A Fraudulent Scheme for the Ages: The complete story of the fraud that brought down Bear Stearns
Part One: Introduction
A new multi-post series from Wall Street Law Blog
The collapse of investment bank Bear Stearns in March 2008 was a consequence of a fraudulent scheme that was both appalling in scale and unconscionable in substance
During the housing bubble era, the five most senior and highest paid executive officers at Bear Stearns presided over, personally profited from, and covered up a vast fraudulent scheme that drove short-term revenues at the firm to unsustainable levels and artificially inflated Bear Stearns’ stock price.
By 2008, the scheme had, among other things, (a) generated more than $1.4 billion in cash windfalls for Bear's five top executives, (b) saddled thousands of Bear Stearns’ public shareholders with billions of dollars in combined stock losses, (c) inflicted tens of billions of dollars in losses on unsuspecting institutional investors, and (d) consigned Bear Stearns to the dustbins of history.
The fraud that consumed Bear Stearns also triggered a chain reaction that culminated in the worst global financial crisis since the Great Depression.
The Key to the Scheme
The key to the scheme was that Bear Stearns managed to deceive institutional investors, and just about everyone else, about the true risks of investments in securities backed by low-quality subprime and Alt-a mortgages.
At the dawn of the 21st century, Bear Stearns operated Wall Street’s most experienced and sophisticated mortgage securitization and trading business. Because of Bear’s expertise in this complex and highly specialized field, the firm was able to identify and exploit an opportunity to fill a void in the marketplace by designing, marketing, and selling bonds backed by risky subprime and Alt-a mortgages to institutional investors. Bear Stearns sold these high-risk mortgage bonds as if they were, instead, investments of the highest quality.
An Illusion of Success
Powered by revenues from the many businesses that were part of the firm's corrupt mortgage securitization machine, Bear Stearns set a new company record for annual profits each year from 2002 through 2006. Moreover, Bear Stearns’ stock price more than quadrupled between the first quarter of 2000 and the first quarter of 2007. Until the scheme crumbled, the 2000s seemed to be the start of a golden age at Bear Stearns.
Inevitably, however, the economic climate changed, making it impossible for Bear Stearns and the Individual Respondents to sustain the illusion of success. By the time Bear Stearns collapsed in March 2008, private label mortgage bonds were exposed as junk quality investments.
The Housing Bubble Burst; the Scheme Unravelled
In 2006, the greatest housing bubble in American history started to deflate. Mortgage defaults skyrocketed. By the spring of 2007, scores of subprime lenders were out of business. For the third time since 1994, the market for mortgage-backed bonds crashed. Trading activity froze. Values for the securities plunged. Bear Stearns was in serious trouble. The firm’s brief golden age was over.
As the scheme fell apart, senior management concealed the true magnitude of Bear's problems. For the balance of 2007 and in the early months of the 2008, Executive Committee members and other high ranking Bear Stearns employees devoted themselves to conducting damage control. For many months, they made false assurance to the investing public.
Among many other facts, Bear Stearns made false asssurances about the following points:
- Senior management claimed Bear Stearns had prepared for the crisis. The firm's leaders said they had factored the inevitable end of a very long and very favorable market cycle into their strategic planning before the crisis began.
- Senior management repeatedly told the public that Bear’s capital ratios, balance sheet, and liquidity were as strong as they had ever been.
- Bear Stearns allegedly had ample cash reserves to serve as a "liquidity buffer" to protect the firm against any short-term interruption in the functioning of short-term credit markets.
- Senior management represented that Bear Stearns had eliminated virtually all of its mortgage exposure.
- In a February 2008 interview with Institutional Investor Magazine, CEO Alan Schwartz assured investors that Bear had “righted the ship” was getting back to "playing offense."
Unbeknownst to the investing public, not one of these representations was true.
In fact, Bear Stearns had not prepared itself for the end of the market cycle. Instead, after years of fraud and corruption, the firm was stuck with a massive cache of illiquid mortgage assets on its balance sheet, was hundreds of billions of dollars in debt, and had no way to replace revenues lost when the mortgage markets shut down.
Moreover, at about $20 billion, Bear’s so-called liquidity buffer was less than a third of the $75 billion or so that the firm borrowed on a typical business day.
And, in February 2008, Bear Stearns was anything but a company that had “righted the ship” and ready to resume “playing offense.” To the contrary, in the early months of 2008 the firm’s financial condition deteriorated sharply and its outlook became increasingly bleak.
The Final Week
The week of March 10, 2008, Bear Stearns faced a liquidity crisis that it could not survive. By March 12 - Wednesday of Bear's final week - the firm had already lost access to billions in short-term credit without which the firm could not afford to operate. Prime brokerage customers were racing to move their accounts from the firm. By Thursday, March 13, the firm’s $20 billion "liquidity buffer" was gone. A few days later, so was Bear Stearns.
Stuck in a minefield
Simply stated, the fraudulent scheme left Bear Stearns stranded in the center of a minefield from which its leaders had no plan of escape. Then again, for senior management, the fact that Bear Stearns was stuck in a minefield was not the disaster that it was for thousands of other Bear Stearns shareholders.
When Bear Stearns blew up, its top executives emerged from the ashes having pocketed cash windfalls so large that the actual amounts are hard to fathom.
Between 2000 and 2008, Executive Commitee members Jimmy Cayne, Warren Spector, Ace Greenberg, Alan Schwartz, and Sam Molinaro, took home a combined total of more than $1.4 billion in cash. Members of the investing public, from institutions all over the world to the vast majority of Bear Stearns' own shareholders, were far less fortunate.
In upcoming parts of this series, Wall Street Law Blog will describe the fraud that brought down Bear Stearns with a level of detail that, until now, was not possible.
By Brett Sherman