Wall Street Law Blog

Bear Stearns collapsed 5 years ago; fraud remains overwhelming success

Part 1:  Introduction -

Understanding securities fraud at Bear Stearns - Backstory of The Global Financial Crisis

Five years later, why should anyone care whether Bear Stearns (through Senior Management) committed securities fraud? 

Because...

(a) To understand how securities fraud by top executives at Bear Stearns toppled what was the fifth largest Wall Street investment bank is to understand why all of Wall Street's major investment banks subsequently disappeared.

(b)  The fraud that caused the end of the era of the traditional Wall Street investment bank gave birth to a chain of events that evolved into the worst financial crisis since the Great Depression.  

-and-

(c) As a direct result of their own securities fraud and other illegal conduct, members of senior management at Bear Stearns collected enormous financial windfalls that they did not earn and do not deserve to keep.  Senior management's windfalls came at the expense of America's economy and the economies of other countries around the world (and, on a "closer to home" level, executive committee members enriched themselves at the expense of Bear's own employees and shareholders).  

There are two basic elements of the financial windfalls that, to date, Bear's executive committee members have managed to retain-

First, Bear Stearns paid its Executive Committee members enormous cash bonuses for "leading" the company to record revenues from 2002 through 2006 with the same unsustainable high-risk business model that (a) caused Bear's failure and (combined with the same, similar, and/or related misconduct at Merrill Lynch and Lehman Brothers and Citi,and Goldman Sachs and insurance giant AIG -- to name a few of the responsible companies) (b) ultimately produced the global financial crisis.  

The second (and far more lucrative) element of the financial windfalls reaped by senior management came from selling massive amounts of Bear Stearns stock at artificially high prices.  The record "success" Bear Stearns achieved because of its fraudulent and unsustainable business model temporarily produced record high share prices for Bear Stearns common stock.   Indeed, from January 2000 to January 2007, the share price for BSC stock quadrupled.  

 During this period of stock price inflation, Bear's five top executives -- all of them members of the former investment bank's executive committee -- reportedly sold more than $1 billion dollars worth of stock-based compensation from prior years. 

Again, the story of unjust enrichment at Bear Stearns is a microcosm of unjust compensation practices all over Wall Street.

So far, securities fraud by Bear's former leaders has been a tremendous success.  The primary reason for this is, we believe, the sheer complexity of the fraud.   From the housing bubble to "affordability mortgages" to the different kinds of derivative securities that were part and parcel of the long running course of securities fraud at Bear Stearns (and on Wall Street generally), the misconduct at issue revolves around a lot of intimidating stuff. 

From easier (but not easy) to understand  concepts like subprime and Alt-a mortgages to harder (often headache inducing) "structured products" like mezzanine collateralized debt obligations, credit default swaps to fixed income terms like yield spreads, it is a daunting task to peel back the layers of fraud on Wall Street during the 2000s.   

"Fraud by complexity" is very dangerous.  Until Main Street has a far better understanding of what happened on Wall Street, then the corrupt rigged game that senior management for the old investment banks played so well for so long will resurface in slightly different form sooner rather than later.  

A deeper examination of securities fraud at Bear Stearns is, we at Wall Street Law Blog believe, a great place to start parsing fact from fiction and isolating the complex -- but ultimately fascinating -- story of the genesis of a financial catastrophe.  

 

The Wall Street Law Blog, a Publication of The Sherman Law Firm.

 

Christopher Columbus and financial risk management... (encore)

By Brett Sherman

Introduction (a slight bit of revisionist history is ok now and then...)

***

1492:  The Italian explorer sailed his three ships from island to island, staking claims for the Spanish King and Queen throughout the calm, crystal blue waters of what would later be called the Carribean Sea.  His three ships navigated the placid sea for months, and the Italian and his men explored islands we now call Cuba, Puerto Rico, and Jamaica, among many others.   March, April, May, June, July, August, and September passed.  The weather was perfect.  The sea was calm.  These were the best sailing waters in the world proclaimed the Italian.  He had "discovered" paradise. 

Then, in early October, a mild storm came and went.  After so many months of perfect weather, some of the crew were uneasy about the sudden turn in the weather.  Perhaps this was a bad omen?  "Nonsense." Days later, another storm, noticeably stronger than the first.  Aberrations, the Italian insisted.  Even in the calmest sea there must be an occasional storm.  Many of the men, now convinced that their run of good luck was over, urged the Italian to safely anchor the three great ships in one of the many naturally protected harbors on the islands the men had explored.  The Italian was stubborn.  He refused to listen.  He had already compiled an enormous treasure - more gold than he had ever imagined, and he was not about to interrupt his accumulation of treasure because his men were worried about some wind and rain.  

Then came a storm unlike any the explorer or his crew had ever witnessed.  It sunk one of the three ships, nearly destroyed the other two.  Many men drowned.  Nearly all of the gold was lost.  The Italian was ashamed.  He had ignored the warnings of the crew.  Now all was lost.  All of those months of calm seas - the calmest seas the explorer had ever encountered. 

He had seen bad storms in his life.  He had seen men die at sea, ships sink, and treasures lost.  But it he had rarely seen even a cloud for months and months.  Terrible storms had not happened here.  Therefore they could not happen here (though he really did not believe his own words).  

Although he had sailed the Caribbean for nearly a year, this was his first October.  Each October, the hurricanes came to the calm waters.  It was a lesson he could have learned from the safety of a protected harbor - had he not been blinded by greed.

*******

Your turn to play CEO

As an attorney, I'll be the first to admit that hindsight is 20-20.  However, this post (in which I am asking you to imagine that it is December 2006) has nothing whatsoever to do with hindsight.  On the contrary, I want you to pretend that you are winding down the year 2006 as Chief Executive Officer of a major Wall Street investment bank.  There is something you know at that time (hence no hindsight issue) - something quite important.  And you've known it for at least ten years, maybe even two decades.  

Financial Panics

Here is what you know Mr. or Ms. CEO - financial panics have become a fact of life on Wall Street.  The frequency of market bubbles and bursts has increased exponentially during your tenure at or near the pinnacle of your profession.  There were exactly zero true market panics between 1929 and Black Monday 1987.  However, through December 2006, you've lived through at least six "market panics" in twenty years, including 5 in the preceding decade alone (in 1987, 1996, 1997, two or more in 1998, and 2000).    

Maybe not so coincidentally, almost all of Wall Street's investment banks went from private partnership to public corporation during the 1980's, right before the new panic era.   Perhaps Wall Street was just a bit less cautious with its money once the risk of loss shifted from the partners to public shareholders.  What do you think, Mr. or Madame CEO?

Anyway, all of these panics were unexpected to one degree or another (whether in terms of timing, intensity, or even crises that were completely unforeseen).  Each of these panics sent intense shockwaves cascading through markets, sometimes infecting market sectors that were unrelated to the genesis of the panic itself (through the ugly tentacles of "contagion").  

Since you are (for purposes of our exercise) the leader of one of the most important financial institutions in the entire world, you really can't credibly deny that you understand some seriously important concepts from the six major panics that seized markets starting on Black Monday 1987. 

Having been in the thick of the action and privy to lessons learned in the aftermath of these crises, you would have had to have been incompetent for years to miss out on the following wisdom:  Panic in the financial sense means pretty much what panic means in every other sense.  Some event (it could be a major occurrence or a series of smaller tremors that eventually build to a critical mass), triggers a crisis of confidence in a given sector of the world economy (perhaps doubts about a booming U.S. housing market?). Once a crisis of confidence is triggered, animal instinct - herd mentality - takes over and truly frightened human beings (investors and investment professionals) stampede in a bloody fight for self-preservation.  A run on financial markets ensues, feeding on itself in a vicious cycle until hearts stop thumping, collective blood pressure levels out, and panic begins to subside.   

 You also know - based on your experiences with recent panics - thatalthough the timing of triggering events, and even the severity of panics themselves, may have been unforeseen, the strong probability of similar events occurring again - especially during economic "booms" - is entirely foreseeable.  You also know that it is only a matter of time until a company that surfs the biggest wave, wipes out and drowns.

Something is going to happen to derail the gravy train eventually. You know this.  After all, you run a major investment bank.  Since 1987, you know you can only to limit the downside to your company from the next crash is live by one guiding precept - Expect the Unexpected.  Translation - Fail to truly stress the importance of effective risk management at your peril. 

The more experience you gained with panics, you realized, the more you knew you should not play games with trying to predict when the next one might come.  You only knew that it would come.  Therefore, the only protection against disaster - the only true hedge - was to keep an even keel.  You had to manage risk prudently, avoid temptation of easy money, resist the pull of greed.  Even the most prudent risk management, of course, can fail.  But easing up on the reigns of risk management could be truly deadly to any company at any time.  This was the lesson you learned from the panics you lived through.  But you ignored it anyway.  

***

PART TWO: Wall Street CEO Do's and don'ts (since your are the CEO, feel free to disagree)

• Do Prepare for the next crash that you know is all but inevitable by making sure your company manages risk sufficiently to limit potential down-side exposure.

• Don't recklessly manage your publicly-held company for excessive short-term profits at the expense of long-term stability. 

• Do concede that it doesn't do shareholders any good to have your stock shoot to the moon if it crashes back to earth (except for the lucky ones who sold out at lunar levels). 

• Don't tie the fortunes of your company to hard to price mortgage-related products that depend on a dangerous and grossly negligent assumption that the U.S. housing market cannot collapse. 

• Don't let a loss of confidence in your firm by creditors (for whatever reason, rational or irrational) kill you because your company is leveraging its balance sheet at an obscene level of 33 times equity.

• Don't be so irresponsible that you focus on squeezing every penny of profit from the mortgage securities boom today and neglect the potential ramifications of your business strategy for tomorrow.

By Brett D. Sherman

Visit The Sherman Law Firm Website

CASINO CAPITALISM: Accountability Time. (greatest hits collection)

BY BRETT SHERMAN

ARE RESPONSIBILITY AND ACCOUNTABILITY NOT TWO SIDES OF THE SAME COIN?   

 If you "Google" the right keywords and patiently read through hundreds of search results, you will eventually find some senior level Wall Street executives who take some responsibility for wrecking the financial services industry and pushing the entire economy to the brink of, well, [readers - please insert your own hyperbole here].

Jimmy Cayne apologized for the collapse of Bear Stearns.  He even admitted he had no clue what he was doing as Bear struggled through the the summer and fall of 2007 (at the time, however, he talked a very different game). Hell, Cayne has all but labeled Bear's independent directors a gaggle of yes men who did not dare interfere with management or corporate governance at Bear Stearns.  

We've also read scores of interviews with senior managing directors at Lehman and Bear Stearns that give chapter and verse on mismanagement by senior officers like Dick Fuld (CEO of Lehman) and Jimmy Cayne.  

Everyone seems to take it for granted that men like Dick Fuld, Stan O'Neil and Jimmy Cayne are responsible for the demise (or de facto demise) of Lehman Brothers, Merrill Lynch, and Bear Stearns. 

And you know what?  Everyone is right.

However, responsibility doesn't mean a whole lot unless it comes with consequences. The near total absence of meaningful consequences for extreme misconduct by Wall Street executives - the kind of consequences that may actually have a sliver of deterrent value - is, quite frankly, shocking. 

    ****

Motivated by unquenchable thirst for wealth and power, many senior Wall Street executives, at minimum, committed acts of extreme recklessness that manifestly jeopardized the long range prospects of their companies.  Did management intend to destroy their companies?  No. But our society is about instant gratification, not long-term rewards.  

A whole lot of executives were so blinded by greed that they refused to look very far beyond the tremendous windfalls they expected to receive at bonus time.     

Of course, many shareholders suffered large losses when the investment banks went down. Victimized shareholders deserve to be made whole.  After all, If Wall Street executives did not commit "fraud," then the federal securities laws and all other statutes that protect investors should be torn from all law books and fed into shredders.  

Oh, we know all about D&O insurance and indemnification agreements.  We don't care about that stuff. The top dogs on Wall Street killed their companies. So what if the D&O insurers pay? Who cares if Bank of America pays legal costs on behalf of Merrill Lynch executive officers?  Who cares if JPM does the same on behalf of Bear Stearns management?  Whatever. Just make defrauded shareholders whole.

Hey, damaged shareholders-     
 

Drag the men and women responsible for your losses into the muck. Sue them, expose them, take action.  Make sure the history books blame the right individuals for the most severe threat to capitalism since the Great Depression.  

It is time for accountability.  Don't you think?  

Please take the time to share your opinion.  Leave a comment.  Wall Street Law Blog values reader feedback, even the negative kind.

Comparing Wall Street Comp. to payrolls in the NFL and MLB (Greatest Hits)

 

ByBrett Sherman

In 2006, total compensation for five Bear Stearns senior executives, including CEO Jimmy Cayne, exceeded the payrolls of the NFL's New York Giants and MLB's Philadelphia Phillies.  The payrolls of these two professional sports teams make for a particularly interesting comparison with the total compensation that was wasted on Bear Stearns’ five executive officers in 2006 (which blew away the money the Giants spent on their 50 plus players and the combined salaries of more than 25 Phillies).   What's our point? Well, only two years later, in 2008, the Giants won the Super Bowl, the Phillies won the World Series and Bear Stearns was out of business.

PERFORMANCE-BASED INCENTIVES ARE BAD BUSINESS

By  Brett Sherman and Phyllis Barrack

Our just completed and admittedly informal study of incentive-based compensation to corporate management yielded some expected results, and some surprises too.

Our main finding pretty much confirmed what we have long believed:  Over the long-term, companies that seek to motivate management with huge short-term incentives nearly always hit a wall.

Although stock prices may fare well at times (when risks pay off), price also tends to slide back on a fairly consistent(when risks cause losses).  The evidence is pretty solid (at least to us) that short-term incentives actually harm the prospects of building shareholder value over time.

The magnitude of risks that management takes (i.e., the size of bet management places) depends on the nature of the incentive itself. When big money is on the line (like millions of dollars) management will nearly always reach for the brass ring, sometimes taking extraordinary risks in a go for broke attempt to meet incentive criteria.

However, the really interesting take-aways (for us) from our "experiment" were these:

ANY PERFORMANCE-BASED INCENTIVE 

DRAMATICALLY INCREASES RISK-TAKING

BY MANAGERS OF PUBLIC CORPORATIONS. 

                                                    ***

WHEN PERFORMANCE-BASED INCENTIVES ARE

RELATIVELY MODEST, MANAGERS SEEMED

WILLING TO TAKE EXCESSIVE RISKS RELATIVE TO 

POTENTIAL REWARDS FOR SUCCESS.   

We are not economists and don't pretend to have any more than rudimentary understanding of economics. We understand that our conclusions may be (a) incredibly basic, or (b) proven wrong by caveman economists 10,000 years ago.  In other words, we know that our study lacks any scientific value. 

Still, we would be remiss if we didn't offer our "insight."  We agreed (amongst ourselves) that incentives are bad for business.  At all levels, the mere existence of an incentive seemed to boost risk-taking behavior to levels that are unhealthy for the long-term welfare of a company.  What goes up, must come down...

We welcome all criticism (we grudgingly accept praise, too).  Please set us straight.  That's what the comments box is for.     

CEO's Cayne and Schwartz refused to raise a cushion of capital. (greatest hits volume 2)

The Sherman Law Firm

Repeated decisions by Jimmy Cayne and Alan Schwartz not to seek an equity investment after the onset of the subprime crisis are not protected by the business judgement rule. 


Bear Stearns' CEO Jimmy Cayne and his successor Alan Schwartz each made  deliberate decisions not to raise equity after the collapse of Bear Stearns' subprime hedge funds in the summer of 2007.  These decisions were irresponsible and driven in part by self-interest.  


Credit markets began to constrict when the subprime crisis began in the summer of 2007.  Lenders grew more cautious during the flurry of bank mark-downs on mortgage-backed securities and collateralized debt obligations.

From early September 2007 Bear Stearns executives frequently urged Bear Stearns CEO Jimmy Cayne andPresident Alan Schwartz to obtain a substantial cash infusion.  

Cayne and Schwartz met with potential investors but ultimately found a reason why each deal could not work. Ultimately, Cayne concluded that he was not interested in an equity investment, and Schwartz concurred. 

In January 2008, when Schwartz took over as CEO, Bear Stearns executives stressed the need to raise money.  Schwartz expressly stated that Bear Stearns had no need for additional equity.  

Bear Stearns had a huge portfolio of mortgage-backed securities and related products, which the firm estimated to be worth 45 billion in October 2007 and 46 billion in March 2008.  

Regardless of Bear Stearns' appraisal of its portfolio, during the week of March 10, no lender was willing to accept the mortgage portfolio as collateral worth 46 billion (or anything remotely close). 

Bear Stearns could not have been surprised at the further tightening of credit and the dimmer view that lenders were taking of mortgage securities in the early months of 2008.  

In mid-February, UBS had written down more than 20 billion from its Alt-A mortgage holdings.  

In early March a large mortgage-backed securities hedge fund owned in part by the white-shoe Carlyle Group could not meet margin calls and ran out of money.  

On March 10, 2008, Moody's downgraded an Alt-A offering issued by Bear Stearns itself.  The markets clearly were according virtually no value to mortgage-backed securities.  Bear Stearns had a liquidity problem.  The rumors were true.  


Still, Executive Committee Chairman Ace Greenberg and CEO Alan Schwartz publicly claimed that the Company did not face a liquidity crisis until late in the week of March 10.  They pointed to the $18 billion in cash Bear held in its accounts.


However, Bear Stearns' liquidity requirements were far greater than $18 billion. 

In fact, Bear had a daily liquidity requirement of about $50 to $75 billion to fund its businesses. Most of Bear Stearns daily liquidity came in the form of overnight repo loans.  Overnight repos must be renewed, or rolled, each business day.  Repo loans are secured. They require collateral.  

Much of the collateral Bear Stearns regularly used to secure repo loans came from the firm's huge portfolio of toxic mortgage-backed securities and related instruments.  

In March 2008, Bear Stearns showed 45 billion in mortgage-related securities on its balance sheet.  No lender was willing to accept Bear Stearns' valuation, and many lenders chose not to accept  mortgage-backed securities as collateral at any price.    

Board Chairman Jimmy Cayne and CEO Alan Schwartz each knew the MBS collateral the firm used to secure its short term lending was distressed if not totally illquid.  Allowing the firm to reach that point without raising equity, selling the Company, or selling off mortgage securities was more than an error in judgment.  It was plain ignornance and incompetence by men who have a duty  to be knowledgeable and competent.   Bear's executives cannot be protected by the business judgment rule. 

Wall Street Rationale Reviewed...

Wall Street deception revealed by a basic analogy:

The housing market has never collapsed is to 

The housing market cannot collapse                                               

-AS-

I have never been dead is to

I am immortal

By Brett Sherman

Thanks to Nassim Nicholas Taleb and Jim Grant for inspiration.

 

High Risk Strategies Fail In the Long Run - See, for example, Bear Stearns

1.      The definition of risk is the chance of loss.  If an action carries a chance of loss, it is risky.  The greater the chance of loss, the greater the risk. Risk magnitude refers to the size of potential loss. If the potential loss from a given risk could wipe you out, the magnitude is very high.

2.      Why do high risk strategies threaten long-term survival?  Think of betting your life savings on a game of Russian Roulette.[1] Once a year,  on New Year’s Eve, you hold a cold steel pistol to your temple.  The gun has six chambers, but only one holds a bullet.  You say a little prayer and squeeze the trigger.  Each year your luck holds, you exhale with relief. You have drawn one of the five lucky chambers. Then you jump for joy.  You not only get to live, but you’ve just doubled your money.

3.      Unfortunately, each year that you win the laws of probability and statistics stack up higher and higher against you.  Luck doesn’t last forever, and math never lies. Next year, your luck may run out.  In any event, if you play for too long, you are almost guaranteed to lose.

 

4.      Of course, losing at Russian Roulette means losing everything you’ve ever had and everything you ever will have.[2]  Therefore, “prudent risk management” (to use the words of former Bear Stearns CEO Jimmy Cayne)  dictates that you shouldn’t be playing the game at all.  The bet is far too risky.  But it is also quite lucrative, and you really like money.  You understand the chance you are taking.  You take it anyway.  You are just like the Executive Committee at Bear Stearns.

5.      The point is this - Frequency of success does not mean anything if the cost of even one failure is too high. Bear Stearns reported record revenues for 5 straight years.  And when the company collapsed, those record years didn’t matter to public shareholders at all (except for those lucky enough to have had a reason to sell BSC long before March 2008).

 

6.      The individuals who truly benefitted from each of those five record years were the Executive Committee members. They received windfall bonuses, including many millions in cash payments, for generating positive short-term performance during an unprecedented bull market. 

---

[1] The idea of the Russian Roulette analogy comes from the trader and author Nassim Nicholas Taleb. 

[2] Rough paraphrase of Clint Eastwodd from the film The Unforgiven.