Wall Street Law Blog

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

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