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).

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*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.
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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.

Would Bear Stearns sales have exposed "mark to market" fraud?

    Did Bear Stearns maintain a massive mortgage-related securities portfolio to avoid huge write-downs, cover fraud, or even hide insolvency?  

We'd sure like to know.

 

• After the subprime crisis began in 2007, senior managing directors at Bear Stearns reportedly urged the firm's Executive Committee to raise capital by, among other actions, selling off chunks of the firm's massive portfolio of mortgage-related products.

• Mortgage boss Tom Marano consistently fought the idea of any substantial liquidation of Bear's mortgage holdings.  

• The ever-worsening mortgage and credit crises meant that Bear Stearns could sell mortgage-related products for only a fraction of their original values.  However, there came a point in 2007 (at the latest) when Bear Stearns management knew or should have known that the market for mortgage-backed securities and related investments was dead in the water.  The housing and credit bubbles had popped.  The party was over.

• Still, according to the estimated values Bear Stearns was assigning to its mortgage holdings in 2007 and 2008, substantial liquidations from Bear's mortgage portfolio at deep discounts could have yielded billions of dollars for the firm's war chest.    

• SEC records show that Bear Stearns had significant liquidity problems by late summer, 2007.  

• In light of Bear's documented liquidity issues and falling demand / prices for MBS and CDO's, there seems to be no logical reason why Bear Stearns would keep huge amounts of the firm's capital locked inside mortgage securities were (a) consistently losing value, (b) had virtually no chance for any real, sustained recovery, and (c) would be difficult to sell quickly if Bear Stearns needed to raise cash quickly (which, of course, is precisely what happened when Bear was undone by a severe liquidity crisis in March 2008).

• Nevertheless, Tom Marano continued to argue against any substantial reduction in the firm's mortgage holdings.  

• THE QUESTION IS WHY:  Why would Marano fight liquidations of mortgage securities?  Why would CEO Jimmy Cayne allow Bear Stearns to keep the over-concentrated mortgage portfolio largely intact when that portfolio obviously was a huge albatross for the firm?  Why would Cayne's successor as CEO, Alan Schwartz, also side with Marano?  

• POSSIBLE ANSWERS (what follows is speculation. However, if there is a better explanation for Bear's inexplicable refusal to sell off chunks of its mortgage securities book, we sure would like to hear it...)  

• Maybe the reason Bear Stearns kept most of its massive mortgage portfolio after the subprime crisis began in 2007 was that the firm knew it had marked the value of its mortgage securities way too high. 

• Maybe Bear Stearns knew that the real prices the market would pay for mortgage securities were far less than the prices Bear was using to value its portfolio (which accounted for a large portion of the total assets on Bear's balance sheet). 

• Maybe Bear Stearns knew it could not sell its mortgage holdings without exposing the firm's false valuations.  

• Bear Stearns certainly knew "mark to market" accounting rules meant sales of large blocks of mortgage securities on the open market would immediately set new benchmark prices for repricing similar, hard to value securities.  

• If Bear Stearns knew that it was over-stating the value of MBS, CDO's and related products, then Bear also knew that using new benchmark market prices to revalue the balance of the firm's mortgage holdings would reveal that the portfolio was worth far less than Bear Stearns was reporting on its balance sheet.  

• If Bear Stearns knew that the value of mortgage-related assets on the firm's balance sheet was substantially lower than Bear was telling the public, then maybe Tom Marano and Bear Stearns senior management resisted any sizable liquidation of the mortgage portfolio to avoid exposing Bear's unreasonably high marks.

• Maybe it is even true that Bear Stearns senior management knew (or believed / feared) that a large sale of mortgage-related assets, and a subsequent revaluation of the balance of the portfolio using new benchmark prices, would show that Bear Stearns was actually insolvent during the second half of 2007 and early 2008.  

Whether some, all, or none of our conjecture is accurate, Wall Street Law Blog firmly believes that any explanation would cast a bad light on the business practices of Bear Stearns. As always, we welcome your thoughts, information, criticism, and wisdom.

By Brett Sherman, The Sherman Law Firm