Bear's excuses

Jimmy Cayne is a truly despicable liar. You might not be familiar with his name, but Cayne was, until late 2007, a titan of Wall Street. He was the CEO and chairman of Bear Stearns.

For a long time, he was also the single-richest banker in history. Over his long career, he amassed more than $1 billion in compensation from Bear, mostly in the form of stock. Today, Cayne testified before Congress that the collapse of Bear Stearns wasn't his fault. In fact, if you believe Cayne, the collapse of Bear was everyone else's fault:

The market's loss of confidence, even though it was unjustified and irrational, became a self-fulfilling prophecy. The efforts we made to strengthen the firm were reasonable and prudent, although in hindsight they proved inadequate. – Jimmy Cayne's written testimony to Congress, May 5, 2010

I know very well that when you look at the mortgage debacle, you won't find any saints. Nearly every market participant was guilty of irresponsible or illegal actions. Borrowers willingly lied about their incomes and assets. Mortgage brokers willingly underwrote loans they knew couldn't be repaid. Real estate agents deliberately sold homes to buyers they knew couldn't pay for them at prices they ought to have known were unsustainable. Bankers behaved with reckless stupidity, buying loans they knew (or ought to have known) were garbage and reselling them to investors, who were stunningly ignorant of the risks of the securities.

Having said that... few people have more personal responsibility for the crisis than Jimmy Cayne. And no one is more at fault for the company's collapse. I say so primarily for three reasons...

First, Bear Stearns was the undisputed leader in the securitization of residential mortgages into bonds on Wall Street. No other firm was more aggressive or made as much money as Bear did on residential mortgage-backed securities (RMBS). Had Bear insisted on higher lending standards, Wall Street's capital would have never poured into subprime debt. Crack houses would have never come to stand behind triple-A-rated securities. Jimmy Cayne should have made sure this never happened.

Second, no other banker was paid as much or had more authority in his firm than Jimmy Cayne. Few people on Wall Street had enough power, experience, and gravitas to stop the kind of mania that gripped Wall Street during 2005 and 2006. Out of the handful who could have prevented the crisis, Jimmy was, by far, the most experienced, highest paid, and the most respected. If Jimmy Cayne had announced at the end of 2004 that underwriting standards had collapsed and Bear wouldn't securitize any additional mortgage bonds without vastly higher lending standards, the credit crisis wouldn't have occurred.

Finally, evidence shows that had he taken steps to raise large amounts of capital in 2007, Cayne could have saved the bank... Yet he did almost nothing to prevent Bear Stearns' collapse. In fact, during those critical months in the summer of 2007, he was routinely out of the office, playing golf in New Jersey or bridge at tournaments in Nashville and Detroit.

No one disputes these facts. Default rates on subprime mortgages soared in early 2007. Investors in the "equity" tranches of Bear Stearns' mortgage securitizations began blowing up in early 2007 – starting with Dillon Reed Capital. As the default rates worsened, one mortgage company after another went bust.

On July 10, 2007, Moody's and S&P downgraded $12 billion of subprime backed RMBS. As a result, two of Bear Stearns' hedge funds collapsed. One lost 100% of its investors' money.

Jimmy Cayne cannot testify he was unaware of these events. He cannot say he didn't understand the direct threat to his firm – his own mortgage hedge funds collapsed. Nor can he say he didn't know his firm was leveraged more than 50 to 1, implying that even a 2% reduction in the value of its assets could wipe out all of its equity.

Most important, Jimmy Cayne cannot pretend he didn't understand how the collapsing price of RMBS would hurt his firm, which held more than $15 billion worth of these securities. As I explained to our subscribers on August 14, 2007, the downgrade of previously triple-A-rated securities would require all of Wall Street to raise enormous amounts of additional capital:

To hold AAA-rated paper, banks, and other financial institutions need only to maintain $0.56 in capital for each $100 of paper. But as the paper is downgraded, the amount of capital they're required to hold goes up, exponentially. At a BBB rating, financial institutions must hold $4.80 of capital. At BBB-, they must hold $8 of capital per $100 of asset-backed securities. Thus, as the crisis worsens, the demand for capital from these firms could grow substantially. – The S&A Digest, August 14, 2007

Here's a question I wish Congress would ask Jimmy Cayne. He continues to claim Bear Stearns sank due to a crisis no one could have anticipated or prevented. If that were true, then how did I write this Digest? In August 2007, I explained all of the core problems Bear Stearns faced. These facts led us to recommend shorting Lehman, Fannie, and Freddie. They led us to doubt (correctly) Goldman Sachs' accounting and to predict the collapse of Merrill Lynch.

So I wish someone would ask Jimmy and all of the other leaders of Wall Street: "How did you miss problems so obvious to everyone else?" For Pete's sake, even Fortune magazine pegged the housing bubble as early as 2004. Yet supposedly, none of Wall Street's most elite bankers saw it coming? I don't believe it. And neither should you.

The truth is, dear subscribers, these men – the top executives at all of the biggest institutions on Wall Street and most of the people in Washington who were supposed to be regulating them – took insane risks with enormous amounts of borrowed money. They did it because they thought, quite simply, that they'd get away with it... that, in some way, shape, or form, they could hedge their risks and still make a fortune.

They tried to pull it off by selling their mortgages to suckers from foreign countries and idiot hedge-fund managers. They believed they could hedge their risks by buying insurance from companies like AIG and MBIA, which were actually leveraged more than the investment banks themselves. In short, they willingly bought into the giant delusion that they could get rich at someone else's expense by selling toxic securities as being "triple A."

It was a lie. But it's a very powerful and seductive lie, and it fueled literally billions and billions of dollars worth of compensation. Keep this is mind: Wall Street banks routinely paid out 40% of revenues in employee compensation.

Keep this in mind too: Washington continues to take insane financial risks with a phony triple-A credit rating. That scheme won't last either.

In the mailbag... more criticism of our track record. Yes, the chances are pretty good if you write a very angry letter accusing us of malfeasance, we'll publish it. There's nothing more useful than a critic to keep us honest. Send your best shot here: feedback@stansberryresearch.com.

"I am glad I quit listening to you and doing the opposite of what you say, and now I am starting to make some of the money back I lost listening to you." – Paid-up subscriber "Randy"

Porter comment: Good luck, my friend. I hope that strategy works for you. Here's something you might want to consider before you spend too much time and capital on that approach...

I frequently get asked about our track record. The truth is, of course, each analyst has a track record and we publish an annual report card that talks about each writer's performance in detail. While I think accountability is critical, I think the idea of basing your opinion of a newsletter's utility purely on its official track record is absurd.

Why? Because the real test of a good analyst isn't whether or not his ideas are good on average, but whether or not he is able to deliver to you truly critical ideas in a way that gets your attention. For example, the average gain of my newsletter in 2008 was slightly negative (the stock market fell in half that year). But what other newsletter writer, anywhere in the world, did such a thorough job of explaining the financial crisis (starting in the summer of 2007)? And who offered more accurate warnings about the key companies destined to collapse?

Were all of my investment ideas on the mark? No, absolutely not. But would you have been far better off reading my letter than investing in a mutual fund? Absolutely. And would you have been far more informed by reading my letter or reading other sources? I think the answer there is obvious, too.

On the other hand, I know trying to convince a skeptic that our letters are outstanding values and offer more sophisticated investment advice than you get anywhere else at any price is a fool's errand. Either you like our work and learn to respect and trust our analysis or you don't. Either way is fine with me. I'm very confident about the quality of what we do here. I know it is widely respected by literally millions of people around the world. Nevertheless, if we're going to engage in a constant argument about track records, we might as well have a fair and accurate reference point.

The big problem with trying to compile a newsletter's track record is each recommendation is made separately, usually a month or two apart. A newsletter's portfolio never "starts" or "stops." So the newsletter track records we publish can only show you an editor's average return. They can't be accurately compared to any other index, like the S&P 500, because they aren't managed as portfolios.

The only real and accurate track records we produce are based on the performance of our model portfolio – the S&A 16.

These quarterly portfolios are available only to S&A Alliance members. They consist of 16 stocks – all of which have been previously recommended in one of our letters.

These portfolios represent how we believe our work ought to be used. They also represent the actual results real subscribers could easily achieve using our work. The results for every single one of our model portfolios is below, alongside the corresponding return for the S&P 500. As you can see, we are beating the market by an enormous margin.

So if you'd like to bet against us accurately, try betting against the S&A 16. You'll go broke pretty quickly.

"Porter, I have a very good friend whom I strongly advised to dump his GE stock based on your very, very firm thoughts on it. Every time I see him socially, he really gives it to me about GE's near double since I advised him to get out of it. I tell him, the same thing I said at the time, 'Sure it might go up, but that is true for many other stocks, which do not have the prospective Armageddon down side it does. So why take the chance?'I still feel comfortable with this explanation and do not find any particular blame or misplaced anger or that sort of doltish silliness directed at you, but I would appreciate your public take on what has happened? This so that I might learn from the outcome, and perhaps gain a bit of new insight on the stocks actual performance." – Paid-up subscriber C Lee Bruner Jr.

Porter comment: Nothing happened except some folks decided they were willing to pay more for GE stock than I believe it is worth. I can't explain their actions – you'd have to ask them.

From my perspective, the problems at GE can't be solved unless you believe the company is capable of repaying $664 billion in debt using an asset base that produces an average return of less than 1% annually. The truth is, absent the U.S. guarantee of GE's debt, the company would have already gone bankrupt. Those guarantees expire in June 2012. Why would you pay nearly two times book value for this business?

"Thank you, thank you, thank you, a thousand times thank you for publishing the Gold Investor's Bible. So much class and quality, straightforward thinking in one place is worth the Wealth Alliance cost many times over. I was a skeptic for many years until Dr. Sjuggerud begged and pleaded for readers to buy gold and over the years I've become more convinced of it's role as money, but nothing pulled the veil from my eyes like these essays. You guys are doing amazing work." – Paid up subscriber Steven M. Abramowicz

Porter comment: You're welcome... thanks for your note.

Regards,

Porter Stansberry
Baltimore, Maryland
May 5, 2010