Wall Street Law Blog

Bear Stearns: Why civil action, not criminal?

The easiest explanation is a really short one - O.J. Simpson.

Translation: To very loosely paraphrase James Carville -  Its the burden of proof, stupid.

 

 

Here's why the first real mortgage-backed-securities fraud case will be a civil action rather than a criminal prosecution:

In a civil action, a plaintiff (there is no prosecutor in the civil case) must meet the preponderance of the evidence standard in order to win.  What is a preponderance of the evidence? 51%.  The AG has, in other words, a pretty big margin of error.

In a criminal case, the burden of proof is the impossible to define, and very hard to meet, "beyond a reasonable doubt" standard.   Or, as re-christened by the late, great Johnny Cochran,  "if it does fit, you must acquit..."

 

Thus, in a criminal case, the prosecutor has a very, very small margin for error. 

To sum up: New York Attorney General Eric Schneiderman is no dummy.  He wants to win.

By Brett Sherman

Managing Attorney

The Sherman Law Firm

BEAR STEARNS BELIEVED IT BOUGHT CREDIT RATINGS

Credit Ratings Shopping Clear? Wall Street Law Blog Thinks So

 

By Brett Sherman

 

Several complaints filed against Bear Stearns, its former subsidiaries, and/or JP Morgan by monoline Insurers like Assured Guaranty and Ambac describe a rather revealing reaction by Bear Stearns to October 2007 decisions by credit ratings agencies S&P and Moody's to cut ratings for certain Bear Stearns mortgaged-backed securities. *

 

On October 17, 2007, Tom Marano, Bear's mortgage chief, reacted to the downgrades in an email he fired off to key subordinates. In the email, an apparently outraged Marano explained exactly how he wanted Bear Stearns to respond to the S&P and Moody's downgrades:

 

"My intention is to contact my peer at each firm as well as the
investors who bought the deals. From there, we are going to
demand a waiver of fees. In the interim, do not pay a single fee to either rating agency. Hold every fee up."

 

We at Wall Street Law Blog submit that the only reasonable interpretation of the October 17 email is that -

 

A) Marano believed Bear had paid, or agreed to pay, good money to buy the credit ratings it needed, and that

 

B) S&P and Moody's had welched on that deal.

 

In other words, Bear Stearns (or at least Tom Marano) literally found the downgrades unacceptable.

 

Other interpretations, as always, are welcome.

 

*Counsel for Assured Guaranty, Ambac and others is the NY firm Patterson Belknap Webb & Tyler.

 

 

---------

Reconcile This: Former Bear Stearns Exec. Either Lied to FCIC or Pulled An Ollie North

Lying Under Oath to The Financial Crisis Inquiry Commission is the Equivilent of Perjury.

The Law:

United States Code, Title 18, Section 1001:

"Whoever, in any matter within the jurisdiction of any department or agency of the United States knowingly and willfully falsifies, conceals work covers up by any trick, scheme or device, a material fact, or makes any false, fictitious or fraudulent statements or representations, or makes or uses any false writing or document knowing the same to contain any false, fictitious or fraudulent statement or entry, shall be fined under this title, imprisoned not more than five years, or both."

FROM THE RECORD OF PROCEEDINGS BEFORE THE FINANCIAL CRISIS INQUIRY COMMISSION.

Excerpted from the FCIC Official Transcript

Hearing date: May 5, 2010, Session One.

Sworn Testimony of Witness Samuel H. Molinaro, Jr., (former CFO / COO/ EXECUTIVE COMMITTEE MEMBER, The Bear Stearns Companies Inc.)

FCIC TESTIMONY (from the official transcript):

Some context here is crucial. In the same FCIC hearing, Molinaro testified that Bear Stearns knew that falling home prices was one of the biggest risks the company faced. And yet, according to the former CFO and COO, Bear Stearns did not model the impact of a "nationwide decline in housing prices." Moreover (as far as Molinaro could recall), there were no concerns or even discussions at Bear Stearns about the possibility of a drop home in prices across the United States.

Wait! Pause. Take a deep breath. Go back and re-read the previous paragraph. Good? Good.

Now answer this question: DO YOU BELIEVE THE TESTIMONY OF SAM MOLINARO?

We, the trusting staff at Wall Street Law Blog, do not. But, to be fair, we have reviewed a few documents that we are willing to bet came to the attention of Molinaro and the other members of senior management at Bear Stearns.

Consider, for instance, this excerpt from a research report about the housing bubble that Bear Stearns published in September 2006. In it, Bear warns that the ratio of home prices to income was "[a]bout as stretched as it has ever been!"

And how about this conclusion from the same Bear Stearns report?

The report - which was one of many warnings Bear issued about the bubble - is from the fall of 2006. That's about a year and a half before Bear Stearns collapsed. Note that Bear Stearns specifically states that home prices were already falling, but cautions that "housing conditions have barely begun to normalize, and it will likely be some time before we begin to see signs of a trough."

 

Now, again we ask: DO YOU BELIEVE MOLINARO?

By Brett Sherman

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 

Bear Stearns Planned to Dance Like Former Citi CEO Chuck Prince.

The plan? Milk as much profit as possible for as long as possible from the mortgage securitization business.

The Method? Keep finding borrowers for home mortgages as long as there were suckers willing to buy ABS CDOs. 

 

 

 

A sucker born every minute...

 

INTRODUCTION

On May 25, 2005, Wall Street trade paper "Asset Securitization Report"  published an article called CDO machine? Managers, mortgage companies, happy to keep fuel coming.  

 The article, written by reporter Allison Pyburn, describes a very interesting (and disturbing) panel discussion at the 2005 Bear Stearns Global Credit Conference. The panel talked about CDOs and the mortgage market.

Panelists were, at the time, all senior executives from Bear's mortgage securitization and trading businesses.  According to the article, they included: (a) Scott Eichel from the Bear Stearns Collateralized Mortgage-Backed Securities group; (b) Tim Kolterman from the Bear Stearns Credit derivatives group (c) Jeff Zavaterro from Bear's CDO group. 

Please note that no one from Wall Street Law Blog was at the 2005 conference.  Nor have we managed to obtain a transcript of this particular panel discussion.  

Based solely on our reading of the article, we believe that panelists were surprisingly candid about Wall Street's plans to squeeze profits from the CDO machine, regardless of consequences, until demand from investors evaporated.

Indeed, per our reading, the Bear mortgage guys were saying stuff that sounded a lot like Citi's former CEO Chuck Prince.  Speaking about the risks of the CDO market, Prince infamously said his company would keep dancing until the music stopped.  

 

Keeping the The CDO Machine Humming

In 2005, Scott Eichel was a senior managing director at Bear Stearns and one of Bear's top mortgage traders.  Ms. Pyburn reported these comments from Eichel in her article:

There is a machine going...

There is a lot of brain power [working] to keep this going...

 

Pushing the Envelope

 

 Ms. Pyburn's article attributes the following quotes to Tim Koltermann, then a managing director/principal in the Bear Stearns credit derivatives group: 

Until there are credit issues, we're going to continue to push the envelope... 

There is so much demand for real estate CDOs, I don't think we'd pull back [production] at all...

 

And then, according to the article, there was this comment from panelist Jeff Zavattero, then a senior managing director in Bear's CDO group:

 

As long as there are investors willing to purchase the product, the market will continue to grow more and more levered...   And demand right now is very high.

 

Like Chuck

 

Wall Street Law Blog's interpretation?

Sounds an awful lot like Bear Stearns CDO experts were, in essence, saying the same thing as Chuck Prince:  The music is still playing and we are still dancing.

 

WE INVITE ANY READER WITH FIRST-HAND KNOWLEDGE OF THE PANEL DISCUSSION TO COMMENT ABOUT OUR INTERPRETATION - IF WE ARE RIGHT, LET US KNOW.  IF WE ARE WRONG, SET US STRAIGHT.

By Brett Sherman, The Sherman Law Firm

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

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. 

 

 

Former Bear Stearns Chief Strategist Trahan Says Sr. Management Ignored His Warnings

In 2005 and 2006, Francois Trahan was...

(a) employed as Chief Investment Strategist at Bear Stearns, and

(b) Wall Street's top-ranked ranked investment strategist according to Institutional Investor Magazine.

Both years, Trahan and his team at Bear Stearns issued detailed and specific warnings about the US housing bubble. Wall Street Law Blog has previously published several posts about Trahan's spot-on warnings about the bubble and his advice to steer clear of investments tied to real estate.

In The Era of Uncertainty, a book published this year and co-authored by the former Bear Stearns strategist,
Mr. Trahan confirms that senior management at Bear Stearns (at the time reporting record profits thanks to its mortgage bond securitization, sales, and trading businesses) was very much aware of his dire prognosis for the housing market and investments linked to real estate.

Indeed, Trahan writes that, before the financial crisis, he had been "pounding the table" about the housing market for "several years."

So why, according to Trahan, did senior management at Bear Stearns ignore all of his warnings? "The answer...," he says in his book, "is that the profits were just too attractive to pass up."

In other words, senior management ignored Trahan because Bear Stearns was raking in the money.

***

Francois Trahan left Bear early in 2007. His book has a ton of other great stuff about Bear Stearns and about the state of financial markets in the 21st century.