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

The Fight Was Fixed - Risk Managers had no chance v. CEO's

By Brett Sherman, The Sherman Law Firm

I know it may be hard to remember at this point, but it wasn't so long ago that the sight of drywall and the sound of hammer striking nail was as common as the ubiquitous "For Sale" signs are today.  The economy was was moving forward so quickly that it was sweating.

During the height of the housing bubble, how many of you forgot the lessons of the technology stock implosion?  As a general rule, we tend to ignore/block out/forget the lessons of past financial traumas whenever the markets are humming and money is flowing. Risk managers are paid to disregard that general rule.

While the rest of us enjoy a bull market, risk managers must be corporate police officers.  A vital part of the risk management function is to guard against a business strategy that capable of crippling a company when the boom market cycle ends (and they always end).

During a boom, risk managers are unpopular.  Hardly anyone wants to hear that a sizzling market will eventually burn out.

The unfortunate reality, however, is that market bubbles have always popped.  Not only do economic boom cycles fizzle sooner or later (often abrubtly), but it is nearly always impossible to predict why or when the end will come. The unfortunate truth is that, no matter how strong a bull market may seem, we can never know for sure that disaster isn't lurking around the bend.

The future is now and always will be a mystery. Therefore, corporate risk managers must manage risk by devising strategies to mitigate potential negative consequences in the event of a market downturn.

Consider the last market bubble, the tech-wreck.  Remember how many people were convinced that we were in a new age of prosperity, a "new economy" in which the old rules of Wall Street no longer applied?

Remember all the "paper millionaires"? Remember Dow 36,000?  Remember how it all ended?  Of course you do.  And so do Wall Street CEO's (and former Wall Street CEO's) and risk managers.

The tech-wreck is a textbook example of a market bubble.  On its heels (thanks to the Fed's loose monetary policy) came the housing and mortgage boom.  Subprime-based mortgage- backed securities were the perfect investment to sell to unwitting investors.  So don't believe Wall Street investment banks when they tell you that they didn't think the housing boom would eventually end like the tech-wreck and so many other market bubbles.

Wall Street firms reported record profits during the housing boom.  High annual profits meant high annual incentive-based compensation for senior Wall Street executives.  Therefore, the risk management function (protecting investment banks from the risks of business models that could lead to the kind of corporate implosions that will forever mark 2008) was at odds with the interests of senior Wall Street executives, who made more money by maximizing short-term returns.  Guess who won that battle?

As someone once said, the brightest stars burn out the fastest.  With effective risk management, Wall Street profits may not have reached the stratosphere during the housing boom. Then again, former investment banks like Bear Stearns and Lehman Brothers still may still have been profitable and lived to make more money another day.

In this day of ultra-sophisticated engineered securities, risk management is vital to the long-term success of any financial institution. Maybe corporate managers will realize that one day soon.

WALL STREET LAW BLOG WELCOMES YOUR COMMENTS.

 

Investment Banks in Moving Business? Not quite.

Securities fraud, 10b-5: 

Material Misrepresentation, 

a textbook example.

• WALL STREET BANKERS SAID THEIR COMPANIES WERE IN 'THE MOVING BUSINESS, NOT THE STORAGE BUSINESS.'  NOT QUITE.

Translation?  For so many years, investment banks thrived by transferring risky assets off their balance sheets as fast as they could.  During the housing and credit bubbles, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and others entered the storage business in a big way.  Then, one by one, the investment banks died.

--------

• Intermediary Role Abandoned

For the majority of its successful run, the Wall Street investment banking model was based on a simple rule. Investment banks were NOT investors. They were intermediaries. They brought sellers and buyers together. This means that investment banks did not hold risky securities on their balance sheets any longer than was absolutely necessary. In "Wall Street-speak," i-banks liked to say they were in the moving business, NOT the storage business. 

During the credit / housing bubble, most of the former investment banks got into the storage business in a big way. They drank their own cool aide, buying high risk mortgage-backed securities, cdos, and related instruments for their own proprietary trading accounts. The investment banks stopped acting as intermediaries, and started acting as buyers and sellers. This was one of two major reasons why Bear Stearns, to cite one example, wound up with a balance sheet clogged with illiquid toxic waste. 

The other reason Bear Stearns ended up with a huge volume of mortgage-backed securities and related products was greed. Bear Stearns was so determined to milk every penny of profit from the bubble that it built up a massive inventory of mortgages to feed into its securitization machine. When the market froze, Bear Stearns was stuck with tons of loans. Bear Stearns also had a huge portfolio of mortgages it securitized but could not sell before demand for mortgage-backed securities completely disappeared. In short, Bear Stearns was left holding the bag. 

The principle of risk transference required the former investment banks to get rid of virtually all securities (except securities that are considered "cash equivalents") as rapidly as possible. Once the investment banks got rid of the mortgage-backed securities they produced - and collected fat fees - they no longer had to worry about default. The risk of default would be fully transferred to investors. On Wall Street, this is how it was supposed to work. At some point, the enormous fees from acting as an intermediary were insufficient to satisfy Wall Street executives. If Wall Street had stayed in the moving business, the meltdown of the investment banks would have been far less severe. Instead, investment banks violated their cardinal rule. They got into the storage business in a big way, and we all are paying the price.

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

On Housing, Highly Leveraged Assets, and Interest Rate Changes (Greatest Hits Volume 2)

A brief bit of common sense.

Warning. We are not about to offer any earth shattering insights in this short post.  However, when the world of finance reaches levels of complexity and duplicity capable of causing the most significant financial crisis since the Depression, simplicity and common sense are often relegated to the far back burner. So, we decided to pour ourselves a bowl of simple facts about housing.

Specifically:

The housing market is hyper-sensitive to interest rate changes.

For a substantial majority of homeowners, houses are their most leveraged assets.  In other words, most people actually own very little of their houses.  For the most part, the bank or investor that owns our mortgage also owns most of our home.

Interest rate changes so significantly impact housing because interest rate level often determines what type of home a family can afford.  Falling rates lead to refinancings and even downward resets of adjustable rate mortgages.  Most significantly, there is higher demand for homes and, eventually, higher prices.  When credit is cheap and easy to get, homes are more affordable (at least in the short run).  Thus, low interest rates generally equals more homeowners and, by the way, low rates of default and foreclosure.

When rates go up, however, refinancings plummet, home sales (and, eventually, prices) decline because the higher cost of borrowing lowers buyer demand.  Adjustable rate mortgages reset upward.  The segment of the home-owning public that chose adjustable rate mortgages to stretch for houses that may have been unaffordable with traditional fixed rate mortgages can find themselves unable to make their new, higher monthly mortgage payments.  Thus, when interest rates increase, defaults and foreclosures follow suit.

As we said, nothing new here.  All common sense.  Which begs the question - who in their right minds would base an entire industry (subprime lending and, by extension, mortgage backed securities) on the premise that there would not be high default rates on ultra-low interest adjustable rate mortgages to people with poor credit histories succeed after the cycle turned and interest rates climbed back toward historical averages (i.e., when rates started to trend toward the mean)?  Who would make this bet?  Was anyone be surprised that bad credit borrowers would default in droves once their low initial monthly payments increased by hundreds of dollars a month?

These are not hard questions now, and they weren't hard questions in 2002 or 2003 or 2004, 05, 06, or 07 either. Wall Streetdrove the subprime lending explosion. Wall Street understood interest rate cycles. Wall Street knew rates would rise.  Wall Street knew defaults and foreclosures would spike. Wall Street didn't care - the money was rolling in.  The fact that Wall Street itself got so badly burned was the product of greed and knowingly reckless risk-taking.

By Brett Sherman, The Sherman Law Firm.

Smoking Gun? Mortgage Meltdown Predicted by Bear Stearns in 2005-06.

Updated 9/14/09

THE INTERVIEW THAT FOLLOWS IS SCRIPTED (part of our forthcoming screenplay, or not). NEVERTHELESS, THE UNDERLYING FACTS AND CONCLUSIONS ARE 100% GENUINE. 

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"[H]ousing activity is only just beginning to cool, and... there is no end in sight for a year or two."

-Francois Trahan (Former) Chief Investment Strategist, Bear Stearns

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Q:  OK, I can't stand the suspense.  So who sounded alarm bells about the end of the housing bubble, credit bubble, the world economy and so on?

A:  What if I told you it was Francois Trahan, Kurt D. Walters, Caroline S. Portney.

Q:  I'd ask you who those people are. [Pauses, gets no response, continues...]  OK, Who are Trahan, Walters, and Portney?

A:  Senior Wall Street Research Analysts.  In fact, Trahan, at the time, was a highly regarded Chief Investment Strategist for a major investment bank.

Q:  [Yawn].  You've told us about your "smoking gun" research reports before.  Deutche Bank.  HSBC.  Even Merill Lynch. 

A: Ah, but this time is different.  This time I've seen the evidence.

Q: OK, ok - enlighten us.

A: BEAR STEARNS.

Q:  Come Again?    

A:  Bear Stearns.  In a September 13, 2006 issue of the Bear Stearns "Investment Strategy" research report called -

"RAMIFICATIONS OF A U.S. HOUSING SLOWDOWN FOR EQUITIES," 

Chief Strategist Trahan and his colleagues emphasized that they had identified a housing bubble in 2005.  That report was called "REIT ALL ABOUT IT."  

Trahan described the growth of the housing bubble in detail, and concluded with conviction that the bubble was deflating.  Finally, Trahan and company predicted possible dire consequences for the global economy.

Q:  And this is important, why?

A:  Because these are BEAR STEARNS RESEARCH REPORTS.  Because they are from 2005 and 2006, when Bear continued to report record profits from selling junk mortgage-backed securities while its own senior people were (no pun intended) very bearish on the housing and mortgage markets.  The 2006 report says, among many other things-

"[H]ousing activity is only just beginning to cool, and... there is no end in sight for a year or two."

That's on page 6, by the way. The report also warns that

(a) rising interest rates have long been an indicator of a coming down-cycle for housing, and 

(b) the expected deflation of the housing bubble would drag down the mortgage market, restrict liquidity, and have serious negative impact on the U.S. economy and the global economy. 

THE BEAR RESEARCH REPORTS ARE FLASHING NEON LIGHTS.  THEY SIGNAL THAT BEAR KNEW IT WAS APPROACHING THE END OF THE LINE FOR ITS MORTGAGE-DRIVEN BUSINESSES. I REPEAT, THE REPORTS PROVE THAT FAILURE OF BEAR'S BUSINESS MODEL WAS FORESEEN BY BEAR STEARNS. 

Q:  OK, I get it.  But aren't the opinions of a few Bear employees just that?  You don't expect the CEO to read every research report, do you?

A:  Not sure.  Maybe.  Maybe not.  But I certainly believe that the senior officers and the Board of Bear Stearns had the obligation to, at the very least, be familiar with the opinions of Bear's Chief Equities Investment Strategist regarding current state of the world economy, and the Chief Strategist's views about the immediate future.  

Q:  That sounds good.  You have me 95% convinced.  But you're missing the one thing that would lock it up for me.

A:  Really?  What's that?

Q:  If you could only show me on the report some sort of adoption and approval by Bear Stearns itself, that would do it.  I mean, that would tell me that the report is the opinion of Bear Stearns and not just Francois Trahan and his team.  You know what I mean?

A:  Sure. I understand.  

The best I can do is here, on page 14, where the report states that it "has been adopted and approved for distribution within the United States by Bear, Stearns & Co. Inc. for its and its affiliates customers."

 ***

By Brett Sherman 

FOR A COPY OF "RAMIFICATIONS OF A US HOUSING SLOWDOWN...", CLICK HERE AND LEAVE YOUR NAME AND A FAX Number OR EMAIL Address, or call The Sherman Law Firm.