Would Bear Stearns sales have exposed "mark to market" fraud?

    Did Bear Stearns maintain a massive mortgage-related securities portfolio to avoid huge write-downs, cover fraud, or even hide insolvency?  

We'd sure like to know.

 

• After the subprime crisis began in 2007, senior managing directors at Bear Stearns reportedly urged the firm's Executive Committee to raise capital by, among other actions, selling off chunks of the firm's massive portfolio of mortgage-related products.

• Mortgage boss Tom Marano consistently fought the idea of any substantial liquidation of Bear's mortgage holdings.  

• The ever-worsening mortgage and credit crises meant that Bear Stearns could sell mortgage-related products for only a fraction of their original values.  However, there came a point in 2007 (at the latest) when Bear Stearns management knew or should have known that the market for mortgage-backed securities and related investments was dead in the water.  The housing and credit bubbles had popped.  The party was over.

• Still, according to the estimated values Bear Stearns was assigning to its mortgage holdings in 2007 and 2008, substantial liquidations from Bear's mortgage portfolio at deep discounts could have yielded billions of dollars for the firm's war chest.    

• SEC records show that Bear Stearns had significant liquidity problems by late summer, 2007.  

• In light of Bear's documented liquidity issues and falling demand / prices for MBS and CDO's, there seems to be no logical reason why Bear Stearns would keep huge amounts of the firm's capital locked inside mortgage securities were (a) consistently losing value, (b) had virtually no chance for any real, sustained recovery, and (c) would be difficult to sell quickly if Bear Stearns needed to raise cash quickly (which, of course, is precisely what happened when Bear was undone by a severe liquidity crisis in March 2008).

• Nevertheless, Tom Marano continued to argue against any substantial reduction in the firm's mortgage holdings.  

• THE QUESTION IS WHY:  Why would Marano fight liquidations of mortgage securities?  Why would CEO Jimmy Cayne allow Bear Stearns to keep the over-concentrated mortgage portfolio largely intact when that portfolio obviously was a huge albatross for the firm?  Why would Cayne's successor as CEO, Alan Schwartz, also side with Marano?  

• POSSIBLE ANSWERS (what follows is speculation. However, if there is a better explanation for Bear's inexplicable refusal to sell off chunks of its mortgage securities book, we sure would like to hear it...)  

• Maybe the reason Bear Stearns kept most of its massive mortgage portfolio after the subprime crisis began in 2007 was that the firm knew it had marked the value of its mortgage securities way too high. 

• Maybe Bear Stearns knew that the real prices the market would pay for mortgage securities were far less than the prices Bear was using to value its portfolio (which accounted for a large portion of the total assets on Bear's balance sheet). 

• Maybe Bear Stearns knew it could not sell its mortgage holdings without exposing the firm's false valuations.  

• Bear Stearns certainly knew "mark to market" accounting rules meant sales of large blocks of mortgage securities on the open market would immediately set new benchmark prices for repricing similar, hard to value securities.  

• If Bear Stearns knew that it was over-stating the value of MBS, CDO's and related products, then Bear also knew that using new benchmark market prices to revalue the balance of the firm's mortgage holdings would reveal that the portfolio was worth far less than Bear Stearns was reporting on its balance sheet.  

• If Bear Stearns knew that the value of mortgage-related assets on the firm's balance sheet was substantially lower than Bear was telling the public, then maybe Tom Marano and Bear Stearns senior management resisted any sizable liquidation of the mortgage portfolio to avoid exposing Bear's unreasonably high marks.

• Maybe it is even true that Bear Stearns senior management knew (or believed / feared) that a large sale of mortgage-related assets, and a subsequent revaluation of the balance of the portfolio using new benchmark prices, would show that Bear Stearns was actually insolvent during the second half of 2007 and early 2008.  

Whether some, all, or none of our conjecture is accurate, Wall Street Law Blog firmly believes that any explanation would cast a bad light on the business practices of Bear Stearns. As always, we welcome your thoughts, information, criticism, and wisdom.

By Brett Sherman, The Sherman Law Firm 

 

Comments

[Adam Dani]

There is no question that things were a mess at Bear Stearns. Very good possible scenarios. It will be interesting to see if we ever get the full picture. Hopefully the case between the SEC & Bank of America will open up the closed door meetings of the last few years that have drastically changed the landscape of the financial industry.

[Former NYCBearLawyer]

Excellent post. Used to work with Bear Stearns in this area and some of these questions arose in my young uninformed mind even at that point.

[RJ Dragon]

The most innocent explanation would be the income stream (mortgage payments) accruing to the mortgage portfolio (in pre-recession 2007) was sufficient to justify their valuation. Fair value accounting would allow this if true. Of course, your suggestion that valuations were kept high to prevent the bank from being insolvent became the reality by mid-2008. There is a fundamental tension in valuation between an income approach DCF valuation and a market approach where values can swing wildly in volatile markets. Financial institutions like banks and insurers exist in part to buffer these swings; an income approach may be more appropriate for their portfolios. On the other hand, for trading houses (casinos) like Bear Stearns, a market approach may be more appropriate. Valuation experts and financial regulators are grappling with these issues.

[Michel Delving]

You may want to try coming at this from a different angle. While the market for mortgage-backed securities was dead in the water, these MBS were worth many times over face value in the credit default swap casinos, particularly on ABX indices where Bear Stearns could short their subprime MBS holdings. Like many others BS realized that mortgage defaults are profitable, especially for those owning subsidiary mortgage servicing companies, like EMC Mortgage Corp., a wholly owned BS subsidiary. These were rigged bets as servicers actively engaged in mortgage servicing fraud to fabricate defaults. EMC had been under federal investigation since 2005 in an FTC action that culminated in a 28 million dollar settlement in Sept. 08. http://www.ftc.gov/opa/2008/09/emc.shtm While Tom Marano was global head of mortgage and asset-backed securities for Bear Stearns, he was also a Director of EMC Mortgage Corp. so he had to be aware of massive servicing fraud emanating from EMC since late 1980's.

Remember the dust up with BS over mortgage modifications in June 2007 when a group of hedge funds led by Paulson & Co. expressed concern this would be manipulation of mortgage bonds? These hedge funds were using CDS to bet against mortgage bonds and would profit from defaults. Tom Marano seemed overly vehement and a little too quick with his response: ``None of the servicing decisions we make are driven by any activity or outstanding positions'' in the credit-default swap market, Thomas Marano, head of Bear Stearns' mortgage business, said in an e-mailed statement.

http://www.bloomberg.com/apps/news?pid=20601087&refer=home&sid=a9LOhnBS.L5c

Given EMC's lurid history, his response lacked credibility.

An earlier piece on the same issue contains this prescient quote:

``The real question is, Are there appropriate firewalls between trading desks and captive servicing businesses,'' said Josh Rosner, a managing director at Graham Fisher & Co., an investment research firm in New York. ``If there are not, it would appear to pose real ethical and possibly legal risks in pitting the fiduciary responsibilities of those banks against those investors they have an obligation to.''

http://www.bloomberg.com/apps/news?pid=20601087&sid=aKNi7PlPCy_g&refer=home

BS didn't need to liquidate their MBS. They were insured at full face value and shorted over and over again for larger profit. Regrettably this play book is not isolated to BS and EMC. Every single mortgage servicer to ABX reference entities has in recent years been charged with mortgage servicing fraud, not only in state and federal courts but in FTC and OTS investigations resulting in “cost of doing business” settlements and supervisory agreements. There is a vast galaxy of single name CDS which can be customized to provide protection against non-performance of highly specific reference obligations for investment banks to identify targets and let subsidiary servicers go to work manufacturing bogus defaults. What you're really looking at here is the largest insider trading scheme of all time.

[WSLB]

Thanks for all of the valuable feedback - much appreciared

[Kate Graham]

Really, isn't this cover-up bigger than Watergate?