Former executives James Cayne and Alan Schwartz testify before Congress Wednesday on the reasons Bear Stearns failed. (AP)

By Jim Puzzanghera
| Former executives of Bear Stearns Cos. on Wednesday defended the
investment bank’s practices and said the firm’s collapse was caused by
an unstoppable run fed by rumors as the financial markets began
spiraling downward in 2008.

But under questioning by the federal commission investigating the causes
of the financial crisis, former Chief Executive James Cayne admitted
that the company had taken on too much risk to handle a severe market
disruption it did not see coming.

“In retrospect, in hindsight, I’d say leverage was too high,” Cayne said.

The company, which was a major player in the mortgage market, was sold to rival JPMorgan Chase & Co. in March 2008 with major assistance from the Federal Reserve, including a $30 billion loan.

It was the first in a series of unprecedented government interventions into the financial system in 2008. Because of that, Bear Stearns’ downfall is the focus of two days of hearings this week by the Financial Crisis Inquiry Commission about the so-called shadow-banking system.

In addition to the executives, the commission questioned two former heads of the Securities and Exchange Commission, Christopher Cox and William Donaldson, about their regulatory failings in the oversight of investment banks.

Cox said that the government set up a system in which there was little oversight of investment banks and that no agency “had as its mission the protection of the viability or profitability of a particular investment bank holding company.”

“Wall Street is littered with the names of distinguished institutions — E.F. Hutton, Drexel Burnham Lambert, Kidder Peabody, Salomon Brothers, Bankers Trust, to name just a few — which placed big bets and lost, and as a result ended up either in bankruptcy or being sold to save themselves,” said Cox, who chaired the SEC from mid-2005 until early 2009. “Failures in the shadow banking system highlighted regulatory gaps. It is urgent that these gaps be filled.”

Cayne, who stepped down as CEO two months before the firm’s collapse, said Bear Stearns’ fall “was due to overwhelming market forces” that showed their power six months later with the failure of Lehman Bros., and the bailouts of American International Group and large banks.

“Considering the severity and unprecedented nature of the turmoil in the market, I do not believe there were any reasonable steps we could have taken, short of selling the firm, to prevent the collapse that ultimately occurred,” he told the commission.

Four other executives made the same case, saying Bear Stearns closely monitored its risks, tried to reduce its exposure to the collapsing subprime mortgage market and did not believe the firm was overextended.

“Fears, rumors and innuendo resulted in irrational behavior that caused the quintessential run on the bank at Bear Stearns,” said Samuel Molinaro Jr., the former chief financial officer and chief operating officer, who added that he was “shocked” by the events in the week before Bear Stearns’ implosion. “In retrospect, I do not believe that there was anything that Bear Stearns could have done differently with respect to its funding model that could have prevented this run on the bank.”

But members of the commission didn’t buy the explanation. Commission Chairman Phil Angelides said the assertion that Bear Stearns’ demise was out of the control of its executives sounded like the testimony of executives of other companies that the financial crisis was an “immaculate calamity.” And Commissioner Byron S. Georgiou called the idea that the crisis happened without anybody doing anything wrong was a “pathetic mythology.”

Angelides said Bear Stearns was highly leveraged and depended heavily on overnight funding for liquidity. He questioned if that business model, based on a banking system that worked in the shadows of the traditional, regulated commercial banking system, was flawed. He called it “a form of financial Russian roulette.”

“You didn’t see going into turbulent waters it was necessary to build a higher levee?” Angelides asked Cayne.

Cayne said he did not. But he said greater protection would not have stopped the rumor-fed run on the company, which lenders became fearful of dealing with because it was the smallest of the five major investment banks then dealing with the meltdown of the mortgage market.

Among the other large investment banks before the financial crisis, Lehman Bros. went bankrupt, Bear Stearns and Merrill Lynch were gobbled up by competitors, and Goldman Sachs and Morgan Stanley converted into traditional bank holding companies.

The commission released a report Wednesday on the shadow-banking system, in which investment banks operated largely outside of traditional regulation and “relied disproportionately on short-term funding markets.” Among the short-term funding vehicles were overnight repurchase agreements between banks, known as repos.

Without the government guarantee of deposits, put in place at commercial banks during the Great Depression to prevent runs by customers, investment banks were unable to stand up to a financial panic, the commission report said.

“Investors knew that such entities could not survive a run, and no investor wanted to be among the last to withdraw,” the report said.

Commission Vice Chairman Bill Thomas said that Bear Stearns and other investment banks were “dependent on others for your daily bread.” Given that, Thomas asked, “did you honestly believe you were immune from fears and rumors, unsubstantiated as they might be?”

Molinaro admitted that the lack of a lender of last resort for investment banks “turned out to be a major flaw.”

Asked why Bear Stearns was the first of the major investment banks to fall, he said the subprime market collapse led to a loss of confidence in firms exposed to it. As the smallest of those investment banks, investors lost confidence in Bear Stearns, Molinaro said.