It is hard to avoid a sense of being an eyewitness to a decisive moment in financial history, the stuff from which much future market lore will be constructed.

---

With events unfolding so fast in the credit crisis, and nobody yet quite sure when and how it will end, there has been little time to pause and take stock. The dramatic demise of Bear Stearns – worth $80 a share one week and knocked down for $2 a share the next – adds yet another extraordinary twist to this ongoing tale. It is hard to avoid a sense of being an eyewitness to a decisive moment in financial history, the stuff from which much future market lore, both sound and unsound, will be constructed.

The collapse of Bear Stearns is a striking example of how suddenly fame and fortune in investment can change. Joe Lewis, the Bahamas investor, has dropped something in the region of $800m, by anybody’s standard a decent sum of money, in less than a year on his ill-timed and ill-fated bet on Bear Stearns’ shares.  The directors and employees who owned a big chunk of the shares of Bear Stearns, assumed to be no mugs themselves, have also lost most of their wealth in a matter of days.

A raft of hedge funds meanwhile, some of them led by illustrious names, seem destined to follow Peloton Partners and Carlyle Capital out of business as bank-induced enforced deleveraging continues. The hedge fund model, it has been noted here more than once, has fundamental flaws that in the wrong hands put their investors at a small but significant risk of a severely bad outcome. Would one of the hedge funds which attempted a power play in Northern Rock shares have acted the same way if it had not had a five-year lock-in that positively encouraged such high risk investment tactics?

Bill Miller of Legg Mason, the man who famously beat the S&P 500 for 15 years in a row, is meanwhile still reeling from the double whammy of making big bets on housebuilders and financials and missing out on the big gains in oil and other commodities. Climactic events in market history, since they often involve excess of one kind or another, often leave even the best known professional investors looking stupid.

Keynes, for example, had a gruelling time during the 1929-32 bear market, losing well over half the money in his portfolios, before making it (and some) back later. Charlie Munger, Warren Buffett’s business partner, had three straight down years in a row when the 1960s bull market turned into the market downturn in the early 1970s. George Soros got thumped in the 1987 crash; despite having correctly predicted that something of the sort was coming, he made the wrong choice of market to avoid.

In more professionalised modern markets, even those who call the big market downturns right typically suffer a different fate, which is to lose business when the markets rise to excess. A notorious example was Julian Robertson, the once fearsome hedge fund manager who abandoned the business because he was unable to make any sense (or any money) out of the bizarre excesses of the Internet bubble. Tony Dye, who died recently at a sadly early age, was likewise famously sacked in 2000 for being way too early in ridiculing the growth stock mania of the same period.

There are other parallels between that period and the current crisis. Just as everyone knew that the Internet bubble was an accident waiting to happen (it was written about at great length for months before it burst), so too no serious professional investors can say, hand on heart, that they were not aware of how the lending excesses of the past three years were likely to end. (I say this with some confidence, having helped to publish a hefty report two years ago by Edward Chancellor that chronicled precisely what was going to happen).

This raises once again the timeless but still puzzling issue of how sensible, experienced and mostly risk-adverse individuals, the kind who lead most banks, hedge funds and other professional financial institutions, can collectively participate in behaviour that risks such painful, expensive and predictably bad outcomes. While perverse incentives are clearly a major part of the answer, it cannot be the only explanation.  (If Bear Stearns was such an obvious goner, incidentally, and the hedge funds were all short of the shares, why did the market still value the investment bank as if it was a multi-billion business just a few days before?).

As the search for scapegoats continues, the Federal Reserve and Alan Greenspan are naturally well to the fore. In his most recent commentary, the veteran market commentator Peter Bernstein rallies to the defence of Mr Greenspan, arguing that to blame everything that has happened solely on the Greenspan Put is (a) far too easy and (b) based on a superficial reading of the historical record. He makes a good, if unfashionable, case. 

It is one thing to say that it is the duty of the Federal Reserve to take away the punchbowl during periods of consumer excess, and rein in reckless borrowing by home-owners, but quite another to say that professional bankers and hedge fund managers should be absolved of blame for making the second rate loan and investment decisions that are now coming home to roost. Nobody forced them to make those decisions, or to put their own and society’s wealth so recklessly at risk.  



Jonathan Davis
Email Jonathan Davis