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

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