Too Much Risk

Yesterday, the Financial Crisis Inquiry Commission conducted a hearing to examine the failure of Bear Stearns in 2008.  The theme of the testimony by Bear Stearns was that there was too much risk in the broker-dealer's capital structure. Here is what the Wall Street Journal reported.

Former Bear Stearns Chief Executive Officer James Cayne said Wednesday that his firm's risk level was too high in the year before it collapsed. "That was the business," Mr. Cayne told a hearing held by the Financial Crisis Inquiry Commission, a congressional panel scrutinizing the financial crisis. "That was really industry practice. In retrospect, in hindsight, I would say leverage was too high." Commission Chairman Phil Angelides said Bear Stearns was leveraged at a ratio of 38 to 1, sometimes as high as 42 to 1, and held $46 billion in exposure to mortgages. "How is that model sustainable in the event of any market disruption of significance?" he asked.

The simple answer to Chairman Angelides' question is that the model is not sustainable at that level of leverage. The problem is that in 2004 the SEC allowed firms like Bear Stearns to increase leverage from a prior limit of 12 to 1 to much higher levels.  So, the government can also look to itself when seeking to place blame for the market collapse.