate higher revenues from this segment.

Bear Stearns lack of geographic diversification and overdependence on the US continues to be a disadvantage for the company. The significance of international diversification will become even more palpable in the near future as the US credit and economic conditions realize the hard landing that I called for last year, and continues to worsen. Bear Stearns derives 25% of its revenues from outside US compared to 40% to 50% of its peers. In addition, Bear Stearns derives a very large chunk of its net revenues from the fixed income business (almost 45%) business, which is at the forefront of the credit market turmoil. The deterioration in the mortgage market is more detrimental to Bear Stearns as compared to its peers as the company has a significantly higher interest in the mortgage market as compared to its peers.

Compensation expenses to be under pressure in the coming quarters

Bear Stearns compensation expenses is anticipated to be under pressure as the significant reduction in revenues of the company will not allow it to lower its employee cost significantly in the short term. The compensation expense as a percent of net revenues has increased to 57.1% in 2007 up from 47.1% in 2006. This was despite compensation expenses coming down to $326 million in 4Q 07 from $664 million in 3Q 07 and $1,052 million in 4Q 06. In addition, the executive committee has decided that they will receive no compensation this year (last year they made $156 million, or 3.6% of total compensation expense).The increase in the severance expense, legal and other expenses will drive the rise in the company’s overall expenses.

Furthermore, if we compare the compensation expenses with its peers, the average increase has been in the range of 20-21% with Lehman brothers giving a rise of 10%, Goldman Sachs 23%, Morgan Stanley 19%. In this scenario, it is likely to be extremely difficult for Bear to attract and more importantly retain people who will make money (and in the past have made money) for them.

Compensation and benefits as a percentage of net revenues
Source: Company data


Pulling it all together - The Sensitivty Analysis and Valuation

Our Sensitivity analysis of its exposure towards riskier assets


Base Case Scenario

Optimistic Scenario

Worst Case Scenario

In $ billion, unless specified otherwise


Stockholder's equity




Total Capital




Number of outstanding shares (in mn)




Bear Stearns Sensitivity Analysis


Losses on MBS&ABS inventories




Loss on couterparty credit exposure




Losses on Level 2 and 3 assets





Total losses




Assumed tax rate





After tax losses





Losses as a % of statutory capital




Losses as a % of total capital





Stockholders equity




Less : Total losses





New Stockholder's equity





Old Book value per share




New Book value per share





Bear Stearns weighted average value per share, with forensic and economic adjustments to risky assets and book value

All Figures in Millions of Dollars, unless othrerwise stated   Base Case Optimistic Case Worst Case
BVPS     32.7 60.2 -1.3
Economic Value Per Share     $33.8 $62.3 -$1.4
Current Stock Price     $87.0 $87.0 $87.0
Stated Book value per share     84.09 84.09 84.09
Current BV trading multiple     1.03 1.03


We have analyzed Bear Stearns exposure towards subprime MBS & ABS portfolio, the level 2 and 3 assets and its exposure towards counterparty credit risk in assigning our fair value. To value Bear Stearns in this report we have considered the Discounted Cash Flow (DCF), Price-to- adjusted book (P/ABV) and Price-to-Earnings (P/E) multiple methods. After a thorough review of the results, I decided to exclude the DCF analysis, primarily due to the theoretical nature of ascertaining risk premia, and the amount of guesswork involved in creating future cash flow streams. The DCF number would have raised the overall valuation by about 15%, depending on the weighting assigned (this is partially due to our generosity and conservatism in assigning quarterly revenue growth to BSC relative to its peers - again guesswork). It threw off a number that was singificantly disparate from that of the P/E and P/Adj. BV valuation models. Based on our final weighted average valuation, we arrive at a fair value price for the Bear Stearns of $36.42, which represent a downside of 58% from current level of $87.03.

Weighted average price (US$)
Methodologies Weight assigned Fair Price Weighted average price
Fair price using P/Adj. BV approach 50.00% 33.84 16.92
Fair price using P/E approach 50.00% 39.00 19.50
Weighted average fair price     36.42
Current price     87.03
Upside from current levels (US$)     -58.2%

The book value numbers are after our economic marking and adjustments, of course. The “E” portion of the P/E ration is quite conservative, since the we built model incorporated BSC doing much better during the next 4 fiscal quarters than their peers are reporting for this quarter, and in my opinion BSC will not only fail to match their peers, but underperform due to the loss of their primary value drivers – mortgage derivative and related fixed income products – not to mention their asset management, legal, and litigation distractions as well as client and talent retention issues.

Am I right about the Bear?

Despite the Bear Stearns negative developments, and my opinion of its value, Bear Stearns has managed to find investors as was mentioned earlier in the insider transaction section. These are accomplished and wealthy investors to boot. My concern is that so many astute, accomplished and economically powerful investors have failed to realize and fully appreciate the depth and breadth of the current real asset recession, burst bubble, and quite possibly asset depression we have recently entered. This has destroyed the value of many bottom fishing value investors, both intitutional and retail.

A brief perusal through my site reveals a fairly decent track record of recognizing the potential damage to be done by this "devaluation diaspora". Only time shall tell the tale of Bear Stearn's contribution to this list. Twelve months to date, BSC has lost over 50% of its share value and it near ground zero of the housing bubble burst. Observing the share price patterns of the companies who were actually at ground zero shows that a 50% is far from the midway mark when tracking from the peak of the bubble. I am certain their may be financial concerns such as well capitalized investment funds, foreign firms/funds, and/or stateside banks who have, and are considering a buyout. Yet, as I have stated with Ambac Financial, MBIA, Beazer Homes, and Countrywide during similar institutional forays into attempted vulture investing - Caveat Emptor: Seeking the bottom of a bottomless pit is a hazardous venture, indeed.

To date, I have been blessed with a modicum of accuracy in my research. As always, I am short any company that I am bearish on, and will be long any company that I am bullish on.

As with most firms on Wall Street today, financial leverage makes the good times, good - but makes the bad times nigh unbearable. BSC is not the most leveraged bank on the street, but it does employ more than enough leverage to get itself into trouble. Trouble is where it is at now. It was excessive leverage that exacerbated the problems at its hedge funds last summer.
Last modified on Thursday, 29 December 2022 12:21