Wall Street Law Blog

Leverage, the Downside; An attempt to simplify (Our top 5 posts of 2011)

THIS WEEK, WALL STREET LAW BLOG REPOSTS OUR 5 MOST VIEWED POSTS OF 2011... 

Originally posted: May 2011.

Leverage, which is usually expressed as a ratio, is a comparison between a company's debt and its equity.  Put more simply, a company's leverage ratio expresses how much it borrows (debt) versus how much it owns (equity). 

 

Thus, if-

(a) Investment Bank X has $100 million in cash and securities on its balance sheet; and

(b) $10 million of X's balance sheet is equity capital; and

(c) the remaining $90 million is funded by debt (bond issues, bank loans, commercial paper, repurchase agreements, etc.), then

(d) Company X has $90 milion in debt and only $10 million in shareholder equity, so it is leveraged 9:1 (If the company was separated into little $10 segments, shareholders owned only about $1 dillar for each of those segments. segment  company x borrowed the other $90)creditors paid for owned $90 of each $100 dollar segment of the company it borrows $90 out of every $100).  Reduced to its least common denominator (remember algebra?), Company X has a leverage ratio of 9:1.  So far, so good, right?

NOW, by the end of 2007, some of Wall Street's old school investment banks -- Bear Stearns, Morgan Stanley, Lehman Brothers -- were leveraged at ratios above 30:1.  Bear Stearns, as an example, was leveraged somewhere around of about 33:1.   By any measure, this is excessive leverage, and it is very risky.

Leveraged 33:1 meant that the former investment bank owned only about 3% of a balance sheet worth nearly $400 billion. The other 97% percent of Bear's assets were encumbered (subject to claims by Bear's creditors because Bear Stearns borrowed so much).

Here is the kicker - the reason why it is incredibly risky for a company to to have equity represent only 3% of its balance sheet...  Creditors have superior claims to equity-holders (typically shareholders).  IN OTHER WORDS, LOSSES ARE, AS A RULE, ALLOCATED TO SHAREHOLDERS ONLY UNTIL ALL EQUITY IS GONE. 

Therefore, if Investment Bank Z is leveraged at 33:1, and declining market conditions cause the value of Z's balance sheet assets to drop by just 3%, Bank Z's equity is wiped out.  It is insolvent. 

Still confused?  Fear not, we can illustrate with a hypothetical.

(a) In May, Z's entire balance sheet consists of collateralized debt obligations (CDOs) valued at par (they are valued at 100 cents on the dollar); but

(b) Market conditions deteriorate in June, causing CDOs values to fall from par to 97 cents on the the dollar. 

A security trading at 97 cents on the dollar doesn't sound too bad.  But for Investment Bank Z, leveraged at 33:1, 97 cents on the dollar is a complete disaster.  This 3% decline in the value of its balance sheet assets means the bell is tolling.  Z's entire equity stake is wiped out.  The company is insolvent. 

THIS IS THE DOWNSIDE OF EXCESSIVE LEVERAGE.

By Brett Sherman, Wall Street Law Blog

 

Diary of a 9-11 Survivor (Our Top 5 Posts of 2011)

THIS WEEK, WALL STREET LAW BLOG REPOSTS OUR 5 MOST VIEWED POSTS OF 2011... 

This morning, the 10th anniversary of the September 11 terror attacks, I coached my daughter in her team's first soccer game of the season.  She was born nearly two years after 9/11.  Last night I watched my son play football.  On 9/11, he was 15 months old. Two weeks ago, my beautiful wife and I celebrated celebrated our fifteenth wedding anniversary.

The past ten years have been the best of my life (so far).  How different things might have been.

 ***

Do you know know where you were and what you were doing on the morning of September 11, 2001? Do you have a clear memory of the moment you first heard about the attacks?

On the morning of September 11,  I was in New York City.   I worked for Morgan Stanley in 2001. My office was on the 65th floor of Two World Trade Center (forever known to the world as the South Tower).

***

September 11, 2001-

I stepped out of the elevator right around 8:30 on the morning of September 11, 2001.   A few minutes later, I crossed the maze of cubicles that filled the interior of our floor and walked into the office of a colleague.  His wife was very pregnant. I planned to ask how she was feeling.

My colleague was at his desk reading the New York Post.   I knocked as I entered. He looked up at me.  But before either of us said a single word, we heard a tremendous roar.  It was a sound that I will never forget, a sound I cannot adequately describe.

That roar -- we now know -- was the engine of a large commercial airliner.  The plane was filled with innocent people and full of highly flammable fuel

Seconds later came a thunderous explosion, the loudest sound I have ever heard. Then, almost immediately, a shockwave radiated out from the blast.  The windows on my floor rattled. The building shuddered.  Right away we knew.  A plane - a jet plane - had slammed into One WTC.

I rushed over to an office with windows that faced the North Tower.  The guy in that office was a lawyer I passed often in the hall, but  he was the type that rarely made eye contact and I doubt we ever spoke to each other.  I think his name was Dave. 

Dave was hysterical.  He stood in front of his desk screaming "My God, My God, My God" over and over again.  

***

I cannot possibly describe everything I saw through the windows of Dave's office.  But I will try to sketch the scene in the very broadest strokes.

There was, of course, a gaping hole.  From where I stood, high in the South Tower, the hole looked massive.  Black smoke, dense and oily, poured  into the sky.   Everywhere was fire.  The flames glowed like the mid-day sun.  And then there was all of that paper.

Juxtaposed against the intensity of the surreal inferno was an incredible mass of paper that floated almost peacefully on the currents of air that swirled between the two towers.   It was paper was from offices on floors in the impact zone.  It may sound odd, but that paper reminded me of a ticker tape parade.

I stood in Dave's office, mesmerized. He kept  screaming.   And then one thought entered my mind.  It was nothing profound.  Just simple common sense.  I thought about my wife and young son. I knew I needed to get the hell out of that building.  It was the best and most important thought I've ever had.

---

I was in one of the overcrowded stairwells, still high in the South Tower, when the second plane tore through the building somewhere on the floors above me.  You cannot tell on television, but the impact made the entire building lean in one direction.  

For what seemed an eternity (but could not have been more than a few seconds), I was certain that the Tower was about to tip over and fall.  It was the one time on September 11 that I believed I was experiencing the final moments of my life. But then the building stabilized.

Ultimately, I reached the lobby.  Then the lower concourse. A police officer told me to go out through the subway.  I did.  And then the building collapsed.

***

Due mainly to sheer luck, I escaped the twin towers on 9/11/2001.  So many others, through no fault of their own, did not.  I dedicate this post to those murdered on September 11, and to the friends and family members they left behind.  

***

A lot has changed for me and my family in the past ten years.  How different things might have been...

 

 

By Brett Sherman

Editor of Wall Street Law Blog

September 11, 2011

 

Why Did So Many Investors Buy Mortgage Bonds for So Long? The Ice Cream Analogy

1. INTRO (a/k/a - Prelude to an analogy)

US Treasury bills have, historically, served as a proxy for riskless investment.  (Risk, in this context, means chance of loss.) The yield on these bonds, therefore, has historically served as a proxy for "riskless rate of return."   

In other words, the yield on Treasuries has represented the return on an investment for which there is no chance of loss. Because of the correlation between risk and return, the riskless rate of return is (a) low, and (b) the benchmark against which returns on other investments are calculated and measured.  

* * *

2. INTERLUDE: A VERY BRIEF RECAP OF THE RELATIONSHIP BETWEEN RISK AND REWARD

As the chance of loss (or perceived chance of loss) rises, so does the return required to entice investors to part with their money.  

We did say that this section would be "very brief..."

* * *

3. ICE CREAM (The Analogy Section!)

Now, to the analogy...

For our purposes, make the following assumptions:  First, you love chocolate ice cream. Second, you are on a diet. Third, despite your diet, you must eat a bowl of chocolate ice cream.  Fourth, you must choose from three bowls filled with an identical amount of ice cream. Fifth, except for two things, the ice cream in each of the three bowls is identical in all respects, including taste, texture and flavor. In sum, all 3 are equally delicious.  And, finally, sixth, bowls one and two have twice the fat and twice the calories of bowl 3.  

Got it?

Since you are on a diet and must choose from among three bowls of ice cream that taste exactly the same, will you select bowl one, two, or three?  

Stupid question, right?

Because bowl 3 has the same taste, but half the fat and calories of the others, the answer should be a no-brainer (hint- You're choice is bowl 3)

Ok. Let's keep our little scenario going.  The facts about the three ice creams are the same. But now there are millions of chocolate ice cream lovers on diets and, so our analogy works, each of these dieting dairy eaters must buy enough ice cream to eat at least one bowl of chocolate ice cream each week for one year.  

If you have stayed with us so far (we assume we lost some readers to a snack break), you can see that there is going to be immense demand for brand 3.  By forcing our "facts" on you, we rigged the market. 

This is precisely what happened with mortgage bonds (CDOs et. al) during the housing bubble.   

Remember those riskless US Treasuries?  Well, they have AAA credit ratings.  So do a handful of really safe bonds.  AAA means (or, before the financial crisis, used to mean) super super safe.  

Wall Street banks rigged the market for AAA investments the same way we rigged the chocolate ice cream market.  They marketing and sold AAA rated investments that, for quite a while, paid a higher yield than Treasuries and other AAA rated bonds.  

Pretend you are a pension fund manager and that most of your holdings must be rated AAA.  Since (a) AAA means virtually no risk of loss, (b) there are a handful of AAA rated bonds you can buy, and (c) you will make more money for your fund if you buy AAA mortgage bonds than any other kind of AAA rated investment on the face of the earth, is there really any choice at all?  Same risk?  More yield?  

It's a no brainer.  Just like the chocolate ice cream.  Of course demand for CDOs and related investments was insatiable.  The market was rigged. 

4.  THE BIG FINISH (conclusion)

Time to complete the analogy. Turns out that we, the nice people at WSLB, knew that bowl 3 brand chocolate ice cream really has twice the fat and calories of brands one and two. No wonder all those dieters packed on the pounds.   Sorry 'bout that.  We didn't mean any harm.  We really didn't think all of those dieters would gain so many pounds. Really. It was kind of unforeseeable. 

Similarly, it turns out that Wall Street's big banks - from Bear Stearns to Merrill Lynch and a whole bunch of others - knew that their AAA rated mortgage bonds were nowhere near as safe as investors believed.  In fact, there is no doubt that they knowingly packed these investments with, well, worthless crap (the term 'toxic waste' is kind of played out).   

Now all of you widget-makers out there know how to engage in market manipulation to create demand for your products.  Please note, however, that (a) it is illegal to manipulate markets, and (b) Wall Street Law Blog does not condone unlawful business practices. 

*Yes, we ripped off the fat free frozen yogurt episode of Seinfeld for our analogy, but we did it to make the world a better place.

By Brett Sherman   

Fake Alex Trebek, Fake Jeopardy!, Very Real financial crisis

Question: HOW BAD WAS THE CONDUCT OF WALL STREET'S FINEST?  

Answer:  Well, read on.  You'll get the idea.

* * *

Today, Wall Street Law Blog examines the scope of fraud and the financial crisis by presenting a simulated episode of our favorite game show (not Card Sharks). The star of our spoof is a hypothetical supercomputer and a fictionalized (though fairly realistic) version of the king of all game show hosts (not Gene Rayburn or Bob Ewbanks - though we have reserved spots for Gene and Bob on the Mount Rushmore of game show hosts).

Rather than drone on with explanations, let's dive right in...   

 

 * * *

 

Announcer:

THIS - IS - JEOPARDY!

(Actually fake Jeopardy!)

 

And now, please welcome your host of fake Jeopardy, fake Alex Trebek-

 

Alex:  

Thank you very much Johnny.  And a warm hello to everyone in our fake studio audience and to all those at home.

Tonight we welcome back our returning champ, Clark, the souless supercomputer that "thinks" like a Wall Street Quant and "speaks"   in a voice that reminds us of a poor man's Stephen Hawking. Rumors are flying that the voice is done by that guy who made all those weird sounds in the Police Academy movies (no, not Steve "Cocoon" Gutenberg). The name of the actor / impressionist is on the tip of our tongues. After the Police Academy franchise was put out to pasture, the guy had a small role in the Mel Brooks classic, Spaceballs! (no, not Rick "Strange Brew" Moranis). 

 

Clark:

Nice to be here,  Al-lex.

 

Alex:

Just a few housekeeping issues before we get started-

Because no human can possibly defeat Clark, and since no other company is wasting its time and money building a robotic game show contestant, we have run out of challengers for Clark.  So, sadly, this will be the final appearance for Clark - the "man of silicon" - on Jeopardy!

And, with only one contestant, we have altered the format of our game tonight.   Legend has it that this evening's edition of the program is the first time since way back when, in '67, when Merv Griffen hosted Donald Fagan, Vanna White, Pat Sajack, Mike Douglas, Dinah Shorr, Sammy Davis and a handful of other FOMs (friends of Merv) for wine, cheese and an impromptu homemade board game in the parlor of Griff's Tuscan villa, that Jeopardy! will be played with just one category.  

Johnny, tell us tonight's sole topic.

 

Johnny:

Right Alex.  Clark, tonight's category is (dramatic pause) - OF MORTGAGE BONDAGE.

 

Alex:  

 Of Mortgage Bondage.  Can't wait to find out what that's all about.  

Clark, are you ready?

 

Clark: 

Charged up Al-lex.   

 

Alex:

 Ah, a little hard drive humor.  Very clever.  Clark, as the only contestent, you get to make the first choice.

 

Clark:

OF MORT-GAGE BOND-DAGE FOR ONE THOU-SAND PLEASE AL-LEX.

 

Alex:

OK.  The answer is:  Guilty, but never prosecuted.

 

Bing!

 

Yes.  Clark.  Go ahead.  And please remember to phrase your response in the form of a question.

 

Clark:

WHAT ARE INVESTMENT BANKS THAT CAUSED THE FINANCIAL CRISIS BY FUNDING AND UNDERWRITING FRAUDULENT HIGH RISK MORTGAGES, POOLING THEM INTO CRAPPY MORTGAGE BONDS, REPACKAGING THOSE MORTGAGE-BACKED SECURITIES INTO CRAPPIER BONDS CALLED CDOs, AND SELLING RHEAMS OF THE TOXIC WASTE THEY CREATED TO BANKS, PENSION FUNDS, AND OTHER INSTITUTIONAL INVESTORS ALL OVER THE WORLD, MARKETING THESE JUNK BONDS AS IF THEY WERE ACTUALLY HIGH QUALITY SECURITIES THAT CARRIED VIRTUALLY NO RISK, ALEX?  

Alex:

Can you be more specific?

 

Clark: 

NO PROBLEM AL-LEX.

WHO ARE OR WERE THE EXECUTIVE OFFICERS AT FORMER AND CURRENT WALL STREET INVESTMENT BANKS LIKE BEAR STEARNS, LEHMAN BROTHERS, MERRILL LYNCH, MORGAN STANLEY, and GOLDMAN SACHS; A SMALL AND ELITE GROUP WHICH - AMONG THEM -  MADE BILLIONS OF DOLLARS EXPLOITING THE GREATEST NATIONAL HOUSING BUBBLE IN AMERICAN HISTORY; A BUBBLE THAT THEY ALL KNEW, OR SHOULD HAVE KNOWN, WAS STRETCHED TO THE BREAKING POINT -- WITH AN UNSUSTAINABLE and FRAUDULENT BUSINESS MODEL THAT WAS BUILT AROUND SECURITIZATION, SALES, AND PROPRIETARY TRADING OF BOGUS MORTGAGE BONDS AND RELATED STRUCTURED INVESTMENT PRODUCTS, ALEX?  

 

Alex:

Oooo.  So very close.  Clark, can you be just a little bit more specific?

 

Clark:

CERTAINLY, AL-LEX.  

...AND WHO ENGAGED IN FRAUDULENT BUSINESS PRACTICES INCLUDING, BUT NOT NEARLY LIMITED TO, OUTRIGHT LIES, INSIDER TRADING AND MARKET MANIPULATION, BY, AMONG OTHER THINGS, BOOSTING SHORT-TERM REVENUES TO ILLUSORY LEVELS AND ARTIFICIALLY PUMPING UP STOCK PRICES IN THE NEAR TERM FOR THOSE COMPANIES THROUGH THE ROOF.

 

Alex:

Almost there-  Just a little more specificity...

 

Clark

...AND JEOPARDIZED AND, IN SOME CASES, DESTROYED, THE  CORPORATIONS THEY MANAGED ON BEHALF OF PUBLIC SHAREHOLDERS, CAUSING MANY OF THOSE SHAREHOLDERS TO SUFFER SUBSTANTIAL FINANCIAL LOSSES WHILE SENIOR MANAGEMENT BANKED ENORMOUS FORTUNES?

 

Alex:

Judges?  No?  Still not specific enough?   Clark, I'm afraid-

 

 

Clark:

...AND ULTIMATELTY CAUSED THE WHEELS OF CREDIT TO GRIND TO A HALT, PLUNGING THE UNITED STATES AND MUCH OF THE WORLD INTO THE MOST SEVERE FINANCIAL CRISIS SINCE THE GREAT DEPRESSION BY CLOGGING BALANCE SHEETS OF THE INVESTMENT BANKS THEY MANAGED, PLUS COUNTLESS OTHER BANKS, INVESTMENT FUNDS, COUNTLESS COMPANIES, AND GOVERNMENT ENTITITES AROUND THE WORLD  WITH ILLIQUID AND WORTHLESS JUNK SECURITIES BACKED BY SUBPRIME AND OTHER NONCONFORMING MORTGAGE LOANS MADE TO BORROWERS WHO COULD NOT AFFORD TO REPAY THEM?

Alex:

Are you feeling ok, Clark?  Is that smoke coming from your mother board?   Would you like to take a break so your IT team can check you out?  Or some water, perhaps?  Maybe an oil can?  

 

Clark:

NO THANK YOU, AL-LEX.

 

Alex:

Ok then.  I'm aftaid our judges are still indicating that they need you to be just a teeny tiny bit more specific...

 * * *

We could go on and on and on, but you probably get the idea.  

By Brett Sherman, Managing Attorney

The Sherman Law Firm

Editor and Publisher: Wall Street Law Blog

 

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

 

Legal Fees: Why Hourly Billing in Commercial Litigation is a Farce... (updated)

Warning!  Common sense ahead.

It is pretty much impossible for lawyers to bill litigation clients by the hour without raising serious conflicts between the best interests of attorneys and the clients they are bound to serve.

[Disclaimer - what follows is an attack on the billing practices of the vast majority if America's most powerful lawyers and law firms. The Sherman Law Firm, publisher of Wall Steeet Law Blog, DOES NOT BILL BY THE HOUR. Therefore, readers are cautioned to read with skepticism and to view this post as an advertisement on behalf of our firm.]

 * * * 

The excerpts that follow are from a post on Wisegeek.com creatively titled  What are Billable Hours?" -

"Nearly all law firms make their money by billing their clients by the hour. These are known as billable hours. The more hours billed, the more money the firm will make."

 

"If lawyers do not bill enough hours each year, they will not make enough money to cover their salaries. The firm's billable hours also cover overheads and partners' profit share."

No mystery so far.  After all, when a law firm charges clients by the hour, isn't the firm really selling a product disguised as a service?

Think about it. McDonald's sell burgers. If burger sales plummet, so do profits.  In the same way, most law firms sell hours. If the number of hours sold plummets, well, you get the idea, right?  

The upshot is this:

Yes, quality of representation is important.  But only to a point (since poor quality representation should, in theory at least, eventually leave a firm with fewer clients).  The most profitable firms are the firms that spend the most time on their cases (sell the most hours to their clients), regardless of result.  

And this brings us back to the wise folks at Wisegeek.com:

"Many firms also set bonus or penalty clauses to make sure that each lawyer achieves their billable hour quota. This can exert pressure on both home and work life with longer hours in the office. Tedious, time consuming tasks such as proofreading corporate reports, document reviews and travel hours are all required to be billed by the hour."

Again, see What are billable hours?

This "billable hour quota" is the real kicker.  Whether they admit it or not, nearly all firms have minimum billable hour requirements.   These requirements are extremely difficult to meet (often at least 2000 billable hours). And there is intense pressure inside most firms to meet or exceed these quotas.

    * * *

As a client, you may lose even when you win. (No, this is not a brain teaser.)  Here's what we mean -

"Victory" in litigation often costs more than it should because law firms often bill more than they should.  Why?  Well, as we (and Wisegeeks.com) explained above, law firms expect their lawyers to bill a whole lot of hours. In fact, the volume of required billable hours is so high that it is extremely hard to achieve. This fact - and it is a fact - is problematic for many reasons.  From a client perspective, the most problematic issue is that a whole lot of law firms reward the lawyers that bill more hours with bigger bonuses, raises, promotions, etc.  Conversely, lawyers on the short end of annual billable hour totals are often penalized. The penalties can range from delayed partnership to no possibility of partnership to the ultimate penalty, termination.  

Publicly, most firms will deny all of this stuff.  Don't believe it.  If you have any friends or family who are lawyers in private practice (as at least some of you must), ask whether their firms ever circulate memos or reports that list hours billed by each attorney.  Nine times out of ten, the answer you will get, if your friend or family member is being honest with you, is YES.  This is because firms do circulate billable hour reports, at least to the partners, on a regular basis.  At many firms, these reports go around each month.  

The bottom line? Lawyers need to find ways to bill hours.  Thus, some lawyers, either on their own initiatives or under implied or coded orders from a superior, do unecessary or repetitive work for the sole purpose of billing more hours.  Others simply pad the hours they report.  

Before you judge too harshly, ask yourself if you might consider jacking up hours on a big corporate client if you thought your job might be on the line.  The problem, in other words, is systemic.

Clients sometimes suspect that they are being charged too much, but it is really hard to know for sure.  And, absent a whistleblower, overbilling is nearly impossible to prove.  Translation?  The problem isn't going away any time soon.  

 A quick hypothetical example to illustrate the problem...

Your company is the plaintiff in a lawsuit.  In the complaint, you seek $3 million in compensatory damages.  You settle for $2 million. Sounds pretty good, right?

But then, when you add up the bills from your attorneys, you are a little bit disturbed. Legal fees and costs total $1.5 million.  You think about complaining.  The bill seems awfully high.  

Then again, the net "value" of your settlement is plus $500,000.  That's half a million more than you had before your very able lawyers put in all of those hours.  At the end of the day, you feel like you won.  

But how do you know that the actual fee wasn't way too high?  What if the hourly billings etc. should have been closer to $1 million?  Or 500,000?

Maybe your lawyers repeated research tasks or turned over rocks that could have been left unturned.  Or - worse - what if you were a victim of phantom billing?  

In a big case, a few extra hours per lawyer per week can add up to a lot of bogus fees very easily.  

Think of it this way -

Each unecessary or imaginary hour billed is real money that a law firm has stolen from its client.   

    * * *

Even some big firms concede serious problems with billing by their litigation clients by the hour.

 In 2009, for example, Evan R. Chesler, a Presiding Partner (at least in 2009) at mega-firm and billable hour factory Cravath, Swaine & Moore wrote an opinion piece for Forbes Online called "The Billable Hour Must Go."

 Here are some choice comments from the pen/keyboard of Attorney Chesler:

 

"Clients have long hated the billable hour, and I understand why. The hours seem to pile up to fill the available space."

* * *

"The clients feel they have no control, that there is no correlation between cost and quality."

* * *  

"The billable hour makes no sense, not even for lawyers. If you are successful and win a case early on, you put yourself out of work. If you get bogged down in a land war in Asia, you make more money. That is frankly nuts."

 

Mr. Chesler also pointed out that elimination of the hourly billing model would prevent clients from being "surprised by a whopper bill and met by the standard (albeit true) explanation that 'litigation is unpredictable'."

Enough said?  We think so.  

 

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.