Wall Street Law Blog

The two most important words in financial risk management?

WHAT -and- IF

By Brett Sherman, The Sherman Law Firm                  

Worst Case Scenario Analysis - Management of low frequency / high magnitude risks. 

 

Companies must have methods for controlling risks inherent in activities with -

(a) a high probability of success, but

(b) can produce catastrophic losses with just one failure.

***

The ultimate risk management responsibility for publicly owned corporations is to assure that a company cannot be crippled if a business strategy / model goes horribly wrong.  

It is impossible to manage against the risk of high loss magnitude events unless corporate risk managers and senior management agree to start all risk analysis with two words - 

"WHAT" and "IF"

 

FOR EXAMPLE-

 

What if our hedging strategy fails?

 

-or- 

 What if home prices fall?  (the common sense question that could have prevented the failure of Lehman Brothers, and Bear Stearns - and maybe even the financial crisis)

* * *

So, why weren't these basic questions asked by nearly enough companies during the housing bubble?  

That's right - Because an overloaded money train was pulling into Wall Street and Orange County, California (the epicenter of nonprime lending) on a regular basis, and asking "what if" questions would have yielded (pun intended) answers that lenders and bankers did not want to hear.  This is risk management by denial (also called willful blindness or, more colorfully, burying one's common sense in the sand).

Tell us what you think: Wall Street Law Blog welcomes your comments and your criticism.

Rampant Securities Fraud - Why it Exists; How to Stop It...

Life is about playing by rules. Sometimes we make a pact to voluntarily follow a set of rules - like when we play golf or tennis or darts or ping pong.

Other times we are requited to obey a rule regardless of whether following the rule is something we want to do. Many of these mandatory rules are called laws, and we comply with laws that we don't like because we worry that the consequences of breaking the rules - of breaking the law - will be unpleasant.

There are plenty of people for whom the annual act of filing a federal income tax return and "giving away" some of their money to the tax man is about as bad as being strapped into a chair in the office of a dentist armed with a drill a sadistic streak, and no anesthetic or anesthesia.

As painful as filing can be for some of us, the fact is that the vast majority of us still file on time in whatever manner the law requires.

Why? Because, as unpleasant as the consequences of forking over our cash to the federal government is each year on April 15, this temporary pain is trumped in our psyches by the threat of what might happen to us if we choose not to file and one day we get busted for tax evasion. (think Al Capone)

Wall Street today is filled too many powerful men and women who literally ignore the anti fraud provisions of the federal securities laws.

Like the US tax code, the Securities Exchange Act of 1934 is a federal statute. A law of the United States.

And there are a range of very serious penalties that are supposed to discourage folks from committing securities fraud, just like our concerns about all the bad things that might happen if we blow off our taxes gives most of us incentive enough to, well, NOT blow off our taxes.

But - at least for purposes of this post - assume that our little hypothesis about why people who might otherwise decide not to pay taxes is correct. How then to explain the staggering number of multi-billion frauds of the past decade? Why should one federal statute - the one that prohibits fraud - be a less effective deterrent then another?

By now, if you follow this kind of stuff, the answer should be pretty clear. It is an 11 letter word that starts with f and ends with... No, really, it starts with E and ends with MENT. That word is enforcement.

It seems apparent to Wall Street Law Blog that there is very little fear among the upper crust of the financial world about any real possibility of enforcement. (An 11 letter synonym that also works here is PROSECUTION).

Last question - what happens when there are rules that nobody really believes will be enforced? Easy answer. People cheat. A lot.

By Brett Sherman

The Sherman Law Firm

 

By Brett Sherman

When is a prime mortgage not a prime mortgage? A different take on contagion... (update 1)

How high-risk borrowers contaminated securities backed by prime mortgages. A story about the financial crisis and contagion.

* * *

In the 1980s we had trickle-down economics. During the first half of the 2000s, we had trickle-up credit scoring.

Before you yawn (or stop reading), consider that credit score inflation was

(1) a real phenomenon, and

(2) helps explain why, when the crisis hit, the market for bonds backed by supposedly high quality prime mortgages suffered from the same kinds of liquidity problems as subprime backed MBS.

Background: The Golden Age of Subprime and its impact on Credit Scores 

The performance of subprime mortgages during the first half of the first decade of the 21st century was strong enough to justify (rationalize) AAA credit ratings for senior tranches of structured bonds backed by those mortgages. However, the banks that jiggered and gerrymandered the structures of those bonds knew that their AAA-like performance was an illusion. The banks knew -- as we have addressed about in numerous prior Wall Street Law Blog posts -- that it was the unique economic climate of the early 2000s, plus the widespread abuse of ARMs with short-term below market "teaser" rates (and loans with similar "affordability" features), that kept subprime default rates down.
 
Because low subprime mortgage defaults concealed the poor quality (i.e., crappiness) of securities backed by subprime mortgages, Wall Street banks could to sell all the subprime-backed MBS that their securitization machines could produce.
 
Being big fans of math, we like to describe subprime's brief but memorable "golden age" with an equation:

(R x Li) + (R x HPA) = BCR

Translation: Record low interest rates plus record home price appreciation equals bogus credit ratings.

Ok. So far, nothing in this post should be news to any amateur crisisologist.

 

But did you know that the number of prime borrowers went way up during the golden age of subprime? It's true. Credit scores spiked in the first half of the 2000s. This period of credit score inflation meant lots of high-risk borrowers could qualify for prime mortgages.

Welcome to the World of  Credit Score Inflation

The fact that credit scores went up at the same time that subprime defaults were low is no coincidence. Indeed, if you think about it, the connection makes perfect sense.

Credit scores went up a for the same reasons that subprime defaults were low. Specifically, credit score inflation was a byproduct of record low interest rates and record home price appreciation.

Remember the equation-

(R x Li) + (R x HPA) = BCR

The equation works equally well if we substitute CSI (credit score inflation) for BCR (bogus credit ratings).

Thus-

(R x Li) + (R x HPA) = CSI

----

NOTE

Equations are for illustrative purposes. We are NOT mathematicians (clearly) and our "equations" really have nothing whatsoever to do with math.

So, before quants and math teachers and algebra students taunt us, please understand that we do realize that BCR does NOT equal CSI.

However, it is still true (as far as we know) that E = MC Squared.

 

* * *

During the golden age of subprime, many credit-impaired homeowners used the theoretical wealth produced by record increases (on paper) in the values of their homes and borrowed a lot of real money by taking out new mortgages. These new mortgages were usually cash-out refinancings or home equity loans.
 
Thanks to securitization, of course, these loans were very easy to come by. In fact, for subprime borrowers, aggressive mortgage brokers practically begged homeowners to borrow against home equity.

Now, after buying a few Plasma TVs and a SubZero Fridge and maybe a Viking Range, a subprime borrower could use the rest of that "free money" (or, since home values kept going up, borrow even more money) and pay off all of their maxed-out high interest credit cards, overdue bills, and other debts that earned the individual subprime status in the first place.

The result of "cleaning up" all this debt? Very quickly, the borrower's credit score improved. Often, the credit score went up a lot. Suddenly, a habitual deadbeat could appear to be a good credit risk. Many beneficiaries of credit score inflation were actually able qualify for prime mortgages.

The Trouble with Credit Score Inflation

First, a quick recap: credit score inflation is a rapid rise in an individual's FICO score for reasons that have nothing to do with that individual's creditworthiness.

During the housing bubble, credit score inflation made a whole bunch of people with poor credit histories seem like good credit risks. Deadbeats suddenly had credit scores that qualified them for prime mortgages even though most were still deadbeats.

When these borrowers refinanced again (as they generally had to do before their mortgages reset to a much higher rate), their new mortgages could be classified as prime mortgages. Suddenly, because of credit score inflation, there was real dilution in the quality of prime mortgage pools.

When the bubble popped, home equity disappeared, returning to the ether from which it came. However, the crop of former subprime borrowers that qualified for prime mortgages through the magic of credit score inflation still had to repay the real money they had borrowed. Many couldn't.

Credit Score Reversion

Before long, the CSI-enabled prime borrowers were behind on bills or defaulting on mortgages. For these folks, this post-bubble period became the era of credit score reversion.
 
From a macro perspective, the problem was that tons of high-risk prime mortgages were marbled throughout the universe of RMBS and CDOs. Of course, like everything else in the derivatives world, it was virtually impossible to know which pools were infected by these faux-prime mortgages and which weren't.

The rest of the story is a familiar one.

By now, we all know that contagion kicks in during a crisis when (a) there are bad assets, and (b) the market for those assets lacks transparency.

Bottom line?

Contrary to Wall Street's standard narrative, the mortgage crisis did not simply spread from subprime to prime because of fear. Certainly fear was a factor, but the reason for the fear was that Wall Street cloaked mortgage bonds in so much complexity and disclosed so little information in order pull off the whole MBS/CDO scam that investors had no way to parse good bonds (assuming there were a few) from bad ones.

But the other, frequently overlooked point is this: There were enough bad mortgages that were not "subprime" - including the faux-prime mortgages described in this post - that the markets acted rationally (for once) by shunning all securities that depended on the performance of home mortgages, regardless of classification, in the United States.

By Brett Sherman
The Sherman Law Firm

 

 

Fake Alex Trebek, Fake Jeopardy!, Very Real financial crisis

Question: HOW BAD WAS THE CONDUCT OF WALL STREET'S FINEST?  

Answer:  Well, read on.  You'll get the idea.

* * *

Today, Wall Street Law Blog examines the scope of fraud and the financial crisis by presenting a simulated episode of our favorite game show (not Card Sharks). The star of our spoof is a hypothetical supercomputer and a fictionalized (though fairly realistic) version of the king of all game show hosts (not Gene Rayburn or Bob Ewbanks - though we have reserved spots for Gene and Bob on the Mount Rushmore of game show hosts).

Rather than drone on with explanations, let's dive right in...   

 

 * * *

 

Announcer:

THIS - IS - JEOPARDY!

(Actually fake Jeopardy!)

 

And now, please welcome your host of fake Jeopardy, fake Alex Trebek-

 

Alex:  

Thank you very much Johnny.  And a warm hello to everyone in our fake studio audience and to all those at home.

Tonight we welcome back our returning champ, Clark, the souless supercomputer that "thinks" like a Wall Street Quant and "speaks"   in a voice that reminds us of a poor man's Stephen Hawking. Rumors are flying that the voice is done by that guy who made all those weird sounds in the Police Academy movies (no, not Steve "Cocoon" Gutenberg). The name of the actor / impressionist is on the tip of our tongues. After the Police Academy franchise was put out to pasture, the guy had a small role in the Mel Brooks classic, Spaceballs! (no, not Rick "Strange Brew" Moranis). 

 

Clark:

Nice to be here,  Al-lex.

 

Alex:

Just a few housekeeping issues before we get started-

Because no human can possibly defeat Clark, and since no other company is wasting its time and money building a robotic game show contestant, we have run out of challengers for Clark.  So, sadly, this will be the final appearance for Clark - the "man of silicon" - on Jeopardy!

And, with only one contestant, we have altered the format of our game tonight.   Legend has it that this evening's edition of the program is the first time since way back when, in '67, when Merv Griffen hosted Donald Fagan, Vanna White, Pat Sajack, Mike Douglas, Dinah Shorr, Sammy Davis and a handful of other FOMs (friends of Merv) for wine, cheese and an impromptu homemade board game in the parlor of Griff's Tuscan villa, that Jeopardy! will be played with just one category.  

Johnny, tell us tonight's sole topic.

 

Johnny:

Right Alex.  Clark, tonight's category is (dramatic pause) - OF MORTGAGE BONDAGE.

 

Alex:  

 Of Mortgage Bondage.  Can't wait to find out what that's all about.  

Clark, are you ready?

 

Clark: 

Charged up Al-lex.   

 

Alex:

 Ah, a little hard drive humor.  Very clever.  Clark, as the only contestent, you get to make the first choice.

 

Clark:

OF MORT-GAGE BOND-DAGE FOR ONE THOU-SAND PLEASE AL-LEX.

 

Alex:

OK.  The answer is:  Guilty, but never prosecuted.

 

Bing!

 

Yes.  Clark.  Go ahead.  And please remember to phrase your response in the form of a question.

 

Clark:

WHAT ARE INVESTMENT BANKS THAT CAUSED THE FINANCIAL CRISIS BY FUNDING AND UNDERWRITING FRAUDULENT HIGH RISK MORTGAGES, POOLING THEM INTO CRAPPY MORTGAGE BONDS, REPACKAGING THOSE MORTGAGE-BACKED SECURITIES INTO CRAPPIER BONDS CALLED CDOs, AND SELLING RHEAMS OF THE TOXIC WASTE THEY CREATED TO BANKS, PENSION FUNDS, AND OTHER INSTITUTIONAL INVESTORS ALL OVER THE WORLD, MARKETING THESE JUNK BONDS AS IF THEY WERE ACTUALLY HIGH QUALITY SECURITIES THAT CARRIED VIRTUALLY NO RISK, ALEX?  

Alex:

Can you be more specific?

 

Clark: 

NO PROBLEM AL-LEX.

WHO ARE OR WERE THE EXECUTIVE OFFICERS AT FORMER AND CURRENT WALL STREET INVESTMENT BANKS LIKE BEAR STEARNS, LEHMAN BROTHERS, MERRILL LYNCH, MORGAN STANLEY, and GOLDMAN SACHS; A SMALL AND ELITE GROUP WHICH - AMONG THEM -  MADE BILLIONS OF DOLLARS EXPLOITING THE GREATEST NATIONAL HOUSING BUBBLE IN AMERICAN HISTORY; A BUBBLE THAT THEY ALL KNEW, OR SHOULD HAVE KNOWN, WAS STRETCHED TO THE BREAKING POINT -- WITH AN UNSUSTAINABLE and FRAUDULENT BUSINESS MODEL THAT WAS BUILT AROUND SECURITIZATION, SALES, AND PROPRIETARY TRADING OF BOGUS MORTGAGE BONDS AND RELATED STRUCTURED INVESTMENT PRODUCTS, ALEX?  

 

Alex:

Oooo.  So very close.  Clark, can you be just a little bit more specific?

 

Clark:

CERTAINLY, AL-LEX.  

...AND WHO ENGAGED IN FRAUDULENT BUSINESS PRACTICES INCLUDING, BUT NOT NEARLY LIMITED TO, OUTRIGHT LIES, INSIDER TRADING AND MARKET MANIPULATION, BY, AMONG OTHER THINGS, BOOSTING SHORT-TERM REVENUES TO ILLUSORY LEVELS AND ARTIFICIALLY PUMPING UP STOCK PRICES IN THE NEAR TERM FOR THOSE COMPANIES THROUGH THE ROOF.

 

Alex:

Almost there-  Just a little more specificity...

 

Clark

...AND JEOPARDIZED AND, IN SOME CASES, DESTROYED, THE  CORPORATIONS THEY MANAGED ON BEHALF OF PUBLIC SHAREHOLDERS, CAUSING MANY OF THOSE SHAREHOLDERS TO SUFFER SUBSTANTIAL FINANCIAL LOSSES WHILE SENIOR MANAGEMENT BANKED ENORMOUS FORTUNES?

 

Alex:

Judges?  No?  Still not specific enough?   Clark, I'm afraid-

 

 

Clark:

...AND ULTIMATELTY CAUSED THE WHEELS OF CREDIT TO GRIND TO A HALT, PLUNGING THE UNITED STATES AND MUCH OF THE WORLD INTO THE MOST SEVERE FINANCIAL CRISIS SINCE THE GREAT DEPRESSION BY CLOGGING BALANCE SHEETS OF THE INVESTMENT BANKS THEY MANAGED, PLUS COUNTLESS OTHER BANKS, INVESTMENT FUNDS, COUNTLESS COMPANIES, AND GOVERNMENT ENTITITES AROUND THE WORLD  WITH ILLIQUID AND WORTHLESS JUNK SECURITIES BACKED BY SUBPRIME AND OTHER NONCONFORMING MORTGAGE LOANS MADE TO BORROWERS WHO COULD NOT AFFORD TO REPAY THEM?

Alex:

Are you feeling ok, Clark?  Is that smoke coming from your mother board?   Would you like to take a break so your IT team can check you out?  Or some water, perhaps?  Maybe an oil can?  

 

Clark:

NO THANK YOU, AL-LEX.

 

Alex:

Ok then.  I'm aftaid our judges are still indicating that they need you to be just a teeny tiny bit more specific...

 * * *

We could go on and on and on, but you probably get the idea.  

By Brett Sherman, Managing Attorney

The Sherman Law Firm

Editor and Publisher: Wall Street Law Blog

 

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. 

 

 

How Wall Street Manipulated the Risk-Reward Tradeoff (updated)

Did The Sheer Complexity of MBS, CDOs, and related "Structured Products" Enable Wall Street to Cheat Investors out of A Reasonable Risk Premium? 

 

 

An impromptu analysis of securities fraud and the mortgage securitization boom that led to the great 21st century Financial Crisis.  

If pressed to identify one factor that made Wall Street's subprime securitization frauds of the last decade so successful (as of this writing, it cannot be credibly argued that these mortgage-based frauds were anything other than an enormous financial success for most of the individuals who ran major investment banks), we would select complexity as that one factor.

In this post, we attempt to explain how we believe the big banks used complexity to disguise risk and con the markets.  

 

Background: Investors bought subprime mortgage bonds for a simple reason. 

For most of the housing bubble era, AAA-rated tranches of nonconforming mortgage bonds (those backed by subprime mortgages and alt-a mortgages) offered investors slightly higher returns than other AAA-rated bonds.

 

Since the risks were ostensibly the same for a mortgage bond carved out of a AAA-rated tranche of an MBS or CDO and other AAA-rated securities, Wall Street knew that most big institutions would choose to buy the higher yielding mortgage bonds.  And this is precisely what happened. 

 

As the housing bubble expanded, investor demand for private label MBS and CDOs seemed insatiable.  Only when market conditions changed enough for the investments to be exposed as the frauds that they always were did investor demand finally disappear.  By that point, however, the personal wealth accumulated by senior management at the major Wall Street banks from securitization and sales of fraudulent mortgage bonds during the 2000s was staggering. 

The housing bubble era was, in sum, a short-term money grab.  Management enriched themselves at the expense of the shareholders they were obligated to serve (not to mention the financial health of most nations on Planet Earth).

 

"Fraud by Complexity": Hiding Risk from Investors.

During the housing bubble era, very bright people designed mind-numbingly complex financial products to conceal risk from investors.

Bear Stearns, Lehman Brothers and the rest of what were the big 5 investment banks (and a group of other powerful financial institutions) knowingly marketed and sold high-risk mortgage bonds to institutional investors all over the world for years as if those risky investments were, instead, extremely safe AAA-quality securities. 

 

Indeed, we believe that complexity is the ultimate x factor that allowed Wall Street to collude with and/or bribe credit rating agencies, which then stamped securitized subprime/Alt-a mortgage bonds with AAA credit ratings.  It was complexity that allowed investment banks and rating agencies to construct formulas and models with bogus inputs and flawed assumptions to "justify" what investors now know were fraudulent credit ratings.

 

It was, of course, the vaunted AAA credit rating that guaranteed a massive market for dodgy (to put it mildly) mortgage bonds for as long as market conditions were such that the true risks of those bonds remained hidden.  When the housing bubble popped and mortgage defaults spiked, firms like Lehman and Bear Stearns kept up the pretense of quality for as long as they could. 

Thus, management at most (though not all) of the big banks squeezed as much personal profit as possible from their fraud factories before mortgage defaults inevitably reached high enough levels, in or around early 2007, to undermine the credibility of previously unquestioned AAA credit ratings. 

When the number of investors who began to doubt the credlt-ratings for mortgage bonds hit a critical mass, the scheme reached a tipping point and the game was up. 

From summer 2007 on, the handwriting was on the wall for the few that, like the big investment banks, were privy to enough information to read it. Soon came the foreseeable, indeed the inevitable, flight to quality that is a core feature of all bond market panics.

 

Flight to Quality

In a flight to quality, investors try to dump everything that is touched by uncertainty and move as much money as possible into investments that they know are safe.  Most often, that means a mass movement of money into Treasuries.  When investors began their flight to quality, demand for mortgage bonds essentially disappeared.  From that point, those on the inside knew, or should have known, that there was no stopping the dominos from toppling.  

 

Concealing Risk; Paying Lower Risk Premiums

Complexity of structured mortgage bonds - from mortgage-backed securities to even more complex CDOs, CDOs-squared, Synthetic CDOs and so on -- was intentionally exploited by Wall Street to hide risk.  By concealing the true risk of these investments, the Bear Stearns and Lehmans of the world manipulated the risk-return tradeoff (from econ 101) so that these financial institutions could profit by paying far less return than is warranted by the risk of these products. 

If a bond issuer uses deception to convince investors to accept a lower risk premium (a lower yield than would be required if the true risks were known to investors), then the issuer fraudulently profits from the difference between the comparitively high risk premium the investment should require and the low yield that is actually paid out.

 

The beauty of this type of scheme, of course, is that -- until the foundation finally caves in -- investors actually believe that they are getting a generous return because the yield is a bit higher than Treasuries and other AAA-rated investments. 

 

The truth, hidden from investors, is that the return on mortgage bonds blessed with bogus AAA-ratings was far too low given the risk of these products.

 

As for those executives who claim they did not understand their own businesses, remember that fraud includes intentional misconduct and wilfull blindness.  

Hiding the true risk of mortgage bonds produced well-documented windfalls for Wall Street's top executives and their lieutenants, even as many of those executives presided over the destruction of the companies they managed on behalf of thousands of public shareholders.  

 

Conclusion: A "AAA-Rating" Does Not (Necessarily) Equal "AAA-Quality"

The fact is that these banks knew the majority of the AAA "private label" mortgage bonds they peddled in the 2000s were high risk, but not high quality.  

 

The banks knew the true risks of subprime MBS and CDOs, but few investors had access to sufficient information to decipher these risks for themselves. 

Instead, investors justifiably relied on the representations of mortgage traders and salespersons and especially on the supposed integrity of credit ratings. Today, we all know what the big banks knew all along -  

AAA is in the eye of the beholder.

 

By Brett Sherman, Wall Street Law Blog

 

Why is Securities Fraud The Crime That Pays?

A Linked-In Discussion

An Ongoing Quest For Answers -

We Invite Readers to Participate By Posting Comments or Joining the Discussion on Linked-In... 

The Issue: 

There are plenty of remedies that regulators and prosecutors could use to go after major Wall Street execs who committed very lucrative securities fraud in recent years. Why so little action?

The Comments:

Louise Harris • I was just talking to another securities lawyer about this on Friday. I think the answer to that question is to be found the aftermath of the blow-ups with Enron, Worldcom, HealthSouth, etc. They were complex cases which were extremely expensive and difficult to prosecute. What did the government get out of those prosecutions? What were the consequences of losing for prosecutors? Were the markets truly stronger as a result or did the fraudsters just move on to other "opportunities"? I think a thoughtful analysis of these events would be very illuminating. Any thoughts?

 

Brett Sherman • I agree completely... Corporate fraud by complexity is a big factor. However, this is a big problem since one could certainly argue that the failure of anything other than window-dressing prosecutions and other cosmetic fixes from the tech-wreck and early 2000s corporate scandals emboldened the kind of over the top fraud that led to the financial crisis. If this is true - and I believe it its - we are on a very slippery slope, don't you think?

Louise Harris • I think so but I get the feeling that there's an element that is willing to prop up the banks at any cost - even if that means turning a blind eye to fraud. You would know better than me having been "in the belly of the beast", but I get the feeling that if your average investor knew what went on at the banks there would be a real ugly crisis of investor confidence. I suppose the banks don't have to worry about that sort of exposure since they have institutional investors over a barrel...

 

Louise Harris • Agreed. The next question is, who can we look to who has the resources to cause reform. There are some truly great public servants at the local and federal level, but they face "heavy winds". I have high hopes for the trial lawyers - what do you think?

 

Laurence Gerowitz • A courageous and provocative discussion; aside from acknowledging the new calculus resulting from multiplying by at least negative two due to the PSLRA, by another minus five for Dura, Tellabs and the erosion of secondary liability, and the successful campaign by the right to demonize the plaintiffs bar . . . we must probably leap completely out of our professional box to a broader societal view. Our culture, at its lowest common denominator, has become one that asks not what is an appropriate behavior, but instead at what level does culpable behavior become risky, riskier and finally reckless. Decades of Charlie Sheen-style "winning" in the corporate arena have not only wet the slope, but washed it without trace into the sea.

 

Brett Sherman • The problem is easy to identify, but would require a social revolution on
par with the civil rights and anti-war movements of the 1960s. The US
Congress - has become a cancer. Both parties - but especially Republicans
focus on posturing for control and power instead of responsible
representative governance. I fear there is little hope - our generation
of Americans matured as we became the richest, most powerful country on
earth. Too many of us are needed to demand systemic change but too few of
us are willing to risk our own privileged place.

Brett Sherman • Oh, and one more thought- I am very disappointed in Obama. He is a
brilliant man. He understands that the top strata of our banking industry
is corrupt. He also understands that he is standing on the only platform in
that there is from which it is possible to focus the world's spotlight on
any issue under the sun. I guess I believed that he had the conviction and
the courage to try to create real change on Wall Street regardless of the
potential consequences for his own career. The President of the US has the
proverbial bully pulpit. Great leaders have guts to use it. We are in the
eye of the financial crisis - the storm is far from over.

WHAT DO YOU THINK? PLEASE COMMENT and JOIN THE DISCUSSION. 

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A reprinted Linked-In Discussion

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Disproving the Big Lie - Securities Fraud at Bear Stearns, Part 2 (encore post)

PART 2 - SECURITIES FRAUD AT BEAR STEARNS - A SPECIAL WALL STREET LAW BLOG SERIES

Only a short post is necessary here - A picture, after all, tells a thousand words. 

According to the "official story" from Bear Stearns top executives -- Jimmy Cayne, Alan Schwartz, Warren Spector, Sam Molinaro -- almost no one (and certainly not Bear Stearns) was able to foresee the extent of the housing bubble and/or the possibility of disastrous consequences...

Well, here is the first page of a report Bear Stearns published in May 2006 (nearly two years before the investment bank failed).  

Draw your own conclusions.

 

Feedback invited...

 

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