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

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.

A brief lecture for your CEO on the basics of risk management. (greatest hits volume 2)

Your CEO just might be a very bad risk manager if...

If your CEO bets the future of your company on a business strategy that has even a small chance of wiping out said company if the strategy turns out to be wrong.  

Competent risk management means that the consequences of being horribly wrong about any investment, business strategy, business model, or any other business decision cannot possibly produce losses that kill a company.  Every company must be able to withstand any economic shock.  

Put another way, risks must be controlled. No event - regardless of how unexpected, unanticipated, unforeseen, or unprecedented the event might be - can ever produce a financial outcome so bad that the event brings the walls of your company crashing down.  This includes market crashes, tsunamis, earthquakes and pretty much anything else. 

   If you are wondering how to avoid a disastrous event if it is entirely unforeseeable, you miss the point.  You certainly cannot avoid the unforeseen event.  If you bet heavily on the Ruble, and Russia decides to default on its debt (as if that could ever happen), then Russia will default on its debt.  If an earthquake destroys your office building and wipes out your computer servers, there aint much you can do about it (except evacuate quickly).  

  The future is impossible to predict (except, I hope, for Madame Sozuka - the psychic who read my palm at a bat mitzvah last year and assured me that I will win the lottery in 2010).  There are too many variables for any expected outcome to be certain. 

  Wars, weather, famine, traffic accidents, food poisoning, bad orange crops, good orange crops, devaluation of the ruble, oil surpluses, oil shortages, terrorism, an unprecedented housing boom, a nationwide housing bust..., the number of unforeseen, unprecedented, unexpected, unanticipated factors that influence future outcomes is always infinite.   

  The idea of risk management is to accept that unexpected events and outcomes - regardless of what causes them - happen all the time.  Sometimes an event is totally unforeseeable (the 9/11 terror attacks), and sometimes an event can be unexpected to some people, but by no means unforeseeable (the housing crash).  Regarding 9/11 - I am a very fortunate survivor from the South Tower of the WTC, 65th floor - I am only suggesting that the attacks were unforeseeable to businesses.  Whether the government should have foreseen the tragedy is another matter.  

Of course, no CEO could have prevented 9/11, or protected those who were injured or killed that day. But any company with effective risk management would have assured that the company itself would survive.  How?  One way was to be certain that vital data, like confidential client information, was backed up on a computer server hundreds or thousands of miles from ground zero to prevent the loss of crucial information for any reason. Similarly, countless risks (such as loss of property) could have been, and in most cases were, insured.  Insurance is one of the most important forms of risk management.   

The CEO of any financial institution who would stake the company's future on "conventional wisdom" that a national crash in the housing market can't happen is worse than bad risk manager.  The words incompetent and criminal come to mind.  

Conventional wisdom is no basis on which to bet the ranch. Even if there had not previously been a national housing slump (a point of some debate), all that would mean is that there hadn't been one yet.  Remember, there also had never before been housing growth that even approached the explosion in home demand, appreciation and ownership that occurred between 1996 and 2005.  Historic booms are often followed by historic busts.  Ask the former paper millionaires in Silicon Valley who had to move back in with their parents after 2000.  

Brett Sherman