BREAKING NEWS:

Questionable Trading Practices May Have Led to Bear Stearns’ Collapse

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 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 about 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 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 led 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 that the firms turn over their research documents regarding 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. Galvin 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 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 wrote, before signaling that he intended to short Bear's stock. No doubt that 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, Galvin re-emerged, 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.

Galvin 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. Galvin also 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.