Wall Street Law Blog

Game On! SEC Says Bear Stearns Subprime Hedge Fund Case Will Go Forward

In a recent post, Fortune Magazine reported that the SEC intends to press forward with a civil lawsuit against ex-Bear Stearns hedge fund managers Ralph Cioffi and Matthew Tannin. See tinyurl.com/3b6a7cs

By Brett Sherman; Wall Street Law Bog, The Sherman Law Firm

CHANCE TO SAVE FACE?

Federal Prosecutors Have Been Criticized For Rushing Their 2008 Indictment in a complex criminal fraud case against former Bear Stearns Hedge Fund Managers Ralph Cioffi and Matthew Tannin.

That Case Ended In Acquittal.

Lawyers for the SEC Have Taken Their Time. But Will The Civil Trial End With A Better Reult For The Government?   Maybe so.

Double Jeopardy is Not An Issue

First, the SEC lawsuit is NOT DOUBLE JEOPARDY.

Double jeopardy is all about the possibility of incareration.  Jail.  Unlike the failed 2009 criminal prosecution of Cioffi and Tannin, the SEC lawsuit cannot result in jail time for the managers of two Bear Stearns subprime hedge funds that went bankrupt in July 2007. Thus, no double jeopardy.

BACKGROUND

The only high profile criminal case about the subprime meltdown and financial crisis ended disastrously for the federal government.

Ralph Cioffi and Matthew Tannin, the now infamous managers of two Bear Stearns hedge funds that failed during the summer of 2007, were arrested and charged in with fraud-based crimes June 2008. The crux of the charges was that the two Bear executives deceived investors about the risks and performance of complex designer securities called collateralized debt obligations (and better known as CDOs).  The CDOs at issue were backed by subprime mortgages.   

Subprime mortgage defaults spiked when the housing bubble popped in 2006.  By 2007, mortgage defaults were so high that investors stopped buying subprime-backed CDOs.  As demand shrunk, the value of these securities plunged.  

 In 2009, a jury found Cioffi and Tannin not guilty of criminal fraud charges on all counts.

 

 

A CHILLING EFFECT?

Pundits have pointed to the acquittal, an embarrassment for prosectors, to help explain the complete absence of subsequent indictments against executives from Bear Stearns or other big players in the market for mortgage bonds.

"There is no doubt in my mind that the verdict in the Bear Stearns hedge fund trial has had a huge chilling effect on prosecutions," said retired judge and trial lawyer Lee Sherman.

It isn't exactly good for the careers of prosecutors to lose these kinds of high visibility cases."

 

Lee Sherman is a senior consultant to The Sherman Law Firm and a regular Wall Street Law Blog contributor.

WHY PUT CIOFFI AND TANNIN ON TRIAL AGAIN?

For many observers, the SEC's decision to press on with its case against Cioffi and Tannin is a surprise. The allegations are nearly identical to the failed Bear Stearns prosecution.

However, Mr. Sherman believes the move makes sense. 

"Remember," Sherman said, "Unlike federal prosecutors, who were bound by the Constitution's speedy trial requirement, the SEC has had years to investigate and prepare for this. Plus -- and I believe this is a major factor -- the SEC has a far easier burden of proof."

 

 

PREPONDERRANCE OF THE EVIDENCE

In 2009, federal prosecutors failed -- in the jury's view -- to prove the two former Bear Stearns executives guilty beyond a reasonable doubt. In the civil trial, SEC lawyers will try to prove civil liability rather than guilt and, therefore, the burden of proof is the preponderance of the evidence standard.

Under the preponderrence standard, jurors are typically instructed to find liability if they feel 51% sure that the evidence supports liability.  Obviously, with the preponderrence standard, the bar is set much lower than it is under the beyond a reasonable doubt required in criminal cases.

REDEMPTION?

Perhaps the biggest reason why the SEC chose to proceed against Cioffi and Tannin is to rehabilitate the Commission's severely damaged reputation.  Under the Bush administration, the SEC failed to detect and prevent fraud by Wall Street investment banks again and again and again.  The Commission has been rightly blamed for being asleep at the switch.     

Under President Obama, personnel and cosmetic changes at the SEC have been made. And there has been the predictable amount of tough talk.  Still, in terms of real change, the SEC still needs a major accomplishment before the public will believe there's a new sheriff in town.

Stay tuned... This may get interesting.

Wall Street Law Blog; A Publication of The Sherman Law Firm

*Information about SEC's decision to move forward via Fortune tinyurl.com/3b6a7cs

Would Bear Stearns sales have exposed "mark to market" fraud?

    Did Bear Stearns maintain a massive mortgage-related securities portfolio to avoid huge write-downs, cover fraud, or even hide insolvency?  

We'd sure like to know.

 

• After the subprime crisis began in 2007, senior managing directors at Bear Stearns reportedly urged the firm's Executive Committee to raise capital by, among other actions, selling off chunks of the firm's massive portfolio of mortgage-related products.

• Mortgage boss Tom Marano consistently fought the idea of any substantial liquidation of Bear's mortgage holdings.  

• The ever-worsening mortgage and credit crises meant that Bear Stearns could sell mortgage-related products for only a fraction of their original values.  However, there came a point in 2007 (at the latest) when Bear Stearns management knew or should have known that the market for mortgage-backed securities and related investments was dead in the water.  The housing and credit bubbles had popped.  The party was over.

• Still, according to the estimated values Bear Stearns was assigning to its mortgage holdings in 2007 and 2008, substantial liquidations from Bear's mortgage portfolio at deep discounts could have yielded billions of dollars for the firm's war chest.    

• SEC records show that Bear Stearns had significant liquidity problems by late summer, 2007.  

• In light of Bear's documented liquidity issues and falling demand / prices for MBS and CDO's, there seems to be no logical reason why Bear Stearns would keep huge amounts of the firm's capital locked inside mortgage securities were (a) consistently losing value, (b) had virtually no chance for any real, sustained recovery, and (c) would be difficult to sell quickly if Bear Stearns needed to raise cash quickly (which, of course, is precisely what happened when Bear was undone by a severe liquidity crisis in March 2008).

• Nevertheless, Tom Marano continued to argue against any substantial reduction in the firm's mortgage holdings.  

• THE QUESTION IS WHY:  Why would Marano fight liquidations of mortgage securities?  Why would CEO Jimmy Cayne allow Bear Stearns to keep the over-concentrated mortgage portfolio largely intact when that portfolio obviously was a huge albatross for the firm?  Why would Cayne's successor as CEO, Alan Schwartz, also side with Marano?  

• POSSIBLE ANSWERS (what follows is speculation. However, if there is a better explanation for Bear's inexplicable refusal to sell off chunks of its mortgage securities book, we sure would like to hear it...)  

• Maybe the reason Bear Stearns kept most of its massive mortgage portfolio after the subprime crisis began in 2007 was that the firm knew it had marked the value of its mortgage securities way too high. 

• Maybe Bear Stearns knew that the real prices the market would pay for mortgage securities were far less than the prices Bear was using to value its portfolio (which accounted for a large portion of the total assets on Bear's balance sheet). 

• Maybe Bear Stearns knew it could not sell its mortgage holdings without exposing the firm's false valuations.  

• Bear Stearns certainly knew "mark to market" accounting rules meant sales of large blocks of mortgage securities on the open market would immediately set new benchmark prices for repricing similar, hard to value securities.  

• If Bear Stearns knew that it was over-stating the value of MBS, CDO's and related products, then Bear also knew that using new benchmark market prices to revalue the balance of the firm's mortgage holdings would reveal that the portfolio was worth far less than Bear Stearns was reporting on its balance sheet.  

• If Bear Stearns knew that the value of mortgage-related assets on the firm's balance sheet was substantially lower than Bear was telling the public, then maybe Tom Marano and Bear Stearns senior management resisted any sizable liquidation of the mortgage portfolio to avoid exposing Bear's unreasonably high marks.

• Maybe it is even true that Bear Stearns senior management knew (or believed / feared) that a large sale of mortgage-related assets, and a subsequent revaluation of the balance of the portfolio using new benchmark prices, would show that Bear Stearns was actually insolvent during the second half of 2007 and early 2008.  

Whether some, all, or none of our conjecture is accurate, Wall Street Law Blog firmly believes that any explanation would cast a bad light on the business practices of Bear Stearns. As always, we welcome your thoughts, information, criticism, and wisdom.

By Brett Sherman, The Sherman Law Firm