July 17, 2008

SEC starts to investigate Bear Stearns. Or does it?

If you read the last few days' posts on the crisis market sometimes but erroneously known as Banking (and you should check up on Lynn's comments on CDOs to see more detail) then you might be forgiven for thinking that the job of the regulators is to ride into town and clean up all the dirty games: subprime, CDOs and toxic mortgages. It could be that way, but the truth is more complicated.

The Bear Stearns affair is illustrative of the dilemmas. At one level, it's just another dirty chip in a card game where seedy reputations are being made, and dirty cards are being played, to mangle the metaphors. At another level, it is indicative that the problem is far more systemic than just another failed bank to be rescued.

In short, this story was about a major bank in the US that very nearly folded its cards. At the time, Bear Stearns went through its "Barings moment" when the bad news of its impending bankrupcy turned up late Friday. By next Monday, however, instead of collapsing, a white knight rescuer in the form of Goldman Sachs JP Morgan, a top-tier investment bank, turned up to offer a charitable price of $2 per share.

Bear-Stearns itself was major because it handled the biggest chunk of securities settlement. That is, the boring back-office task of swapping money for shares, or owners for owners, depending on how you look at it. Which brings to mind that if the major back-end settlement bank failed, this could clog the markets. Can you say systemic risk ?

Alan Greenspan can say that with authority, and this was what prompted his fabled rescue of another major player, LTCM (for Long Term Capital Management) back in the late 1990s. When LTCM was rescued from its too-big-to-comprehend positions, the financial world sucked much breath between collective teeth. Weren't we supposed to be passed the notion of rescuing failed financial players? Wasn't the Barings failure a wake-up call that we should take our risks and carry them too?

Was LTCM really that big?

In the event, Alan Greenspan proved to be the supreme player of poker: The Fed didn't spend any money on the deal, and instead fingered the banks who were to share the risk. A strong implication was that the big financial players (such as Morgan and Goldman) were in deep for the profits, and they should pay up for the losses. History suggests that he more or less got it right, or right enough, even to the extent of a few rebels who short-sold him and had to be punished later on.

For LTCM, the collective breath was slowly let out as the news and rumours trickled in as to how deep it was.

Because of its core role in settlements, Bear Stearns may have been the same, or maybe not. The financial brethren collectively drew breach in, but early fears of systemic risk were quickly replaced by cries of "rip-off!" Just exactly how did Goldman Sachs JPMorgan manage to engineer a bargain-basement price for a key player and competitor? After some huffing and puffing, the price went up to $10, which tells us something about the real value here.

Just maybe, the regulators have now moved to ask those questions:

BOSTON, July 16 (Reuters) - Dozens of hedge funds and broker dealers are scrambling to send reams of e-mails and trading records to U.S. regulators probing suspected stock price manipulation, several sources at hedge funds said.

The U.S. Securities and Exchange Commission recently sent subpoenas to more than 50 firms concerning trading in investment banks Bear Stearns, which was rescued in March, and Lehman Brothers Holdings Inc (LEH.N: Quote, Profile, Research), whose shares have been hurt badly by rumors about its financial health, said four sources, who have seen the documents but were not authorized to speak about them publicly.

Among those receiving subpoenas was investment bank Goldman Sachs Group Inc (GS.N: Quote, Profile, Research) and prominent hedge fund firms SAC Capital Advisors LLC and Citadel Investment Group. All three were named in a recent article about the Bear collapse in Vanity Fair.

Is this good news? On the surface, it sounds like hard dealing. Finally, the regulators are riding into town. Hip hip hooray!

But a few things are disquieting, and cheers may be premature. Firstly, the regulators were already in on the deal, so they were already in-the-know. If they are now investigating a game they were in on, this looks no good: Either they were duped, or they were players.

Secondly, the SEC has no particularly good reputation for these sorts of investigations (remember Lazio, mutual funds, etc?). It is an agency that is thought to be understaffed, under-missioned, under-enforced and generally turns up to the party after the barn has burnt to the ground. Indeed, perhaps minded by the SEC's record as a political hired-gun, Congress is musing on the possibilities of a UK-style super-regulator, and/or handing that power to the Federal Reserve.

Thirdly, subpoenas are a two-edged sword. Although they might feed information to the issuer of the subpoena, they also shut down the information for anyone else. It's as simple as the players saying to everyone and anyone "we have no comment on running cases;" they've been handed a get-out-of-jail card at least as far as investigative reporting goes. Likewise, the subpoena is a club that can just as easily be wielded within an investment bank or hedge fund as against any outsider; it's a licence to martyr any whistleblower who might accidentally have a momentary attack of morals. Not only that, the information is now likely to be locked down within the SEC's investigation department, which would typically protect it fiercely for several years in a real investigation, and as long as it takes for the heat to die down in a political paid-favour.

Fourthly, of the investigations I have seen, the good ones are done quietly, with surgical strikes for information. A subpoena is sent only after other tools have been exhausted because it raises the stakes in the game so high. To send 50 out at once is about as surgical as carpet-bombing.

The overall sense then remains. The Bear Stearns affair smells, and rumour has it that the Brothers Lehman were seen washing at the same laundry. Who else? IndyMac? It might be a coincidence, but there is no end to the bad news for the USA Federal investigative and regulatory arms in recent years.

Which brings us to the point of the article, and the lesson as to why financial cryptographers read and understand the financial markets. The financial regulators promote a model of independent and fair regulation, but this is simply not the case. Briefly, sometimes, we experience periods in history where regulators do strive to stand apart and to regulate lightly and fairly. For the benefit of more than the incumbents. But more often than not, the regulators are the best heeled but least well-equipped players in a rigged game, always on the back foot, and operating to a steady series of political favours which will generally make matters worse.

With the retirement of Greenspan, and the political assassination of Spitzer, the USA markets are now normalising towards a stability of chaos. For financial cryptographers, then, it is important to understand that the structure of the market is dominating, and the regulators are players in that structure, not fair policemen, or designers of that structure. Enter that game at your peril, and if you do, understand it better than they do.

Addendum: of course, not getting the names right doesn't help understanding at all... JP Morgan bought Bear Stearns, not Goldman Sachs.

Posted by iang at July 17, 2008 08:05 AM | TrackBack
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