Wall Street Law Blog

The Great Mortgage Swindle: Most Lucrative Fraud of All Time?

By Brett Sherman

To be clear, Wall Street Law Blog does not intend the title of this blog post to be sarcastic, ironic, or hyperbolic.

1. Introduction (Summary of The Great Mortgage Swindle - the short, short version)

Financial institutions like Bear Stearns, Lehman Brothers, and Merrill Lynch
(to name a few) deceived sophisticated investors, including countless financial professionals around the world, about the relative risks and rewards of investments in complex structured securities backed by risky subprime and Alt-a mortgages (RMBS, CDOs and related securities).

Big Wall Street banks marketed and sold high risk mortgage bonds as if these securities carried risks comparable to US Treasuries (which are generally accepted as a proxy for riskless investments) and other highly rated bonds. 

 *As always, Wall Street Law Blog defines risk as "chance of financial loss."

Because AAA mortgage bonds higher yields than other AAA rated "low risk" investments, issuer banks knew that investor demand for these securities would be massive.  And, for a long time, as the housing bubble expanded, the banks couldn't produce enough subprime/Alt-a MBS and CDOs to meet this demand.   In a word, investor demand was inexhaustible. 

Another word that works is insatiable. Insatiable demand subsided only after market conditions changed enough to gradually expose bonds backed by subprime and Alt-a bonds as  junk investments.  The disintegration of the market started sometime in mi to late 2006. By mid-2007, the market for these OTC traded securities was DEAD. Governments, companies and individuals lost trillions. The individuals responsible for this disaster were more fortunate. Indeed, personal wealth accumulated by senior management at the major Wall Street banks from bogus securitizations and related profit centers was staggering.

The reality of the housing bubble era is this: It was a short-term money grab by a cartel of powerful banks that generated enormous windfalls for senior management and executives in the mortgage securitization and trading businesses of those banks.

2. Why Don't AAA Credit Ratings Excuse Wall Street Fraud?

Why indeed?  So glad you asked.  

The credit ratings agencies, Moody's, S & P, and Fitch, did in fact give AAA ratings to mortgage bonds.   These agencies are not affiliates of the big Wall Street banks that designed and manufactured the mortgage bonds.  So - the standard Wall Street defense goes -  the investment banks truthfully marketed and sold mortgage backed bonds with credit ratings AAA ratings. 

Turns out, we now know, that the big securitizers knew there was a
significant distinction between the toxic AAA rated securities which the banks pushed like drug dealers and other AAA quality investments. While a majority of mortgage bonds were rated AAA, the bankers that designed, manufactured, and sold them knew that the AAA ratings they received were pure bull!$&@.

Fraud, in the context of securities transactions, is all about misleading
investors about important facts. Material facts are facts a reasonable investor would want to know when making a decision about whether to buy or sell securities. For example, the fact that toxic mortgage bonds received AAA ratings that were pure bull!$&@ is quite material.

3. Not Your Average Scam 

At this point, the Great Mortgage Swindle may very well be the most financially rewarding crime in history.  So, for context and perspective, we draw your attention to the following (the proverbial tip of the iceberg)

Among them, the five top executives at Bear Stearns in the 2000s took home
more than $1.4 billion in cash (cash based compensation plus sales of stock-
based compensation at pumped up prices) between 2000 and 2008.  

For emphasis, we think it is okay to be a bit repetitive here:  

Bear Stearns.
1 RUINED COMPANY.  
5 Top Execs pocketed $1.4 BILLION In CASH during 2000s.   

NOW, PLEASE, AS A PERSONAL FAVOR, GO BACK 10 LINES OR SO AND RE-READ, STARTING WITH "NOT YOUR AVERAGE SCAM."

In other words, during the 2000s, the 5 top dogs at Bear Stearns -
killed the company, a major investment bank that was more than eight decades old, and
banked, on average, nearly $300 million apiece in cash (please spare us any tax-related excuses or adjustments).

Oh, and Bear was no aberration. The "take" was nearly identical for the 5 highest paid execs at Lehman Brothers.  

And then there is former Merrill Lynch CEO Stan O'Neil.  

Here are some of the highlights from O'Neil's reign of terror:  

(a) He took a scalpel to Mother Merrill, cutting thousands and thousands employees from the Merrill Lynch payroll like he was an oncologist attacking a malignancy.

(b) He deployed legions of Six Sigma "black belt" storm troopers throughout Merrill Lynch, turning a company that had long inspired loyalty from its workers into the corporate equivalent of a fascist state.*

(c)  He immunized Merrill's ultra profitable mortgage CDO group from any real scrutiny by qualified risk-managers or compliance professionals.

(d)  He banked a personal fortune that probably makes him wealthier than many royal families. 

And, as a final spit in the collective eye of Merrill's public shareholders and hordes of hard-working folks fired by O'Neil, the disgraced ex-CEO took home an astounding severance package worth more than $150 million, reportedly among the five highest severance payouts of all time when Merrill's board justifiably ordered big Stan to walk the plank. 

When Stan O'Neil took over as CEO Merrill Lynch was one of Wall Street's premier brokerage firms.  He left Merrill scandal ridden and broke. The company was in critical condition when Stan rode off into the sunset, presumably requiring a convoy of armored to haul all the wealth he accumulated while he steered the Thundering Herd to the brink of bankruptcy (ultimately, Bank of America came to the rescue and grossly overpaid to buy Merrill Lynch).

-----
*NOTE -
This post is not "about" Six Sigma, but if you don't know what Six Sigma is, we respectfully refer you to Wikipedia or Google for a tutorial on this evil of the corporate universe.
----

4. Conclusion

Is the Great Mortgage Swindle the most lucrative fraud ever?   Who the hell knows? Perhaps this is a better question- How can we possibly let these folks get away with it?

All of top Wall Street's executives during the 2000s remain free as birds. Very, very rich birds.

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

 

The Mortgage Securities Crash of 1994...

1994 - WHEN MORTGAGE-BACKED SECURITIES TURNED ILLIQUID IN THE BLINK OF AN EYE.   

 

In 1994, the market for mortgage-backed securities crashed.  The ensuing liquidity crisis took down investment advisor David Askin's leveraged mortgage securities fund.  Ultimately, the MBS crisis of 1994 led to massive Wall Street losses and the dismantling of investment bank Kidder Peabody.  

By Brett Sherman

What happened to the lessons of 1994? 

That year, a small and unexpected interest rate hike crippled the mortgage-backed securities market with astonishing speeed.  As was the case in mid-2007, the market for mortgage-backed securities virtually disappeared.  Like 2007, investors holding mortgage bonds lost big, and so did the investment banks that sold them.  

Why do so few of us remember the mortgage securities crisis of 1994?  

Because the MBS market was a fraction of the size it was during the recent housing and credit bubbles. In 1994, most people outside the world of finance had even heard of mortgage-backed securities. But Wall Street knew all about them. In the early 1990's, as in recent years, investment banks booked tremendous profits from the sales of MBS.

How significant could the 1994 crash have been? 

Very significant.  

Before the 1994 crash,mortgage-backed securities /CDOs accounted for roughly one-third of the total US bond market. 

The big three Wall Street producers and sellers of mortgage-backed securities were Kidder Peabody, Bear Stearns, and Lehman brothers. All three firms (as well as many others) took big hits when the MBS market evaporated in 1994. 

Kidder Peabody's mortgage-related losses led to the firm's demise.  Kidder's parent company, GE, shut down the legendary firm and sold off pieces of Kidder Peabody to the highest bidders. 

The crisis also ruined hedge fund manager David Askin. Askin ran a leveraged fund that held mortgage-backed securities. When the mortgage securities market started to collapse, Akin's creditors grew uncomfortable accepting nearly illiquid MBS as collateral for the large loans Askin's MBS fund needed to finance its holdings and stay afloat.   

As the 1994 crisis deepened, buyers for mortgage-backed-securities grew more and more scarce. Askin's creditors issued margin calls.  Lenders demanded more and less risky collateral to secure the loans. Askin could liquidate enough of the fund's holdings to meet these margin calls. 

As Askin's clearing agent, Bear Stearns was one of the fund's creditors that demanded additional and higher quality collateral.  Once it was clear that Askin could not meet creditors' demands, the race to seize assets was on and Askin's MBS fund collapsed.  Reportedly, the first firm to seize assets from Askin's mortgage-backed securities fund was Bear Stearns, then in its second calendar year under CEO James E. "Jimmy" Cayne.

The similarities are striking between the collapse of Askin's leveraged MBS fund and the bankruptcy of two Bear Stearns leveraged MBS funds roughly 13 years later (indeed, the collapses of the Askin and Bear MBS funds were microcosms of the subsequent failure of Bear Stearns itself in 2008).  

Although Bear Stearns and Lehman Brothers were prime players during the 1994 mortgage securities crisis, and had front row seats for the demise of Kidder Peabody, Jimmy Cayne and Dick Fuld apparently blocked out painful memories from 1994.

Why did Wall Street ignore the lessons of 1994?

Maybe it had something to do with immense profits and huge compensation...  Ya think?