Wall Street Law Blog

Bear Stearns Report: Relative to Income, Home Prices "About as stretched as [they have] ever been!"

Another in an occasional series in which Wall Street Law Blog posts excerpts from primary source documents that flat out contradict Wall Street's revisionist history of the financial crisis...

Top executives at Bear Stearns - as we like to point out - have repeatedly insisted (including in sworn testimony) that they did not have any inkling that there might be a massive national housing bubble.  

The truth, however, (as we also like to point out) is that Bear Stearns knew there was a really big housing bubble, and that the end of the housing bubble era would not be pretty.  

Our excerpts today are from a September 13, 2006 Bear Stearns research report.  

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Any questions?

Brett Sherman, Wall Street Law Blog

The Great Mortgage Swindle: Most Lucrative Fraud of All Time?

By Brett Sherman

To be clear, Wall Street Law Blog does not intend the title of this blog post to be sarcastic, ironic, or hyperbolic.

1. Introduction (Summary of The Great Mortgage Swindle - the short, short version)

Financial institutions like Bear Stearns, Lehman Brothers, and Merrill Lynch
(to name a few) deceived sophisticated investors, including countless financial professionals around the world, about the relative risks and rewards of investments in complex structured securities backed by risky subprime and Alt-a mortgages (RMBS, CDOs and related securities).

Big Wall Street banks marketed and sold high risk mortgage bonds as if these securities carried risks comparable to US Treasuries (which are generally accepted as a proxy for riskless investments) and other highly rated bonds. 

 *As always, Wall Street Law Blog defines risk as "chance of financial loss."

Because AAA mortgage bonds higher yields than other AAA rated "low risk" investments, issuer banks knew that investor demand for these securities would be massive.  And, for a long time, as the housing bubble expanded, the banks couldn't produce enough subprime/Alt-a MBS and CDOs to meet this demand.   In a word, investor demand was inexhaustible. 

Another word that works is insatiable. Insatiable demand subsided only after market conditions changed enough to gradually expose bonds backed by subprime and Alt-a bonds as  junk investments.  The disintegration of the market started sometime in mi to late 2006. By mid-2007, the market for these OTC traded securities was DEAD. Governments, companies and individuals lost trillions. The individuals responsible for this disaster were more fortunate. Indeed, personal wealth accumulated by senior management at the major Wall Street banks from bogus securitizations and related profit centers was staggering.

The reality of the housing bubble era is this: It was a short-term money grab by a cartel of powerful banks that generated enormous windfalls for senior management and executives in the mortgage securitization and trading businesses of those banks.

2. Why Don't AAA Credit Ratings Excuse Wall Street Fraud?

Why indeed?  So glad you asked.  

The credit ratings agencies, Moody's, S & P, and Fitch, did in fact give AAA ratings to mortgage bonds.   These agencies are not affiliates of the big Wall Street banks that designed and manufactured the mortgage bonds.  So - the standard Wall Street defense goes -  the investment banks truthfully marketed and sold mortgage backed bonds with credit ratings AAA ratings. 

Turns out, we now know, that the big securitizers knew there was a
significant distinction between the toxic AAA rated securities which the banks pushed like drug dealers and other AAA quality investments. While a majority of mortgage bonds were rated AAA, the bankers that designed, manufactured, and sold them knew that the AAA ratings they received were pure bull!$&@.

Fraud, in the context of securities transactions, is all about misleading
investors about important facts. Material facts are facts a reasonable investor would want to know when making a decision about whether to buy or sell securities. For example, the fact that toxic mortgage bonds received AAA ratings that were pure bull!$&@ is quite material.

3. Not Your Average Scam 

At this point, the Great Mortgage Swindle may very well be the most financially rewarding crime in history.  So, for context and perspective, we draw your attention to the following (the proverbial tip of the iceberg)

Among them, the five top executives at Bear Stearns in the 2000s took home
more than $1.4 billion in cash (cash based compensation plus sales of stock-
based compensation at pumped up prices) between 2000 and 2008.  

For emphasis, we think it is okay to be a bit repetitive here:  

Bear Stearns.
1 RUINED COMPANY.  
5 Top Execs pocketed $1.4 BILLION In CASH during 2000s.   

NOW, PLEASE, AS A PERSONAL FAVOR, GO BACK 10 LINES OR SO AND RE-READ, STARTING WITH "NOT YOUR AVERAGE SCAM."

In other words, during the 2000s, the 5 top dogs at Bear Stearns -
killed the company, a major investment bank that was more than eight decades old, and
banked, on average, nearly $300 million apiece in cash (please spare us any tax-related excuses or adjustments).

Oh, and Bear was no aberration. The "take" was nearly identical for the 5 highest paid execs at Lehman Brothers.  

And then there is former Merrill Lynch CEO Stan O'Neil.  

Here are some of the highlights from O'Neil's reign of terror:  

(a) He took a scalpel to Mother Merrill, cutting thousands and thousands employees from the Merrill Lynch payroll like he was an oncologist attacking a malignancy.

(b) He deployed legions of Six Sigma "black belt" storm troopers throughout Merrill Lynch, turning a company that had long inspired loyalty from its workers into the corporate equivalent of a fascist state.*

(c)  He immunized Merrill's ultra profitable mortgage CDO group from any real scrutiny by qualified risk-managers or compliance professionals.

(d)  He banked a personal fortune that probably makes him wealthier than many royal families. 

And, as a final spit in the collective eye of Merrill's public shareholders and hordes of hard-working folks fired by O'Neil, the disgraced ex-CEO took home an astounding severance package worth more than $150 million, reportedly among the five highest severance payouts of all time when Merrill's board justifiably ordered big Stan to walk the plank. 

When Stan O'Neil took over as CEO Merrill Lynch was one of Wall Street's premier brokerage firms.  He left Merrill scandal ridden and broke. The company was in critical condition when Stan rode off into the sunset, presumably requiring a convoy of armored to haul all the wealth he accumulated while he steered the Thundering Herd to the brink of bankruptcy (ultimately, Bank of America came to the rescue and grossly overpaid to buy Merrill Lynch).

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*NOTE -
This post is not "about" Six Sigma, but if you don't know what Six Sigma is, we respectfully refer you to Wikipedia or Google for a tutorial on this evil of the corporate universe.
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4. Conclusion

Is the Great Mortgage Swindle the most lucrative fraud ever?   Who the hell knows? Perhaps this is a better question- How can we possibly let these folks get away with it?

All of top Wall Street's executives during the 2000s remain free as birds. Very, very rich birds.

Bear Stearns, Merrill Lynch Expected Housing Disaster (our all-time most viewed post; first published Oct. 2010)

"These aren't simply the comments of some junior level analysts" Lee Sherman, securities litigation consultant

the question of foreseeability asks at what point in time senior management at these investment banks should have foreseen the possibility of the disasters that eventually befell them.

the significance of these reports is that they conclusively establish the views of top economic analysts at Merrill Lynch and Bear Stearns. Whether plaintiffs' attorneys prove that senior management at the two investment banks actually read the reports ought to be immaterial.

UPDATE: Because Bear Stearns Execs' FCIC testimony largely focused on allegedly unforeseeable, "unprecedented" market forces to defend their lack of competent management, Wall Street Law Blog decided to re-post one of our favorites. 

Long before their respective employers ceased to exist as independent companies, former Merrill Lynch Top North American Economist David A. Rosenberg and former Bear Stearns Chief Equities Investment Strategist Francois Trahan published research reports with explicit warnings about asset and credit bubbles in the U.S. housing and mortgage markets.

As early as August 2004, Mr. Rosenberg, Chief Economist at Merrill Lynch for North America, published a detailed analysis regarding the precarious state of the American housing market. Rosenberg warned that there could serious problems ahead in an Economic Commentary entitled: "Housing: If not a Bubble Then an Oversized Sud."

Former Bear Stearns Chief Equities Investment Strategist Francois Trahan first published a report that raised serious questions about housing and real estate investments in a May 2005 report called "REIT all About it." Trahan and his team at Bear Stearns followed their 2005 report with publications in 2006 that explicitly warned about the difficult future facing the U.S. housing market and even raised the possibility of a global credit crisis. The 2006 Bear Stearns reports definitively described the housing market as an unsustainable "bubble" and further cautioned that the term bubble was not one the Bear team used lightly.

It was not until 2008 that overcommitments to mortgage-backed securities (a byproduct of the housing boom), CDO's and related products tied to residential and commercial mortgages caused Merrill Lynch and Bear Stearns to suffer backbreaking losses so severe that Merrill sold itself to Bank of America and Bear Stearns narrowly avoided bankruptcy with a Fed-assisted fire sale to JP Morgan.

--Background

Along with a number of other Wall Street firms, Merrill Lynch and Bear Stearns lost tens of billions of dollars because of their firms' respective commitments to securities backed by mortgages in the "subprime" and "Alt-A" categories. Subprime and Alt-A residential mortgages are considered risky loans because they carry higher default rates than "conforming" mortgages (also called prime mortgages, or agency-quality mortgages). Typical subprime or Alt-A borrowers cannot qualify for a conforming mortgage due to factors that include, but are not limited to, bad credit histories, personal bankruptcies, insufficient income, and the inability to make sufficiently large down-payments.

--Significance of the Merrill Lynch and Bear Stearns reports

While the ultimate import of the reports remains to be seen, The Sherman Law Firm says there is no doubt that the documents are crucial to the touchstone litigation element of foreseeability. "In a litigation sense," said Managing Attorney Brett Sherman, "the question of foreseeability asks at what point in time senior management at these investment banks should have foreseen the possibility of the disasters that eventually befell them."

According to The Sherman Law Firm, the reports at issue may show that senior management at Merrill Lynch and Bear Stearns should have foreseen the liklihood of a looming financial crisis with ample time to permit business model shifts that may have prevented crippling losses and, ultimately, the end of these former pillars of Wall Street as independent companies.

--Likely Defenses and Response

When confronted with documents like the reports at issue, senior managers may respond that they cannot be expected to read the huge volumes of research produced by their companies. The view of Brett Sherman, securities fraud lawyer and Managing Attorney of The Sherman Law Firm is that "the significance of these reports is that they conclusively establish the views of top economic analysts at Merrill Lynch and Bear Stearns. Whether plaintiffs' attorneys prove that senior management at the two investment banks actually read the reports ought to be immaterial."

Litigation strategist and recently retired attorney Lee Sherman - a frequent consultant to The Sherman Law Firm, former municipal court judge, and founding partner of a top Philadelphia area firm - concurred. "These aren't simply the comments of some junior level analysts," Sherman said. "I mean, we're talking about the Senior North American Economist of Merrill Lynch and the Chief Equities Strategist at Bear Stearns. Any claims by their CEOs and the other senior decision makers at these banks to the effect that they should not have been well-aware of the opinions and outlooks of the top economic and market experts at their companies are simply not credible." 

Lee Sherman continued: "Remember, from mid-2004 until the subprime crisis had clearly arrived, the Fed steadily raised interest rates. For lesser quality borrowers, most of whom had adjustable rate mortgages, higher interest rates meant higher default rates. To say the least, there was great uncertainty as rates were rising about where we were headed. Then, the housing market slowed. I'm talking about 2005 now, before home values really fell off the table. It strikes me as incredible that the kinds of warnings in these reports were out there for years, yet seem to have gone unheeded."

The Sherman Law Firm represents investors in securities fraud / investment loss claims of all types, including claims against investment banks for losses related to mismanagement and other misconduct during the housing and credit bubbles.

Brett Sherman, The Sherman Law Firm