O'Shaughnessy says warned on Bear leverage

NEW YORK (Reuters) - Star stock fund manager James O'Shaughnessy, before leaving Bear Stearns in early 2007, said he had warned the investment bank's executives that some of its investment funds were taking too much risk.

By the middle of last year, O'Shaughnessy was at his own firm managing $8.8 billion of assets, while his former employers were struggling with high-profile losses generated by two highly leveraged mortgage securities funds.

"I did express, at some point, my concern about the use of leverage and was politely told to mind my own business," O'Shaughnessy said at the Reuters Investment Outlook Summit in New York.

O'Shaughnessy, who left Bear on amicable terms, stressed that the firm was hardly alone in using lots and lots of debt to amplify returns made trading illiquid instruments, such as some subprime mortgage-backed bonds and collateralized debt obligations.

"I had been on record for a long time saying that was among the most stupid things you could do," he said.

Indeed, he said piling up excessive leverage is the root of every financial crisis, including the one that ultimately forced Bear Stearns out of business in March this year. Bear was forced into a shotgun marriage with JPMorgan Chase & Co (JPM.N).

O'Shaughnessy and his team of quantitative stock fund managers had left Bear in 2007 to form O'Shaughnessy Asset Management. He left after eight years as part of Bear Stearns Asset Management and before BSAM's highly leveraged mortgage funds began to raise doubts about Bear's ability to navigate the building credit crunch.

"I don't think Bear Stearns was doing anything any different than the other investment banks, as we saw," O'Shaughnessy said. "So from my perspective, was there a systemic failure on Wall Street? Yes, there was. They were using too much leverage."

During the past year, investors have put pressure on Wall Street banks to reduce their use of borrowed money from more than 30 times equity to less than 20 times. O'Shaughnessy, who personally carries no debt, believes any leverage ratio above 4 times equity is too much.

"When that happens, you take risks," he said. "I think that my desire to not play in that game is what led to me rolling back out" of Bear Stearns.

Recently, O'Shaughnessy's firm repurchased a 10 percent equity stake in the firm from JPMorgan, he said. Royal Bank of Canada (RY.TO) remains an outside investor.

Beyond letting leverage levels rise too high, O'Shaughnessy said Bear failed to manage its risks across its fund groups.

"The BSAM way of doing things was in silos. We had an equity team. There was also a value team and a growth team. And then there were the hedge funds: Ralph (Cioffi) and his team. Melissa Ko and her currencies team," he said. "We didn't have a lot of interaction with the hedge fund guys."

That hands-off approach allowed two Cioffi-led mortgage funds to build up positions that became difficult to sell when markets began to tighten up in late 2006. By the middle of 2007, the funds were in the red and ultimately collapsed into bankruptcy.

Bear Stearns leaders like Chief Executive James Cayne and Warren Spector, as well as executives at other firms, "should have been more forceful on risk management," O'Shaughnessy said.

In the end, he said, Bear Stearns was just the first ship to get hit by the financial storms of the past year.

"It's easy to say with hindsight. Yet this was an epidemic. You can't really just say 'J'accuse Bear!' You have to go around to everyone at the table, which were all the other investment banks and a hoist of hedge funds which were doing exactly the same thing."

(For summit blog: summitnotebook.reuters.com/)

(Editing by Leslie Adler)