Bear Stearns: Are the Directors at Risk?

The recent fall and near collapse of Bear Stearns has been breathtaking. What has caused this once great company to flirt with becoming a penny stock? Will there be stockholders’ suits for this remarkable collapse of value?

Management of Bear Stearns decided to ride the mortgage-backed securities boom at the worst time. They apparently took an outsized position in these risky securities that eventually led to the Federal Reserve guaranteeing to pony up to JPMorgan Chase up to US$30 billion if Bear’s most toxic assets become worthless.

The toxic assets that we’re referring to are the securities that are backed by risky mortgage loans made to homeowners with little or no credit. Everyone, it seemed, thought that there was nowhere home prices could go except up. Unfortunately, as we’ve since seen, there’s been quite a depression in home prices. In fact, some experts feel that it might be two years before prices bottom out.

Some people I know that are heavily invested in real estate have decided to wait awhile before purchasing more property — until the bargains become more enticing. I asked someone recently, “When might that be?” His response was, “Who knows? I’ll just wait and watch and strike when I think that things have settled down.”

A Run on the Bank

The simple fact is that once a bank gets your money, they do what they are supposed to do with it — invest those deposits to make attractive returns for their customers. They leave a relatively modest amount in liquid assets so that when the occasional customer comes to the bank to withdraw funds, the bank has the funds readily at hand.

All financial institutions — both regular banks and investment banks — are able to keep their doors open because of one factor: confidence. There is no bank that I know of that could survive a run once its customers lose confidence. This is why the Federal Deposit Insurance Corporation (FDIC) exists, to make sure that depositors’ confidence doesn’t easily wane.

What Bear Stearns experienced was a good old-fashioned bank run. Its customers heard rumors that Bear was in trouble and were concerned with their deposits in the company as well as whether the company had the ability to properly and timely execute trades.

Thus, many customers started to withdraw their funds from Bear Stearns, and that’s when the trouble began. The trickle of withdrawals became a torrent, and the bank was unable to meet the ever-increasing demands on its cash. Technically, it was insolvent since it could no longer meet and pay its obligations as they became due.

In fact, the situation was so dire that The New York Times quoted Alan D. Schwartz, Bear’s CEO, as saying “We are a collective victim of violence. … This deal (the proposed sale to Morgan) cost me big time. But if there wasn’t a deal, we’d be toast.” That quote is the most stunning street definition of insolvency that I’ve ever heard.

What was stunning about Bear is that the Federal Reserve had no moral or legal obligation to rescue the company because it was an investment bank, rather than a regular bank. They did it so that there wouldn’t be a spreading loss of confidence in the banking system that would spiral into the illiquidity and then failure of many more investment banks. Simply put, they had to bail out Bear.

Exposure of Directors

It seems that when things are going well, there is very little litigation. When things turn sour, however, the lawsuits begin to fly. There is no doubt in my mind that there will be lawsuits in the Bear Stearns situation. The question is: Will they stick?

From Bear’s point of view, they can make the argument that I just made, namely that no bank can survive a meaningful run on its assets. They could say that any depositor/investor in an uninsured investment bank knows, or should know, that his assets are at risk because investment banks are not insured by the FDIC.

On the other hand, litigants could take directors to task for taking unnecessary risks with depositor-investor money. They could argue that Bear was clearly over-invested in mortgage-backed securities: derivatives. In my opinion, they might have a strong argument here.

The Federal Reserve is clearly taking the right tack in trying to calm the markets and bring confidence back into the banking system by putting the faith and credit of our government behind Bear Stearns, thus defusing a ticking bomb.

All of us have to calmly step back and take a few breaths. I have do doubt that this threat will pass. Good luck!

Theodore F. di Stefano is a founder and managing partner at Capital Source Partners, which provides a wide range of investment banking services to the small and medium-sized business. He is also a frequent speaker to business groups on financial and corporate governance matters. He can be contacted at [email protected].

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