Wall Street Law Blog

Bear Stearns collapsed 5 years ago; fraud remains overwhelming success

Part 1:  Introduction -

Understanding securities fraud at Bear Stearns - Backstory of The Global Financial Crisis

Five years later, why should anyone care whether Bear Stearns (through Senior Management) committed securities fraud? 

Because...

(a) To understand how securities fraud by top executives at Bear Stearns toppled what was the fifth largest Wall Street investment bank is to understand why all of Wall Street's major investment banks subsequently disappeared.

(b)  The fraud that caused the end of the era of the traditional Wall Street investment bank gave birth to a chain of events that evolved into the worst financial crisis since the Great Depression.  

-and-

(c) As a direct result of their own securities fraud and other illegal conduct, members of senior management at Bear Stearns collected enormous financial windfalls that they did not earn and do not deserve to keep.  Senior management's windfalls came at the expense of America's economy and the economies of other countries around the world (and, on a "closer to home" level, executive committee members enriched themselves at the expense of Bear's own employees and shareholders).  

There are two basic elements of the financial windfalls that, to date, Bear's executive committee members have managed to retain-

First, Bear Stearns paid its Executive Committee members enormous cash bonuses for "leading" the company to record revenues from 2002 through 2006 with the same unsustainable high-risk business model that (a) caused Bear's failure and (combined with the same, similar, and/or related misconduct at Merrill Lynch and Lehman Brothers and Citi,and Goldman Sachs and insurance giant AIG -- to name a few of the responsible companies) (b) ultimately produced the global financial crisis.  

The second (and far more lucrative) element of the financial windfalls reaped by senior management came from selling massive amounts of Bear Stearns stock at artificially high prices.  The record "success" Bear Stearns achieved because of its fraudulent and unsustainable business model temporarily produced record high share prices for Bear Stearns common stock.   Indeed, from January 2000 to January 2007, the share price for BSC stock quadrupled.  

 During this period of stock price inflation, Bear's five top executives -- all of them members of the former investment bank's executive committee -- reportedly sold more than $1 billion dollars worth of stock-based compensation from prior years. 

Again, the story of unjust enrichment at Bear Stearns is a microcosm of unjust compensation practices all over Wall Street.

So far, securities fraud by Bear's former leaders has been a tremendous success.  The primary reason for this is, we believe, the sheer complexity of the fraud.   From the housing bubble to "affordability mortgages" to the different kinds of derivative securities that were part and parcel of the long running course of securities fraud at Bear Stearns (and on Wall Street generally), the misconduct at issue revolves around a lot of intimidating stuff. 

From easier (but not easy) to understand  concepts like subprime and Alt-a mortgages to harder (often headache inducing) "structured products" like mezzanine collateralized debt obligations, credit default swaps to fixed income terms like yield spreads, it is a daunting task to peel back the layers of fraud on Wall Street during the 2000s.   

"Fraud by complexity" is very dangerous.  Until Main Street has a far better understanding of what happened on Wall Street, then the corrupt rigged game that senior management for the old investment banks played so well for so long will resurface in slightly different form sooner rather than later.  

A deeper examination of securities fraud at Bear Stearns is, we at Wall Street Law Blog believe, a great place to start parsing fact from fiction and isolating the complex -- but ultimately fascinating -- story of the genesis of a financial catastrophe.  

 

The Wall Street Law Blog, a Publication of The Sherman Law Firm.

 

Fraudulent AAA Credit Ratings Have Many Tentacles, Don't They?

Food for thought...

Isn't there a direct relationship between bogus AAA credit ratings and fraudulent SEC filings?

 

Let’s say, circa January 2006, a hypothetical investment bank’s mortgage securitization group solicited and obtained AAA credit ratings (via ratings shopping) for RMBS (or related structured products) even though the bankers KNEW that, in reality, the mortgage bonds were far riskier than AAA rated investments are supposed to be. 

Now, let’s say that the same bank is holding some (or even a lot) of these dubious AAA rated mortgage-backed securities at the end of the 2006. 

 

 

AAA Credit Ratings Like Octopi?

 

 

Wouldn’t Bear Stearns - er Lehman - er Merrill ...  I mean, wouldn’t the hypothetical bank - knowing that the AAA ratings were bogus - account for the bonds in the annual report as if the bonds were virtually, if not entirely, riskless?  And, if so, how could the annual report be anything other than materially misleading (i.e., securities fraud and accounting fraud)? 

Just asking...

By Brett Sherman

The Sherman Law Firm, Publishers: Wall Street Law Blog 

Difference maker? An Admission that Bear Stearns Chose Not to Share With Its Shareholders (Corrected)

-Warning:

If you owned shares of BSC (the former NYSE ticker symbol for Bear Stearns common stock) when Bear's share price was falling during 2007 and early 2008, you may be somewhat pissed off by an admission that Bear made to the SEC.  

If I had owned shares of BSC, I am pretty sure I would freak.  I am positive that, if I was a Bear Stearns shareholder back then, I would have sold every single hare I owned immediately upon learning what Bear told the SEC in a letter dated January 31, 2008.  

The January 2008 letter, signed on behalf of Bear Stearns by SAM MOLINARO - at the time Bear's CFO and COO - says, among other interesting things, this:

We believe that based on the Company's level of involvement in subprime lending and the broader impact on global credit markets, a material adverse impact on the Company's financial condition, results of operations or liquidity is reasonably possible.

Translation: There is a real possibility that Bear Stearns' subprime exposure could cause the company to suffer severe financial damage.  

Wait.  I know what you are thinking.  You were going to say something like this:  So What?  Everyone on Earth knows that Bear's mortgage exposure was a pretty big factor in the collapse of the investment bank.  

True.  But not everyone knew that on January 31, 2008.  Certainly, there was a great deal of concern about Bear.  And if you were a stockholder of the Bear Stearns Companies Inc. in 2007 and 2008, you were concerned about the value of your investment.  After all, Bear was widely known as the king of mortgage securitization at a time when it clearly was definitely not (in the words of Mel Brooks playing Louis XIV in Brooks' classic History of The World, Part 1) "good to be the king."   

-BUT-

Bear Stearns executives repeatedly addressed all that.  They denied that the firm had anything other than temporary problems based on difficult market conditions that were the natural result of an inevitable turn in the business cycle.  

Top executives devoted themselves to damage control.  And the story they told did not vary.  The short version of the fairy tale went like this- 

TOUGH MARKETS; REAL, BUT TEMPORARY PROBLEMS;  HEALTHY BALANCE SHEET;  AMPLE LIQUIDITY; BRIGHT FUTURE...

* * *

-THE REST OF THE STORY

After shares of BSC peaked at a price north of $150 in January 2007, the stock began a long bumpy slide toward the abyss.  Stockholders outside the small cloistered circle of truly informed insiders, were in a tough spot. The issue, of course, was whether to sell while the price headed south, or hang in there, ride out the storm and hope Bear's problems were temporary.  

Senior management at Bear Stearns understood that they had a ton of influence over whether the market saw the Bear Stearns glass as half empty or half full.  Bear's top executives pushed the half full angle. In other words, they decided to be extremely optimistic about the situation. 

For example, management claimed that, in formulating Bear's growth strategy, the executive committee had expected and accounted for trouble in the mortgage markets.  Yes, they acknowledged market conditions were probably worse than anticipated.  But Bear's unique expertise with distressed mortgages, they said, meant great things for Bear Stearns in the not too distant future.  

Management even portrayed the drop in the Bear Stearns stock price in a positive light.  What could be good about the price slide?  Management took the position that the market had overreacted to temporary market conditions and oversold the stock.  Speaking at Bear's October 3, 2007 investor day, then CEO Jimmy Cayne called the stock a "compelling value."

In his investor day speech later that morning, CFO Sam Molinaro expanded on Cayne's compelling value comment.  Molinaro gave a detailed presentation to investors and analysts to show them why the price decline created an investing opportunity.  Molinaro's argument was based on a comparison of Bear's then current price to book value ratio and Bear's similar price-to book calculations during a series of prior market crises. 

In each prior instance, the stock had quickly rebounded and investors who bought shares during other crises realized substantial gains.  The problem with Molinaro's explanation was that Bear's true book value was really much lower than reported.  

In any event, Bear Stearns' executives kept pushing silver lining scenarios through 2007 and early '08.  This strategy was rational from their personal perpectives because these guys owned a lot of stock. They had a vested interest in propping up the share price up for as long as they could.

--MISREPRESENTING EXPOSURE TO MORTGAGE RISK

Because subprime and other risky mortgages were at the heart of market concerns about Bear Stearns, management made a concerted effort to promote the great job the company had done to reduce mortgage-related risk exposures.

For example, eight days after Molinaro admitted in the January 31, 2008  letter that it was "reasonably possible" that Bear's subprime exposure could have a "material adverse impact...," Molinaro made one of a series of road-show presentations, this time at a Credt Suisse conference, on what amounted to a good-will / propaganda tour on behalf of Bear Stearns in late '07 and early '08.  

The following slide was part of Sam Molinaro's presentation at the Credit Suisse conference-

  

In light of the admission in the SEC letter about a week earlier, there is a term for the message conveyed by this slide.  That term is material misrepresentation.  Another one is securities fraud.

By Brett Sherman

The Sherman Law Firm

Fraud by Complexity: On mortgage bond issuers, boilerplate risk disclosures, lies, and cover-ups...

[Editor's Note - This is a new post with relevant excerpts from a previous Wall Street Law Blog publication about fraud, complexity, and a David Faber interview with Alan Greenspan]  

 

IS IT REASONABLE TO BELIEVE WALL STREET USED COMPLEXITY TO FOOL SOPHISTICATED INVESTORS ABOUT THE QUALITY OF BONDS BACKED BY NONCONFORMING MORTGAGES DURING THE HOUSING BUBBLE ERA?

In a word - ABSOLUTELY.

Indeed, there was so much comlexity in the various methods Wall Street used to package and repackage mortgage bonds in the 2000s that it was nearly impossible for anyone outside the big banks that engineered and sold the products to know the truth about how risky they really were.  And the truth was that these products were extremely risky.

Indeed the vast majority of mortgage bonds sold to investors during the 2000s were junk, toxic waste. The problem is that these investments were packaged and sold by issuer banks, with the help of rubber stamped credit ratings, as high quality (safe) securities.  

Were the risks disclosed in prospectuses, as some have argued?   In a word, nope.

Sure, there were boilerplate risk disclosures.  Tons of 'em in fact.  But there was no loan level data.  No specifics about the actual mortgages.  And the actual mortgages were the root of the problem.  

Oh, and the issuing banks concealed real known problems from investors by cloaking the problems as risk factors. What the heck does that mean?  Glad you asked.  It means that risk factors in a prospectus are warnings about potential hazards.  A hazard that has already come to fruition at or before issuance is in fact already a problem.  Because there is no longer anything "potential" about a risk, it is fraud to label it as a risk factor.  

Still confused?  That's ok.  The whole idea was to confuse investors.   Here is an example of what we mean:

One risk factor in every mortgage bond prospectus we've read is about potential liquidity problems with CDO investments.  In other words, a prospectus would warn investors that there is no assurance that there would be a secondary market for the bonds.  Unlike stocks, mortgage-based derivatives don't trade on an exchange.  Market demand could dry up, and if it did, investors who wanted to sell their bonds might be out of luck.    

By late spring 2007, there was virtually no secondary market for CDOs.  Technically, it was probably possible to sell them, but almost exclusively to bottom feeders at distressed prices (nowhere near face value).  And yet, there were tons of new CDO offerings in 2007.  The issuing banks concealed the absence of a real secondary market because they wanted to unload as much of their inventories of bad mortgages and mortgage bonds before the jig was up.  

The issuers - banks like Bear Stearns and Merrill Lynch and Lehman Brothers (to name a few) - knew that there were big problems in the secondary market.  Instead of disclosing the fact that the after-market was well on its way to being totally frozen, these issuers kept right on including the same old generic risk factor about the possible absence of a secondary market.  

Also, there is ample evidence that the big banks (a) created the false appearance of market demand for CDOs by selling the investments to each other, and (b) that, when the mortgage bond market was imploding, these same big banks colluded to hold bad mortgage investments on their balance sheets so they could report artificially high maket prices and avoid/delay taking true mark-to-market writedowns. 

Just how confusing were CDO's to investors?  Consider the following excerpts from an interview that David Faber conducted with Alan Greenspan.

September 4, 2008

David Faber: I would think you're one of the few people who might understand what a CDO really is...

 

Alan Greenspan: But some of the complexities of some of the instruments that were going into CDOs bewilders me.

I didn't understand what [the banks that produced CDOs] were doing or how they actually got the types of returns out of the mezzanines and the various tranches of the CDOs that they did. And I figured if I didn't understand it -- and I had access to a couple hundred PhDs -- how the rest of the world is going to understand it sort of bewildered me.

But here I am observing all of these very sophisticated investors trying to buy more of this stuff than existed.

 

David Faber: Yes, but this goes to my original point in my question to you-  If Alan Greenspan can't understand how they are getting to where they are getting on these particular structured products, then how are any of these investors supposed to understand?

 

Alan Greenspan: Well, we learned the answer to that. THEY DIDN'T.

 

By Brett Sherman, The Sherman Law Firm

 

Risky business on Wall St: Contrary to claims of some, there is securities fraud in them thar risks.

 

• RISKY BUSINESS IS (usually) OK IF CLEARLY DISCLOSED TO INVESTORS.

 

• HOWEVER, MATERIAL MISREPRESENTATIONS ABOUT RISK is something else altogether (something called fraud).

By Brett Sherman, The Sherman Law Firm

Deception is the essence of fraud.  Bear Stearns deceived investors (and the markets generally) about crucial facts, including (a) the firm's management philosophy and approach to risk management, (b) performance of Bear's core mortgage businesses, and (c) the financial condition of the former investment bank.

Today, Wall Street Law Blog looks at one aspect of fraud at Bear Stearns - The Executive Committee lied time and again about risk management at the former investment bank.

 

                   Bear Stearns Umbrella "Risk Managed"

Risk Management LIES:

Please note that time and space limitations require us to list only a few material misrepresentations.  But we assure you that we can, if necessary, go on for hundreds of pages and thousands of years (a little hyperbole is ok now and then)-

 

• The risk management infrastructure and processes remain conservative and consistent with past practices. This structure and strong risk management culture has allowed the firm to operate for all of its history as a public company without ever having an unprofitable quarter.
  

 

• By maintaining a strict approach to risk, and by allocating capital wisely, we have achieved one of the lowest levels of trading revenue volatility on Wall Street. At Bear Stearns, we know we cannot predict the future, but mitigating the risks ahead this part of the foundation upon which this firm was built....
  

 

• True to our culture, we continue to search for ways to run our business more efficiently, always balancing risk and reward.
  

 

• Our commitment to excellence and measured approach to balancing risk and reward has kept Bear Stearns focused...We continue to avoid short term trends by staying focused on the long term strengths of our businesses.
  

 

• Our culture of risk management -- I just want to emphasize it is central to everything we do...So, risk management comes first and then growth.
  

 

• The philosophy of creating value over the long term also drives our approach to product innovation and entering new businesses... This philosophy is evident in the disciplined approach we take to managing the firm's risk...

• We're very proud of the way we do risk management. It's an integral part of our culture

 

• dedication to risk evaluation and management that has given us the ability to expand carefully and conservatively.
  

 

• The strict risk discipline imposed on our trading desks is reinforced by the strong sense of ownership that permeates the culture of the corporation.
  

 

• You can expect us to continue to adhere to our core values, including this consistent and deliberate approach to risk...
  

 

And we could go on and on and on...

Risk Management TRUTHS:

AT THE SAME TIME BEAR STEARNS WAS BUSY REASSURING INVESTORS HOW GREAT THE FIRM WAS AT MANAGING RISK, SENIOR MANAGEMENT KNEW BEAR'S RISK MANAGEMENT SYSTEM SUCKED.

 

THE EVIDENCE (some of it)

February 4, 2008 - internal Bear Stearns email to members of Bear's management committee, with reminder of meeting with outside consulting firm Oliver Wyman and attached risk presentation entitled: "RISK GOVERNANCE DIAGNOSTIC, RECOMMENDATIONS, AND CASE FOR ECONOMIC CAPITAL DEVELOPMENT PLAN"

Really, the slide called "Gaps in Risk Management" says it all.

 On that slide, consultant Oliver Wyman described a risk management system that was about as bad as it gets.  Some of the risk management lowlights, according to the Wyman Report- 

• Bear Stearn's did not have any formal system for determining the company's risk-appetite. It seems to us that it just may be kind of hard to manage risk when there is no guidance about how much risk a business is willing to assume.

• No uniform requirements or system for approval of trades. Again, it sure seems like a firm with 15,000 employees would need formal systems for things like trade approvals.

• Risk management personnel frequently had little advance notice of proposed transactions.  Worse, Bear's traders and business desks apparently did not feel compelled to provide very much information to the firm's risk managers. To us, this suggests that few people really wanted input from Bear's risk managers.

• Bear's internal risk limits were often ignored or overridden by management without regard for additional risk exposure. To us, this suggests that risk limits were put in place to placate regulators rather than to actually manage risk.

• Bear Stearns had no formal policies or procedures to evaluate risks of its business operations. Oliver Wyman used the term "ad hoc" to describe how Bear made strategic risk decisions.
  

• Risk management personnel at Bear Stearns lacked "stature" (i.e., respect and authority). They were second class citizens with little influence over actual business practices.
  

 

In sum, Bear Stearns management did not articulate a risk-appetite for the company (or at least no specific guidelines for risk tolerance were communicated throughout the company); Bear Stearns did not listen to or respect its risk managers;  Bear Stearns had no formal procedures for risk managers or business units to follow; and there was no real methodology for making risk management decisions.

Other slides from the presentations show that Bear had poor channels of communication regarding risk-taking and no effective plan for matching capital to risk (i.e., Bear did not determine its capital needs based on its risk exposures) 

CONCLUSION

 

The Wyman Report is an exhibit introduced by the Financial Crisis Inquiry Commission during the FCIC'. In May 2010, five former Bear Stearns senior executives gave testimony before the FCIC (FCIC.gov), about the shadow banking system and the collapse of Bear Stearns.

In a recent post, Phil's Stock World reacted to the hearings so perfectly that, despite our best efforts, Wall Street Law Blog could not top Phil's summary.  So, with all due credit given, we excerpted part of the post.  Phil's Stock World pointed out that, during their testimony, Bear's former honchos seem to have blocked out some relevant stuff, including:

[Bear's ] insanely high leverage (up to 42:1), large holdings of MBS, poor risk management, and overnight borrowing from the repo market ($50 to $60 billion) had nothing to do with their collapse. They did nothing wrong and were the victims of a conspiracy of evil traders who seized upon their temporary lack of liquidity and sent them over the edge when investors irrationally lost confidence. Talking about an alternate universe, these folks should be sent to St. Helena to think about cause and effect for a while. Jimmy Cayne would probably just play bridge there."  

 The post from Phil's (you can read the rest here) had us hooked at "St. Helena."    

* * *

 

Bottom line here?

Bear Stearns deliberately promoted a supposed commitment to high quality risk management that, during the 2000's at least, was a total fiction.  In other words, Bear Stearns constant touting of its risk management prowess was material and false.

Our favorite synonym for material misrepresentation is a word we like to call fraud.  And - as we will show in future posts - Bear's fraud went much deeper than its false claims about risk management. 

 

 

10b-5 Claim for Securities Fraud: Whom to sue?

You can sue primary violators of Rule 10b-5.  You cannot sue those who merely aid and abet a securities fraud.  Trouble is, the line between primary violators and those who aid and abet a securities fraud moves like the San Andreas fault.

 

In the landmark Central Bank of Denver case, the US Supreme Court ruled that there is no private right of action available against those who aided and abetted another to commit securities fraud.  In other words, you can't sue people who merely helped another to defraud you.

Ever since the Central Bank decision, there has been considerable disagreement about where to draw the line between aiders and abettors and primary violators (who, unlike aiders and abettors, can be sued for investment losses). 


The debate about who can be sued for securities fraud cannot be settled until there is a consensus line in the sand type test for separating primary violators from mere helpers.

The following post, reprinted from Jim Hamilton’s World of Securities Regulation, describes the SEC's position on a major point of controversy in the "who to sue" debate.

 

********************

In an amicus brief filed in the Second Circuit Court of Appeals, the SEC said that attribution of a false or misleading statement to a person is only one means by which that person can create the statement and thus be a primary violator under the Central Bank rubric. A person who, acting with the requisite scienter, creates a misstatement is a primary violator regardless of whether the victim knows the person’s identity. Thus, the SEC disagreed with the district court’s holding that, in order for a person to be a primary violator with respect to a publicly disseminated false or misleading statement, the person must have been identified to potential investors as the maker of the statement or, in other words, the statement must have been attributed to the person at the time it was made. Pacific Management Company LLC v. Mayer Brown LLP, CA-2, on appeal from SD NY, 09-1619-cv.

This is a Rule 10b-5 private damages action. While the SEC, unlike a private party, has express statutory authority to bring aiding and abetting claims, there are instances where the Commission might need to assert a claim for primary liability. The SEC is concerned that the district court appeared to recognize language in the Second Circuit’s 2008 ruling in US v. Finnerty suggesting in dictum that attribution is required even in a government law enforcement action.

In Central Bank v. First Interstate Bank, the Supreme Court drew a distinction between persons who aid and abet securities fraud violations and primary violators of Rule 10b-5, ruling that private parties cannot bring actions against aiders and abettors, only against primary violators. The Court said that secondary actors, such as lawyers and accountants, could be primary violators if they made a false or misleading statement.

In the SEC’s view, a person makes a false and misleading statement and can thus be liable as a primary violator of Rule 10b-5 when he or she creates the statement. In this context, a person creates the statement if they write or speak the statement or if they provide the false or misleading information that another person puts into the statement or if they allow the statement to be attributed to them. For example, a person who actually drafted an offering document containing false or misleading statements can be a primary violator, as can a person who supplied the writer with the false or misleading information in the document, as can a person who signed the offering document or otherwise acknowledged to investors that the statements were his or her own.

The SEC argued that its position is consistent with the Court’s Central Bank ruling. The Court did two things in Central Bank, said the SEC, first the Court held that there is no private right of action for aiding and abetting under Rule 10-5 but only for primary violations and, secondly, it stated that a plaintiff would have a private cause of action against a secondary actor for primarily violating Rule 10b-5 when the secondary actor was a primary violator, that is, had, among other things, made a false or misleading statement. According to amicus, the Court thus excluded liability when a person’s responsibility for a false or misleading statement did not rise to the level of a primary violation and made clear that if a person’s liability did rise to that level, then the person would be liable even though he or she might not have been the principal actor in the alleged fraudulent activity.

The word ‘’make’’ as used in Central Bank, noted the SEC, does not give rise to a requirement that only a person who has been identified to investors can be deemed to have made a statement. A person can ``make’’ a false or misleading statement anonymously or indirectly through someone else.

A test imposing primary liability when a person creates a false or misleading statement reflects both of the Central Bank concerns, said the SEC. Such a person is, with regard to the statement, not just an aider and abettor, he or she is responsible for the statement coming into being. As such, the person should be held primarily liable. And, continued amicus, a person creating a false or misleading statement would be primarily liable without regard to whether he or she acted alone or with others. They would also be primarily liable regardless of whether they initiated the false or misleading statement.

The SEC also contended that an attribution requirement would shield significant misconduct from liability by allowing a person who created a false or misleading statement to escape primary liability by acting anonymously or in another’s name. Thus, the SEC reasoned that an attribution requirement could provide a defense for the person having the greatest culpability for a deception.

Thank you Jim Hamilton’s World of Securities Regulation.

*******************

There is an answer to the "who to sue" question-

Sue anyone you have a reasonable and good faith belief may have played a core role in committing securities fraud.

Then just wait for the motion to dismiss based on Central Bank of Denver...

Contact The Sherman Law Firm.

 

 

 

No Defense to Securities Fraud: "We just did what everyone else was doing..." (updated)

The Industry Standards or Industry Practices Defense is No Defense At All in Securities Litigation.

 

"That's just the way the industry worked" is just another version of the "I was just following orders" defense that the world rightly rightly rejected at Nuremburg.

• Nearly every client we represent in securities fraud cases related to the financial crisis asks the same question - "Aren't the banks just going to say that everyone on Wall Street was doing the same thing?"  (**Note - former Bear Stearns executives did, in fact, assert a so-called industry standards defense to explain their misconduct during testimony before the Financial Services Inquiry Commission on May 5, 2010).

 

• Our answer is always the same - "Sure they will, but it won't work."

 

• For instance: If all the major Wall Street banks knowingly securitized crappy loans and misrepresented them as AAA quality (regardless of credit rating), that just means there was a whole lot of fraud on Wall Street.

 

• And a whole lot of fraud is not an acceptable defense in any jurisdiction. For reference, you may want to google Henry Blodget and the rest of the pay for play analysts from the 1990s tech IPO boom.  

 

                           HENRY BLODGET, FORMER MERRILL LYNCH INTERNET ANALYST

• So, in conclusion:

Securities fraud at Merrill Lynch, Lehman Brothers, AIG, CITI does not excuse securities fraud at Bear Stearns or Goldman Sachs or JP Morgan.

And Vice Versa.

By Brett Sherman, The Sherman Law Firm

How Wall Street Manipulated the Risk-Reward Tradeoff (updated)

Did The Sheer Complexity of MBS, CDOs, and related "Structured Products" Enable Wall Street to Cheat Investors out of A Reasonable Risk Premium? 

 

 

An impromptu analysis of securities fraud and the mortgage securitization boom that led to the great 21st century Financial Crisis.  

If pressed to identify one factor that made Wall Street's subprime securitization frauds of the last decade so successful (as of this writing, it cannot be credibly argued that these mortgage-based frauds were anything other than an enormous financial success for most of the individuals who ran major investment banks), we would select complexity as that one factor.

In this post, we attempt to explain how we believe the big banks used complexity to disguise risk and con the markets.  

 

Background: Investors bought subprime mortgage bonds for a simple reason. 

For most of the housing bubble era, AAA-rated tranches of nonconforming mortgage bonds (those backed by subprime mortgages and alt-a mortgages) offered investors slightly higher returns than other AAA-rated bonds.

 

Since the risks were ostensibly the same for a mortgage bond carved out of a AAA-rated tranche of an MBS or CDO and other AAA-rated securities, Wall Street knew that most big institutions would choose to buy the higher yielding mortgage bonds.  And this is precisely what happened. 

 

As the housing bubble expanded, investor demand for private label MBS and CDOs seemed insatiable.  Only when market conditions changed enough for the investments to be exposed as the frauds that they always were did investor demand finally disappear.  By that point, however, the personal wealth accumulated by senior management at the major Wall Street banks from securitization and sales of fraudulent mortgage bonds during the 2000s was staggering. 

The housing bubble era was, in sum, a short-term money grab.  Management enriched themselves at the expense of the shareholders they were obligated to serve (not to mention the financial health of most nations on Planet Earth).

 

"Fraud by Complexity": Hiding Risk from Investors.

During the housing bubble era, very bright people designed mind-numbingly complex financial products to conceal risk from investors.

Bear Stearns, Lehman Brothers and the rest of what were the big 5 investment banks (and a group of other powerful financial institutions) knowingly marketed and sold high-risk mortgage bonds to institutional investors all over the world for years as if those risky investments were, instead, extremely safe AAA-quality securities. 

 

Indeed, we believe that complexity is the ultimate x factor that allowed Wall Street to collude with and/or bribe credit rating agencies, which then stamped securitized subprime/Alt-a mortgage bonds with AAA credit ratings.  It was complexity that allowed investment banks and rating agencies to construct formulas and models with bogus inputs and flawed assumptions to "justify" what investors now know were fraudulent credit ratings.

 

It was, of course, the vaunted AAA credit rating that guaranteed a massive market for dodgy (to put it mildly) mortgage bonds for as long as market conditions were such that the true risks of those bonds remained hidden.  When the housing bubble popped and mortgage defaults spiked, firms like Lehman and Bear Stearns kept up the pretense of quality for as long as they could. 

Thus, management at most (though not all) of the big banks squeezed as much personal profit as possible from their fraud factories before mortgage defaults inevitably reached high enough levels, in or around early 2007, to undermine the credibility of previously unquestioned AAA credit ratings. 

When the number of investors who began to doubt the credlt-ratings for mortgage bonds hit a critical mass, the scheme reached a tipping point and the game was up. 

From summer 2007 on, the handwriting was on the wall for the few that, like the big investment banks, were privy to enough information to read it. Soon came the foreseeable, indeed the inevitable, flight to quality that is a core feature of all bond market panics.

 

Flight to Quality

In a flight to quality, investors try to dump everything that is touched by uncertainty and move as much money as possible into investments that they know are safe.  Most often, that means a mass movement of money into Treasuries.  When investors began their flight to quality, demand for mortgage bonds essentially disappeared.  From that point, those on the inside knew, or should have known, that there was no stopping the dominos from toppling.  

 

Concealing Risk; Paying Lower Risk Premiums

Complexity of structured mortgage bonds - from mortgage-backed securities to even more complex CDOs, CDOs-squared, Synthetic CDOs and so on -- was intentionally exploited by Wall Street to hide risk.  By concealing the true risk of these investments, the Bear Stearns and Lehmans of the world manipulated the risk-return tradeoff (from econ 101) so that these financial institutions could profit by paying far less return than is warranted by the risk of these products. 

If a bond issuer uses deception to convince investors to accept a lower risk premium (a lower yield than would be required if the true risks were known to investors), then the issuer fraudulently profits from the difference between the comparitively high risk premium the investment should require and the low yield that is actually paid out.

 

The beauty of this type of scheme, of course, is that -- until the foundation finally caves in -- investors actually believe that they are getting a generous return because the yield is a bit higher than Treasuries and other AAA-rated investments. 

 

The truth, hidden from investors, is that the return on mortgage bonds blessed with bogus AAA-ratings was far too low given the risk of these products.

 

As for those executives who claim they did not understand their own businesses, remember that fraud includes intentional misconduct and wilfull blindness.  

Hiding the true risk of mortgage bonds produced well-documented windfalls for Wall Street's top executives and their lieutenants, even as many of those executives presided over the destruction of the companies they managed on behalf of thousands of public shareholders.  

 

Conclusion: A "AAA-Rating" Does Not (Necessarily) Equal "AAA-Quality"

The fact is that these banks knew the majority of the AAA "private label" mortgage bonds they peddled in the 2000s were high risk, but not high quality.  

 

The banks knew the true risks of subprime MBS and CDOs, but few investors had access to sufficient information to decipher these risks for themselves. 

Instead, investors justifiably relied on the representations of mortgage traders and salespersons and especially on the supposed integrity of credit ratings. Today, we all know what the big banks knew all along -  

AAA is in the eye of the beholder.

 

By Brett Sherman, Wall Street Law Blog