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

Bear Stearns: Fact or Fiction?

Welcome to the first edition of:

Bear Stearns / Not Bear Stearns, The Wall Street Law Blog Securities Fraud Quiz.

The format is simple - In each edition of The Quiz, we list 5 real "Bear" quotes and five "Not Bear" quotes. Your mission is to figure out which are which.

Good luck. May the Schwartz be with you.

1) "This was no boating accident."

2) "At Bear Stearns, we know we cannot predict the future, but mitigating the risks ahead this part of the foundation upon which this firm was built...."

3) "We know that markets can change quickly or evolve exceedingly slow. That cyclicality and our goal to remain profitable led us to create a balanced portfolio of businesses that helps us turn market challenges to our advantage."

4) "Wait'll Otis sees us; he loves us!"

5) "We continue to avoid short term trends by staying focused on the long term strengths of our businesses."

6) "Do you believe in miracles? Yes!"

7) "The philosophy of creating value over the long term also drives our approach to product innovation and entering new businesses... This philosophy is evident in the disciplined approach we take to managing the firm's risk..."

8) "We're big boys. We knew what we were doing."

9) "Mooooon River- You using the whole fist doc?"

10) "Ace, I am your father."

Tie breaker: What was the name of Richie Cunningham's brother on Happy Days?

Feel free to submit comments with your guesses. We are considering the possibility of offering cash and prizes...

By Brett Sherman
The Sherman Law Firm

www.ShermanLawyers.net

The confession of Bear Stearns CEO Jimmy Cayne... (greatest hits)

Updated 
 

By Brett Sherman, The Sherman Law Firm

In July 2007, Bear Stearns CEO Jimmy Cayne wrote to Bear Stearns hedge fund investors.  Cayne's mission that day was critically important, and he knew it.  In the wake of the shocking failure of two leveraged Bear Stearns hedge funds with heavy ties to the subprime mortgage market, the CEO needed to convey his confidence in the future of his company. Cayne cooly reassured hedge fund investors that Bear's conservative tradition, strong risk management culture, and plan to pare its mortgage backed securities portfolio would assure Bear Stearns a speedy and full recovery from the summer's disastrous fund collapses.   

A year later, Cayne sang a completely different tune in an interview with Fortune.  Fortune Magazine, "The Rise and Fall of Jimmy Cayne," August 2008.  The ex-CEO of Bear Stearns revealed that the strength he projected in the summer of 2007 was in fact false strength. 

According to Fortune,

Cayne "did not know how to deal with the devaluation of the firm's mortgage-backed securities and other illiquid assets. Nor did he know what to do ... when two hedge funds that contained those same toxic assets collapsed and further poisoned the company's balance sheet."  

But wait, there's more!

Bear's all-powerful dictator admitted he was paralyzed by the crisis that his firm helped ignite in mid-2007.  Cayne had absolutely no idea how to cope with the company's financial troubles. 

"It was not knowing what to do. It's not being able to make a definitive decision one way or the other, because I just couldn't tell you what was going to happen."  

Cayne even indicted himself regarding Bear Stearns' debt-laden balance sheet.  

"I didn't stop it. I didn't reign in the leverage..." 

said Jimmy Cayne.  So there you have it.  Cayne understood that Bear was super-leveraged and blamed himself for doing nothing about it.   

 

While Cayne's numerous admissions to Fortune may sound like a deathbed confession, the former Bear Stearns CEO somehow still tries to convince us that Bear Stearns was done-in by a conspiracy of short-selling, rumor spreading hedge fund managers.  

Perhaps the long-time CEO cannot face the fact that he was a primary contributor to the destruction of a company that, by all accounts, he loved to run.  In any event, conspiracy theories about the end of Bear Stearns have been raised time and time again since March 2008.  These theories have consistently wilted under even modest scrutiny. 

 

Wall Street Law Blog has attacked many of Bear conspiracy theories in prior posts. Fortune discredits Cayne's delusions with simple common sense -

 

"What Cayne's conspiracy theory overlooks is the fragility of Bear's balance sheet. Regardless of whether hedge funds and short-sellers exploited the firm's weakness, it was Cayne and his colleagues who made the firm financially vulnerable. They sealed the firm's fate by choosing to finance the vast majority of the firm's daily needs - about $50 billion a day - in the overnight repurchase agreement(or "repo") market, using some 71% of its mortgage book as the collateral." 

 

"Bear's reliance on overnight repo effectively gave the overnight lenders - such as Fidelity and Federated Investors - a vote on the firm's viability every night. And during that fateful week in mid-March, those overnight lenders voted a collective no."  Id. Emphasis added.

 

*****

 

Breakingviews.com made this insightful comment about the Fortune Article:

"Cayne’s admission that he didn’t know what to do, even last summer, is extraordinary. If that was the case, [Cayne] should have handed the reins to someone else with more ideas – or been forced to do so by Bear's board. But no-one seems to have challenged his leadership until too late."  

 

The consensus around the Wall Street Law Blog water cooler is that the Fortune article is remarkable.  

Jimmy Cayne -  still the all-powerful Oz at Bear Stearns for all of 2007 - admitted he was a deer in the headlights when he conducted damage control following the unprecedented collapse of Bear's subprime hedge funds. Clearly, Cayne misled the public by writing letters, issuing press releases, and participating in conference calls designed to sure up shaken confidence in Bear Stearns. 

Cayne conceded he had no clue how to right the ship at Bear Stearns. Therefore, his false words of reassurance about Bear's future are fraud.

 

The CEO was not doing a thing to fix the numerous problems at Bear Stearns following the collapse of the subprime hedge funds (nor, apparently, was anyone else).  Jimmy Cayne did not even bother to address the only real issue - how to restore Bear's health for the long-term. Cayne, in his own words, "didn't reign in the leverage."  He could have. 

 

Bear's 2007 fund disaster demonstrated in bright neon lights the extreme danger of over-reliance on leverage.  By not taking affirmative steps to reduce leverage throughout the company, and by continuing to rely on short-term financing for the bulk of Bear Stearns operating costs, Cayne and the rest of Bear Stearns senior management (including soon to be CEO Alan Schwartz) were continuing a pattern characterized by a laser-sharp focus on short-term profitability, overconcentration of mortgage-backed-securities (MBS) in Bear's own portfolio, dangerous reliance on overnight repo financing to fund daily operating costs, a desperate need for a cash infusion, a total disregard for risk management, and a lack of concern for Bear Stearns shareholders or the long-term welfare of the Company.  

 

 

Banking is a Confidence Game. (updated)

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THE UNIQUE VULNERABILITY OF FINANCIAL INSTITUTIONS TO THE DREADED CONFIDENCE CRISIS

More than any other type of business, financial institutions are vulnerable to crises of confidence.  The demise of former powerhouse investment bank Bear Stearns is an ideal example.  

First, the financial world lost confidence in Bear's assets, which impaired its access to short-term credit.  Then the market lost confidence in Bear Stearns itself.   Hedge funds raced to pull their assets out of prime broker accounts at Bear.  The cycle repeated itself until Bear's failure was a foregone conclusion

Bear's mortgage assets were an albatross;  liquidity of the oversized portfolio dropped like a lead weight in water.  

Bear Stearns had a substantial prime brokerage unit. In simple terms, this means that other financial institutions - primarily hedge funds -  used Bear Stearns like you and I would use our local bank. Bear was custodian of billions of dollars for these prime brokerage clients. And it was these customers that drove the much talked about "run on the bank" that ate up Bear's insufficient liquidity and forced it into the arms of JP Morgan.

To paraphrase the Corleone men, 'it isn't personal, its only business.'  The "run" on Bear Stearns (i.e., hedge funds and other prime brokerage clients pulling their assets out of Bear the week of March 10, 2008) was not only justified, but fund managers would have been incredibly stupid / grossly negligent to leave assets with an investment bank that conceivably could end up filing for bankruptcy.  

There was no way  customers of Bear Stearns could afford to gamble millions and millions of dollars on the possibility that Bear would solve its nearly insurmountable problems and live happily ever after. 

When the market has no more confidence in your bank, the only prudent thing to do, the only smart thing to do, the only thing that makes any sense at all, is to get your cash out of Dodge. Why?  For this reason: When doubts arise about the viability of a major financial institution like Bear Stearns, you can bet that there are serious underlying problems at the heart of the matter.  

Therefore, any financial institution that suffers a crises of confidence must act swiftly and decisively to restore the market's faith and trust.  Failure to do so can mean a death sentence.

Excuses (difficult market conditions, evil short sellers) and denials (we don't need to raise cash, our balance sheet is strong, there is no pressure on our liquidity) only exacerbate a crisis of confidence.  That is exactly what happened to Bear Stearns.  The executive officers and directors of the fallen investment bank know very well that they can only blame themselves for the demise of Bear Stearns.

There is no question that the crisis of confidence suffered by Bear Stearns was the product of self-inflicted wounds.  

For starters, the company had a distinctly undiverse business structure. Bear Stearns was far too dependent on its fixed income businesses, and the firm lacked business units capable of replacing mortgage revenues after the market for mortgage-backed securities (MBS) collapsed. 

Lacking reliable replacement streams of revenue was bad enough, but Bear Stearns had also overloaded its own portfolio with, you guessed it, MBS. Bear Stearns drank its own cool-aide, and creditors eventually decided that illiquid (and therefore worthless) MBS were not acceptable collateral. 

To complete the trifecta, Bear Stearns buried itself beneath a mountain of debt. Bear was the most leveraged firm on Wall Street, at close to 35:1.  In other words, the firm borrowed almost all the money it used to fund its investment activities. Bear Stearns also depended on borrowing more than $50 billion each day in the overnight repo market just to have enough money to cover daily operating expenses. 

Bear Stearns was a mess and the markets knew it.  Instead of fixing the mess, or even owning up to it, management pretended everything was going to be fine.  Bear's strong culture of risk management would see it through some rough times.  In October 2007, Bear publicly declared that its businesses were recovering. Bear's reassurance was one of many lies senior executives foisted on the public.  Apparently, Bear hoped to stall long enough for market conditions to miraculously reverse and save the firm. 

For many months, Bear Stearns navigated dangerous, icy waters.  In March 2008, the firm slammed into an iceberg.  It took only a few days for the firm to go under. 

Jamie Dimon coined the term "fortress balance sheet."   By fortress balance sheet, Dimon, the CEO of JP Morgan, means financial institutions must have sufficient liquid capital to survive any shock to their balance sheets. 

Bear Stearns ignored this golden rule, and the firm paid the ultimate price.      

Investment Losses? Learn how to opt out of class action.

Update of report originally published in or around May of 2008 (data is current to that time period).

SECURITITES FRAUD CLASS ACTIONS

Why Aggrieved Shareholders Should Strongly Consider Opting Out of Securities Fraud Class Action Lawsuits...

 

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Based on available data, state and federal statutes, and a well developed body of case law, The Sherman Law Firm recommends that current and former aggrieved shareholders of Wall Street financial institutions (i.e., Bear Stearns, Merrill Lynch, Bank of America, Citi, Lehman Brothers, Goldman Sachs) and other large corporations strongly consider "opting out" of any securities fraud class action litigation. 

************

On average, investors stand to recover a far higher percentage of their losses by opting out of a securities fraud class action rather than participating as a class member plaintiff.

 

***

A.  Class Action Overview      

A class action is a special type of lawsuit in which a group of plaintiffs that share substantially similar legal claims against one or more defendants band together in a single lawsuit.

 

Class actions lawsuits are classified as “representative actions” because one or more plaintiffs are actually named in the complaint as representative(s) of the entire class of aggrieved individuals and/or entities (in this instance a class might consist of one or more categories of former Bank of America shareholders). 

Investors must keep in mind that securities fraud class actions are frequently dismissed for failing to meet the strict pleading requirements of the Private Securities Litigation Act of 1995.

Most class action claims that survive dismissal motions settle. The end result, however, is that there often is not much money distributed to individual class members. In a 2006 article, Lawsuitssearch.com stated:

“Often being part of a class action lawsuit is not financially advantageous to an individual. Even though the defendant named in the case may be required to pay out a large sum of money, one individual who is part of the class action will only receive a small portion of that sum.” 

A study published by NERA Economic Consulting (NERA) supported the statements of Lawsuitsearch.com. NERA reported that the average settlement recovery in securities class actions in 2006 was only 2.2% of investor losses. 

B.  “Opt out” Cases: An Overview                                                                    

Opt out cases receive have received little attention from the press to-date.   For this reason, it is not surprising that many Bear Stearns employees are unaware of the right to opt out of any class action litigation. 

By opting out, shareholders elect not to be part of a class, not to be bound by rulings that affect the class, and not to be forced to accept any class action settlement.

Investors / shareholders that choose to opt out of securities fraud class action lawsuits generally hire their own lawyers and file their own independent claims against in an individual litigation. 

Research reveals very clearly that opt out plaintiffs can and often do fare much better than the 2.2 percent average securities class action settlement in 2006. 

A prominent opt out success story is the recent AOL Time Warner Class Action. In April 2007, Oakbridge Insurance Services wrote in its “Insights” report that AOL Time Warner opt-out plaintiffs reported recoveries that were between 6.5 and 50 times higher than amounts  plaintiffs received in the AOL class action settlement. Other sources indicated that the average AOL Time Warner opt-out investor recovered 20 times more than the average class action investor. 

It is too early to tell whether the huge advantage for AOL Time Warner opt out plaintiffs will prove to be high or typical. Still, Oakbridge noted that, as a whole, the “the elevated percentage of investment loss recoveries in the opt-out cases” is a concern to class action defendants and to D&O insurers. 

C.  Conclusion

 

Information in report is intended to illustrate the potential relative merits of class action litigation and opt out litigation for securities fraud plaintiffs. Based on statistical evidence from NERA and the outcomes of prominent securities class actions, our conclusion is that shareholders with substantial losses have a strong chance to recover a higher percentage of losses in individual opt out cases.

 

 

*All aggrieved investors should seek professional advice prior to selecting any course of action

Disclaimer

 

Because the report is largely statistically based, it does not take into account individual circumstances such as quality of counsel, and facts which may be unique to any institution or individual.

This report is solely for informational purposes. It is not legal advice.

Brett D. Sherman, Esq.

Managing Attorney

The Sherman Law Firm

Email:

Info@shermanlawyers.net

 web:  

www.shermanlawyers.net

blog:  

 The Wall Street Law Blog

Phone: 201-723-9470

Fax: 646-395-1438