Bear Stearns' appetite for risk and lack of foresight were criticized at a hearing into the roots of the financial crisis, where former executives argued the firm's collapse was due to events beyond their control.
Members of the Financial Crisis Inquiry Commission grilled the executives on Wednesday over why the investment bank was so vulnerable to the loss of confidence that caused it to become the first major collapse of the crisis in March of 2008.
Commission Chairman Phil Angelides said Bear had a significant portfolio of mortgage-backed securities in 2007. About a month before its collapse, Bear had about $12.5 billion in loans with either no documentation or deficient documentation, more than the firm's total equity.
Why would you think that would be sustainable in any kind of market disruption? Angelides asked.
The congressionally-appointed commission is charged with chronicling the causes of the worst financial crisis since the 1930s and has been holding a series of hearings. It is due to deliver a report to lawmakers and White House by December 15.
Congress is already working on a bill to overhaul financial regulation but Angelides has said there will still be scope for further reforms, including possible changes to mortgage financing.
Bear Stearns was the first investment bank to experience a run on the bank in the crisis. Similar fears led to the demise of Lehman Brothers in September 2008 and the reorganization of the other three large investment banks.
NOT OUR FAULT
Paul Friedman, Bear's former senior managing director, said the loss of confidence in the firm was unwarranted given the firm's strong capital position and substantial liquidity.
Samuel Molinaro, Bear's former chief financial officer, told the commission that fears, rumors and innuendo in March 2008 resulted in irrational behavior that caused a quintessential run on the bank at Bear Stearns.
While our liquidity and capital planning failed in the face of these overwhelming market forces, in this environment, without a lender of last resort or the stability of a deposit base, neither we nor the independent investment banking model itself could survive, Molinaro told the commission.
Both echoed comments made by former Chief Executive James Cayne, who left that post in January 2008, just months before Bear was sold to JPMorgan Chase & Co for a fire-sale price. Cayne said in prepared testimony that the lack of confidence in the firm was unjustified and irrational.
The financial commission's vice-chair Bill Thomas did not buy the former executives' arguments and questioned whether the firm overextended itself with too much leverage and complex mortgage securities.
How could you folks, as sophisticated as you were, with the models that everyone felt comfortable with, believe you were the victim... of unsubstantiated rumors, fears and innuendo -- that your colleagues did you in? Thomas asked.
Cayne and his successor, Alan Schwartz, were due to testify later on Wednesday to the commission about how the shadow banking system, a loosely regulated group of non-bank institutions and markets, contributed to the financial crisis.
Angelides sounded incredulous that Bear did not better position itself to survive a credit crunch. It seems like there were a lot of warnings signs, a lot of red and yellow lights going off.
Bear's fall was swift in March 2008. Despite an emergency line of credit from the Federal Reserve, it became clear within days the firm could not survive on its own, and the Federal Reserve and U.S. Treasury scrambled to arrange a sale to JPMorgan for the eventual price of $10 per share.
Five months later, Lehman filed for bankruptcy and the remaining large investment banks -- Merrill Lynch, Goldman Sachs and Morgan Stanley -- sought safety in the form of federal oversight. Merrill was bought by Bank of America. Goldman and Morgan became bank holding companies and are now subject to much stricter capital requirements and regulation.
All five investment banks were loosely supervised by the Securities and Exchange Commission for capital and liquidity requirements under the agency's voluntary so-called Consolidated Supervised Entity program.
SEC inspector General David Kotz said in prepared testimony for the commission that Bear Stearns was a highly leveraged firm with less capital and less diversification than other investment banks.
He criticized the SEC for becoming aware of numerous potential red flags about Bear Stearns' risk-taking but not taking action.
The SEC monitoring program has since been dismantled.
Other witness due to testify on Wednesday include former SEC chairmen Christopher Cox and William Donaldson.
(Reporting by David Lawder, Rachelle Younglai, Karey Wutkowski; Editing by Tim Dobbyn)