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

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.

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• 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.