Wall Street Law Blog

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

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. 

 

 

Forget Hindsight - Housing bubble was foreseeable (updated)

Wall Street Law Blog responds to FCIC Testimony of Bear Stearns execs and others...

****

NOTE TO WALL STREET CEO'S:  FRAUD BY HINDSIGHT? SERIOUSLY?

One of the primary arguments Wall Street executives have been asserting to defend themselves before the Financial Crisis Inquiry Commission goes something like this- 

We could not foresee the collapse of the housing market, and therefore any allegations of fraud are merely impermissible claims of "fraud by hindsight." 

Survey Says? - X (pop culture reference)  Wall Street Law Blog doesn't buy it. 

 

(Brief digression -GO PHILLIES - despite recent inability to score a run, we have faith)

The Fraud by hindsight defense is asserted by defendants in many securities fraud cases.  The meaning of the defense is (as you guessed) that there is no fraud (i.., intentional or reckless misrepresentations or material omissions) if the alleged fraud can only be discerned after the fact.  Hindsight is, as they say, 20/20.  

*****

Returning to the housing and mortgage markets, and the marketing / sale of mortgage-backed securities, cdo's and related products...

Wall Streeters insist that they did not believe, and could not reasonably foresee, the housing and mortgage bubbles that expanded and ruptured in recent years.  

Umm, let's look at some facts:  

• From 1895 through 1996 home price appreciation very closely corresponded to the rate of inflation (roughly 3% per year).  

• Then, from 1995 through 2006 alone - even after adjusting for inflation - housing prices rose by more than 70%.  
  

How could such an unprecedented increase in the rate of home price appreciation rationally occur without alerting the self-anointed experts on "The Street" to watch out for signs of a massive housing bubble?  

For that matter, how would Wall Street executives and risk managers explain their alleged lack of bubblevision in light of the quite relevant fact that the greatest "boom" in the history of U.S. housing was peaking just a few short years after a little event we like to call the tech-wreck.  Remember the great technology stock bubble that ruptured at about the same time many of us were just recovering from the hoax that was Y2K?    

If their collective memories are so short, what the hell were they doing running our largest financial institutions?  (Rhetorical question)

Come on, Wall Street.  You need to come up with something better than the fraud by hindsight defense.   If you can...

Bear Stearns Executive Committee (minus Ace Greenberg) to Testify This Week

By Brett Sherman

The Sherman Law Firm

This should be very interesting-

The Financial Crisis Inquiry Commission, a bipartisan group examining the causes of the credit crisis, will hear testimony from four of the former big five members of the  Bear Stearns Executive Committee this week.

Cayne and fellow former CEO Alan Schwartz, for CFO Samuel Molinaro, and President and Co-Chief Operating Officer  Warren Spector all are expected to appear on Wednesday or Thursday.

Notably, Ace Greenberg - another former Bear Stearns CEO, and the fifth member of the infamous quintet that (according to a Harvard University Study) split more than $1.4 billion in CASH compensation between 2000 and 2008 (annual cash bonuses plus proceeds from selling Bear Stearns common stock paid to them as part of their bonus packages in previous years) - is not scheduled to appear.

In recent post, Wall Street Law Blog pointed out Ace Greenberg's seemingly damning comments about his own conduct in an interview with PBS shortly after Bear Stearns collapsed in March 2008.

Perhaps the FCIC does not read our Wall Street Law Blog yet...