New York | The failure of Bear Stearns & Co a decade ago illustrates the key lesson of financial markets, namely that non-banks are dependent upon 1) banks and 2) clients for liquidity. And no amount of capital will save a non-bank that has a deficit in terms of confidence. In times of market stress, credibility and character are far more important than capital.
Like the Crisis of 1907, when JPMorgan (NYSE:JPM) had to rescue the trust banks at the behest of President Teddy Roosevelt, the investment banks in 2008 were abandoned by the markets. Lacking stable funding in the form of core deposits, the non-banks failed in droves, starting in 2007 with New Century Financial, once among the largest issuers of subprime mortgages.
And it can happen again. Mark Adelson wrote in the Journal of Structured Finance:
“By the summer of 2007, the prices of subprime mortgage-backed bonds already had begun to plunge. New Century, once a major lender, had declared bankruptcy; two hedge funds run by Bear Stearns were collapsing; and as emails obtained via lawsuits and investigations would later show, the rating agencies were well aware of the problems. In April 2007, one S&P analyst told another, ‘We rate every deal. It could be structured by cows and we would rate it.’”
We recall sitting in a conference room with a group of investors early in March 2008, listening to people congratulate themselves for not "facing" Bear. Little did they suspect that the whole non-bank sector was toast and that Lehman Brothers would be next. While JPM took down Bear without a default, Lehman eventually failed and filed bankruptcy because nobody could get comfortable with the firm’s financials.
The markets today are just as vulnerable to a "run on liquidity," with Goldman Sachs (NYSE:GS) now the smallest of the universal banks followed by Morgan Stanley (NYSE:MS). Since 2008, non-banks have grown in residential mortgages and other areas that are totally dependent upon bank financing. The changes made by the Securities and Exchange Commission in 1998 to Rule 2a-7, which prevents non-banks from issuing their own paper for purchase by money market funds, gave the big banks a monopoly on short-term warehouse credit, thus making the 2008 crisis inevitable.
Bear was the smallest and least beloved of the bulge bracket Wall Street securities firms, having figuratively pissed on the floor by not agreeing to help rescue Long Term Capital Management in 1998. Nobody on the Street forgot that slight. Governance at Bear was at a minimum. The firm was run like a bridge tournament in a high school auditorium, with each table representing a different business unit and no overall enterprise management.
Regulators and members of the academic community like to say that non-banks caused the financial crisis in 2007, but the reality is that banks as well as non-banks failed when liquidity disappeared. Regulators correctly point to issuers such as New Century, Lehman Brothers and Bear, Stearns as examples of wayward non-banks, but key players in the banking sector such as Wachovia, Washington Mutual and Countrywide also were culpable and vulnerable to runs.
Jonathan Rose (2014) notes that during the subprime panic in 2007-2009, many large depositories such as Wachovia were subject to runs by institutional investors, both in terms of institutional deposits and even debt. WaMu, for example, lost significant deposits during 2008 leading up to its resolution by the FDIC and subsequent sale to JPMorgan.
By March of 2008, in another example, Wachovia was seeing a significant outflow of deposits and demands from bond investors for early redemption which led to the bank being acquired by Wells Fargo later that year. Only the fact of “too big to fail” protected larger names such as Wells Fargo (NYSE:WFC), JPMorgan, Bank America (NYSE:BAC) and Citigroup (NYSE:C) from the contagion.
The funding support provided to the non-banks and second tier banks by the large depositories, as well as the market demand provided by the mortgage securities issuance of the GSEs and large banks, are important factors that drove the overall demand for subprime mortgages. The eventual collapse of demand led to the failure of both banks and non-banks alike.
Countrywide’s warehouse was largely financed by Bank of America, which was forced eventually to acquire the crippled institution. Washington Mutual and Bear Stearns were likewise funded by the large banks and money market funding, and were eventually acquired by JPMorgan with support from the Federal Reserve Bank of New York. Moreover, substantial parts of the balance sheet funding of “banks” such as WaMu and Countrywide were sourced from non-core deposits in institutional money markets.
Many observers fret about the risk presented by nonbanks, yet the dependence of these institutions on bank financing means that the credit and market risk remains “in the bank.” In the event that a large nonbank financial firm in future experiences liquidity or solvency problems, the lender banks would almost certainly be compelled to acquire the nonbank. Non-banks, at the end of the day, are the customers of the big banks. That is the key lesson of the failure of Bear Stearns.