The near-collapse of the Wall Street firm Bear Stearns Cos. Inc. illustrates the danger of focusing executive compensation on company performance without considering the amount of risk undertaken to achieve that performance. Much of the risk that executives undertook was hidden on the firm’s balance sheet until the mortgage crisis revealed the true worth of the assets was considerably less than their book value. Bear Stearns narrowly avoided bankruptcy by agreeing on March 16 to a shotgun marriage with JPMorgan Chase & Co., presided over by the federal government. The price? A mere $236 million, a fraction of Bear Stearns’ previous stock market value of $20 billion in January 2007.[1]

Under pressure from Bear Stearns employees and shareholders JPMorgan Chase increased its bid on March 24 from $2 to $10 per share.[2] Bear Stearns CEO James Cayne, who held 5.82 percent of the investment bank’s total outstanding shares, was one of the biggest beneficiaries of the increased price.[3] A day after Bear Stearns’ directors agreed to the increased offer from JPMorgan Chase, Cayne unloaded his entire holdings at $10.84 a share, creating a $61.3 million profit.[4]

Given Bear Stearns’ reputation on Wall Street for savvy risk management, it is ironic that Bear Stearns’ own hedge funds helped trigger the subprime mortgage meltdown that ultimately cost the firm its independence. In June 2007, Bear Stearns bailed out two of its troubled hedge funds that had invested in collateralized debt obligations.[5] By combining subprime loans into a single security, these collateralized debt obligations supposedly transformed high-risk debt into investment grade credit ratings.[6] The financial pages of the past year show that this kind of magical transformation is illusory.

The Wall Street Journal described the fire-sale price of Bear Stearns as having “shaken American capitalism.” In a deal orchestrated by Treasury Secretary Henry Paulson, the Federal Reserve agreed to lend JPMorgan Chase up to $30 billion in exchange for liquid mortgage securities held by Bear Stearns. The bailout was the first time since the Great Depression that the Federal Reserve lent money to a company that was not a bank.[7]

In many ways, the near-collapse of Bear Stearns resembled a classic “run on the bank” financial panic from the 1930s. As concerns about the quality of its subprime mortgage investments spread, Bear Stearns could no longer raise short-term funds by selling mortgage-backed assets on the securities repurchase market.[8] When rumors spread that Bear Stearns could become insolvent, many of its lucrative hedge fund clients began pulling their prime mortgage accounts.[9]

Facing criticism for his hands-off approach to the mortgage credit crisis, Cayne announced his resignation as CEO in January 2008. While Bear Stearns’ hedge funds were losing more than $1.6 billion last summer, he was busy playing golf and at a bridge tournament.[10] Both the U.S. Securities and Exchange Commission and the U.S. Attorney’s office are investigating the collapse of the Bear Stearns' hedge funds.[11]

Cayne’s compensation peaked at the height of the real estate bubble. In 2006, he received a $17 million bonus, $14.8 million in restricted stock, $1.7 million in stock options and more than $6.1 million in other compensation, including preferential earnings under the Capital Accumulation Plan for executives. The compensation committee determined the size of the 2006 executive bonus pool based on Bear Stearns’ after tax return on equity.[12] Cayne did not receive any bonus or units under the Capital Accumulation Plan last year.[13] But he realized $10.3 million from vesting stock awards in 2007.[14]

In hindsight, it appears that Cayne’s compensation was not adequately tied to risk-adjusted performance measures. For example, Bear Stearns’ decision to link executive pay to return on equity can encourage executives to use increased leverage. The board of directors may not have paid sufficient attention to the amount of mortgage-related risk that Bear Stearns was undertaking as it did not establish a finance and risk committee until Jan. 10, 2007.[15]

The real estate crisis hasn’t been all bad news for Cayne. He didn’t need to take out a mortgage to buy his $25.8 million luxury condo at the Plaza on Fifth Avenue at Central Park.[16]

[1] “J.P. Morgan Buys Bear in Fire Sale as Fed Widens Credit to Avert Crisis,” The Wall Street Journal, March 17, 2008.

[2] “J.P. Morgan Quintuples Bid to Seal Bear Deal,” The Wall Street Journal, March 25, 2008.

[3] Bear Stearns proxy statement filed with the U.S. Securities and Exchange Commission on March 27, 2007.

[4] “Toward the Exit: Cayne Sells Big Stake in Bear,” The Wall Street Journal, March 28, 2008.

[5] “Lifeline: Bear Stearns Bails Out Fund with Big Loan - Injection of $3.2 Billion Caps Days of Drama; Subprime Sector Fears,” The Wall Street Journal, June 23, 2007.

[6] “Center of a Storm: How CDOs Work,” The Wall Street Journal, June 23, 2007.

[7] “The Week That Shook Wall Street: Inside the Demise of Bear Stearns,” The Wall Street Journal, March 18, 2008.

[8] “Another Source of Quick Cash Dries Up; Firms Rethink Reliance On 'Repo' Financing as Conditions Tighten,” The Wall Street Journal, March 17, 2008.

[9] “Hedge Funds, Once a Windfall, Contribute to Bear's Downfall,” The Wall Street Journal, March 17, 2008.

[10] “Cayne to Step Down as Bear Stearns CEO,” The Wall Street Journal, Jan. 8, 2008.

[11] “Bear Probe May Center on Investor Call,” The Wall Street Journal, Feb. 15, 2008.

[12] Bear Stearns proxy statement filed with the SEC on March 27, 2007.

[13] Bear Stearns 10-K/A filed with the SEC on March 31, 2008.

[14] “Bear Stearns’ Cayne Realized $10.3M from Vesting in FY 2007,” Dow Jones Newswires, March 31, 2008.

[15] Bear Stearns proxy statement filed with the SEC on March 27, 2007.

[16] “ Dealbook Extra: Bear’s Den,” The New York Times, March 14, 2008.