Questionable Trading Practices May Have Led to Bear Stearns’ Collapse
Last March, Scott Coren and Michael Nannizzi, analysts at Bear Stearns, issued a report upgrading the stock of New
Century Financial, a company that provides sub-prime mortgages to low-income homebuyers, from "underperform" to
"peer-perform."
California-based New Century's stock rallied on Coren and Nannizzi's research note to investors, rising 3% in afternoon
trading on Thursday March 1, 2007, to close at $15.78.
In April 2007, a month after the analysts issued their somewhat upbeat report, New Century filed for bankruptcy
protection due in large part to the massive number of borrowers who were defaulting on their loans.
The move by Coren and Nannizzi, as well as an analyst at UBS who, in February 2007, also upgraded the mortgage company's
stock, to lead investors into believing that New Century was undervalued and on solid footing underscores how little
Wall Street has learned since Enron imploded in a wave of accounting scandals in 2001.
The historic, unprecedented federal bailout of Bear Stearns over the weekend came as the company engaged in questionable
trading practices and allegations that it failed to inform investors the true financial condition of its subprime
investment business.
Bear’s collapse represents the failure of federal regulators to enact reforms in the $6.5 trillion mortgage securities
market, an industry far bigger than the United States treasury market.
“The regulators are trying to figure out how to work around it, but the Hill is going to be in for one big surprise,”
said Josh Rosner, a managing director at Graham-Fisher & Company, an independent investment research firm in New York, and an expert on mortgage securities, in an interview http://www.nytimes.com/2007/03/11/business/11mortgage.html?_r=1=login with The New York Times in November. “This is far more dramatic than what led to Sarbanes-Oxley,” he added, referring
to the legislation that followed the WorldCom and Enron scandals, “both in conflicts and in terms of absolute economic
impact.”
Federal regulators have been slow to act, despite the obvious warning signs (an increase in foreclosures and loan
defaults), because the housing market drove the economy over the past five years and Bear Stearns led the pack as one of
Wall Street's top underwriters of mortgage backed securities. That meant that Bear's financial stability was tied
directly to the repayment of loans at the mortgage firms it was underwriting.
Indeed, what Coren and Nannizzi's research note on New Century didn't say was that Bear Stearns was one of the Wall
Street banks that financed New Century's mortgage operation. Their positive report on the company seemed to be about
protecting Bear's investment and the bank's bottom line than it was about providing investors with sound financial
advice.
As with Enron and WorldCom, sell-side firms such as Bear Stearns issued biased stock recommendations during the housing
boom in the hopes that they would win investment-banking business. And when the bubble burst the banks continued to
reassure investors until dozens of mortgage companies such as New Century closed their doors or ceased making loans
available, which lead to a massive sell-off of banking stocks.
William Galvin, Massachusetts' secretary of the commonwealth, subpoenaed Bear Stearns and UBS just two weeks after Coren
and Nannizzi issued their report on New Century in March 2007, demanding the firms turn over their research documents
into New Century. Galvin alleged that Bear and UBS violated a 2003 global research settlement following the Nasdaq crash
of 2000 in which Wall Street firms paid hefty fines and promised to keep their sell-side away from the investment
banking side after regulators accused analysts of writing biased research reports in order to win lucrative investment
deals from the companies the analysts covered.
"Recent revelations that research analysts issued positive reports on mortgage lenders...even as those companies faced
more and more defaults suggests that the commitment of 2003 has not been met," Galvin said in a prepared statement at
the time. Glavin had worked closely with then New York Attorney General Eliot Spitzer on the settlement. Spitzer
resigned as governor of New York last week after he was alleged to have been a customer of an escort service.
Still, at least one savvy trader saw through Coren and Nannizzi's overly optimistic report on New Century and acted
accordingly. Last March, the trader commented on a popular financial message board http://seekingalpha.com/article/29385-the-bear-stearns-new-connection-time-to-short-select-investment-firms last year that Bear Stearns was "trying to cover its own behind with that upgrade."
"The question on everyone's mind should be, "How much are they on the hook for?" the commenter asked, before signaling
that he intended to short Bear's stock. No doubt that the savvy trader is a very rich person today. Bear was sold to
JPMorgan Chase for $2 a share last weekend in a deal brokered by the Bush administration.
In November, Glavin reemerged accusing Bear Stearns of an inherent conflict-of-interest when it engaged in trading with
two hedge funds the firm managed that specialized in mortgage securities that suffered $1.6 billion in losses and
eventually filed for bankruptcy.
Glavin filed a civil complaint against the bank saying it violated securities laws and its own internal regulations by
failing to inform the hedge funds' independent directors that it had traded mortgage securities from its own accounts
with hedge funds that it also advised. Glavin claims Bear Stearns violated the US Investment Advisers Act of 1940, which
bars such transactions unless hedge fund clients receive prior notification in writing about self-dealing and agree to
the transaction. That case is still pending.
“This begins to explain how the subprime genie got out of the bottle,” Galvin told the Associated Press in an interview.
The meltdown in the mortgage industry “happened in part because there was a seemingly limitless amount of capital put in
the hands of people who had conflicts of interest that weren't disclosed,” he said.
The hedge funds--Cayman Islands-based Bear Stearns' High Grade Structured Credit Strategies Fund and the Enhanced
Leverage Fund – bet wrongly on securities that were backed by subprime loans for home buyers with poor credit ratings.
When homeowners defaulted, losses at the hedge funds mounted. Bear Stearns then informed its investors that their
investments were worthless
In December, investors filed a new round of legal claims against Bear Stearns claiming the bank mismanaged the hedge
funds and concealed the condition of the funds until it was too late.
"Officials at Bear Stearns engaged in a concerted effort to conceal the true state of affairs at both of these hedge
funds for an extended period of time before they imploded," attorney Steve Caruso of Maddox, Hargett & Caruso in New York, one of four firms representing plaintiffs, said in December.
Another plaintiffs' attorney, Ryan Bakhtiari of Beverly Hills, said Bear Stearns used the hedge funds "as a dumping
ground."
"Given Bear Stearns' dominance in the mortgage-backed securities underwriting market, they knew or should have known how
much subprime exposure both of these hedge funds faced," Bakhitari said in December. "We're finding, in our
investigation of these funds, that many investors in these funds simply were unaware of what was being held in their
portfolios because it was not adequately disclosed."
On Monday, a lawsuit was filed against Bear Stearns on behalf of investors alleging the company issued materially false
and misleading statements regarding its financial condition
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Jason Leopold is the author of the National Bestseller, "News Junkie," a memoir. Visit www.newsjunkiebook.com for a
preview. He is also a two-time winner of the Project Censored award, most recently, in 2007, for an investigative story
related to Halliburton's work in Iran. He was recently named the recipient of the Military Religious Freedom
Foundation’s Thomas Jefferson Award for a series of stories he wrote that exposed how soldiers in Iraq and Afghanistan
have been pressured to accept fundamentalist Christianity. Leopold is working on a new nonprofit online publication,
expected to launch soon.