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

Corruption or what? CDOs, Treasuries and Credit Ratings...

CDOs and Treasury Bonds - Risk, Return, and Credit Ratings? We aren't economists, but something sure seems wrong.

PLEASE - set us straight if we are off base here...   

OK, if two fixed income investments have the same risk profile, they should offer the same return (or something very close to it).  Right?

If so, then are we right to assume that two classes of fixed income investments stamped with the same credit rating should have very similar risk characteristics?  If one investment offers higher returns with no added risk, common sense (and, we presume, the science of economics) dictates that rational investors will choose the higher yielding investment product.  

So far, so good?  If so, then what in the world were the Credit Rating Agencies doing during the housing bubble?   

A huge volume of mortgage-backed securities (MBS) and related investments like collateralized debt obligations (CDO's) received AAA credit-ratings and offered investors yields that, for several years, were superior to AAA U.S. bonds.  To managers of massive pension funds, sovereign wealth funds, and other investors, a AAA credit-rating means there is virtually zero risk of default (we looked that one up). Therefore, the only logical conclusion is that Moody's, S&P, and Fitch told investors that certain mortgage securities were pretty much impregnable, just like obligations of the United States government.  

It seems kind of clear to us that no fund manager would purchase super safe U.S. government bonds when investments in high-rated tranches of MBS and CDO's carried higher yields with no added risk? Predictably, demand for mortgage-related securities skyrocketed.

In nearly every case, investors relied on credit ratings.  Institutions believed the CDOs were safe.  AAA means AAA, and because financial engineers at places like Bear Stearns and Lehman brothers were able to slice and dice the cash flow from all kinds of mortgages in ways that were too complex for practically anyone to truly understand, even sophisticated investors were unable to do any independent risk assessment.  

Again, it is our understanding that the basic risk-reward principle dictates that two or more AAA-rated fixed income investments issued in the same interest rate environment should produce virtually identical returns.  Is there some basic fact or principle that Wall Street Law blog is missing?  And yet...

Vast quantities of AAA-rated mortgage-backed securities and CDOs consistently promised and, until the credit bubble started to leak, actually delivered significantly higher yields than AAA-rated U.S. Treasury bonds (which are, of course, guaranteed by the full faith and credit of the United States Government). 

All of this leads us to one of two conclusions -

EITHER-  

The science of economics and/or the business of credit ratings are farsical-

-OR- 

Wall Streeters like Merrill Lynch, Lehman Brothers and Bear Stearns colluded with the major credit rating agencies to obtain bogus investment grade ratings (at least for AAA tranches) in order to maximize the universe of potential investors for CDOs.  

If we have this stuff way wrong (and maybe we do), we'd sure like to hear what really happened and where our amateur analysis went awry.      

The Sherman Law Firm