Snakes and Laddering: The Bear Stearns Debacle

Search form

Snakes and Laddering: The Bear Stearns Debacle

Snakes and Laddering: The Bear Stearns Debacle
Tue, 10/30/2012 - by Andrew Smith

You wonder what President Obama was expecting when he set up the Residential Mortgage-Backed Securities Working Group in January under the chairmanship of New York Attorney General Eric Schneiderman. If headlines accompanying the group’s first announcement last month told the whole story, the president would have been pleased.

Schneiderman accused Bear Stearns, the ailing merchant bank which was eventually bought by JP Morgan, of "fraudulent and deceptive acts" in its packaging of sub-prime mortgages into securities. The bank failed to carry out due diligence and knowingly sold bad investments, the AG said.

More heinous still, sellers of mortgages to Bear Stearns were obliged to pay a penalty on any loans that later failed – but rather than pass these funds on to investors, Bear pocketed the cash and left the failed mortgages in the pot. Warned by their own lawyers and accountants that this would be wrong, they did it anyway.

Schneiderman hasn’t put a figure on the damages he hopes to wring from JP Morgan, but has claimed that such behavior cost investors $22.5 billion in 2006-7. He also hints at charges to come, promising that "we’re looking at tens of billions of dollars [of fraud], not just by one institution, but by quite a few." No wonder the most common first response to the Schneiderman charges was "Hurrah! It’s payback time!"

Until gradually we noticed a mystifying thread of smallprint.

First, Schneiderman made no mention of criminal charges and named no individuals: banks would be dealt with as faceless bureaucracies in which no one bore responsibility for particular decisions, and as a result no one would go to jail. Second, charges were brought under a New York statute called the Martin Act, which allows conviction for fraud without a need to prove intent. This despite the fact that Schneiderman’s evidence, if valid, appears to show clear intent.

If traders were using phrases like "sack of shit" to describe their own securitizations, why fear the concept of "intent"? And why is no one on Wall Street sweating a stretch behind bars?

Quoted in the European edition of the Wall Street Journal, no less, the former regulator William Black called Schneiderman’s approach "a continuation of the failure of leading prosecutors to bring a criminal case against any of the elite players." Even Bloomberg News noted ruefully that "You can’t have fraud without fraudsters.’"

So what happens next is going to be fascinating – and this is something we should all watch closely, because a pattern is appearing.

Four years ago, I started work on a book about the eccentric New York internet pioneer Josh Harris and the wild first dotcom boom of the late 1990s. Behind the boom was a group of young people caught in the deep recession of the early 1990s, but who, with time and energy to spare, discovered the magic of the internet before most people had even heard of it.

Captivated, they found each other and exchanged ideas, learned to navigate the new domain of cyberspace, always from enthusiasm and curiosity rather than expectation of making money ("This is going to be bigger than CB radio!" they joked).

Then abruptly, in 1995, big business and Wall Street found them. They were showered with money to start companies that were eventually rushed to IPO and given absurdly high valuations by the market, as the public scrambled to buy these hyped and sexy-sounding shares. Most of the tyro dotcommers’ wealth was on paper, but they felt rich and appeared to be making a new world in their own excitable image.

Until in March-April of 2000 when the entire tech sector collapsed, and by the end of the year had simply vanished. The question was, why?

In "Totally Wired: On the Trail of the Great Dotcom Swindle," I thought I was going to be telling a tale of technology and hubris, a kind of "Fear and Loathing in Cyberspace," but slowly my focus changed. I’d set out wanting to know who or what had killed Web 1.0, and progressively found my attention turning to Wall Street.

The break came when an interviewee pointed me to a little-publicized $12.5 billion class action lawsuit against 55 underwriters who had taken dotcoms public, most of them investment banks. The suit described a practice called "spinning," in which underwriters allocated tranches of artificially low-priced shares to favored or potential clients, who could then "flip" them into the opening day frenzy for an instant profit.

More incendiary by far, however, was the class action’s description of a device called "laddering," by which clients received share allocations on the condition that they agreed to buy more post-opening shares at predetermined higher prices, which could be staggered through the day thus deliberately escalating the price.

The lucky clients would then be free to sell all of their shares to "retail" investors – members of the public – at the mid-afternoon top of the market, sometimes "shorting" them on the way down for good measure. "We were like Gods that year," one ex-Goldman staffer told me, referring to the IPO mania of 1999. "We were basically handing out money."

The class action ran from 2001 and was settled for a paltry $586 million in 2009, as plaintiffs feared a large-scale banking collapse and no recompense at all. Throughout, the defense case rested not on a denial that "spinning" and "laddering" had taken place, but on an insistence that these practices were not illegal – a view I found confirmed by Professor Joseph Grundfest of Stanford Law School, and a former commissioner at the Securities and Exchange Commission. No wonder a member of J. P. Morgan’s legal team purred of the settlement, "Our client is pleased with the outcome."

So the dotcom "bubble" was exuberant, but not (as Chairman of the Federal Reserve Alan Greenspan suggested at the time) irrational. In effect, the dotcom crash was a heist. Investment banks had used the young businesses as financial vehicles, conveying them to market regardless of virtue, just as they would sub-prime mortgages. Indeed, given that much of the money withdrawn from technology went into real estate, it is possible to view the two crises as one.

A bitter truth: by dragging the case out for eight years, delaying its acceptance as a class action until 2004 and then forcing a settlement with no admission of guilt, banks stifled information which might have helped prevent the financial crisis from which we’re still reeling.

Of particular significance to us now, however, was the response of regulators to the dotcom crash. New York’s then Attorney General Eliot Spitzer went after a few individuals and "analysts" like Henry Blodget, who were easy to demonize and offer to the public on a spit.

Of his successor Eric Schneiderman’s current pursuit of JP Morgan, Spitzer said: "He’s finally telling a story so that people can understand the depth and magnitude of what went on." What Spitzer didn’t mention is that much of Schneiderman’s evidence has been in the public domain since at least 2010, as a consequence of private prosecutions which actually named names – making the current Attorney General’s failure to cite individuals all the more bizarre.

He also failed to note that the Justice Department and the Securities and Exchange Commission are represented on Schneiderman’s working group; that both could have used the same evidence to bring criminal charges, but chose not to. All of which suggests that we may be in for the same old dotcom-style whitewash.

Our best counsel, then, is to watch this case like a hawk, remembering that it’s often when banking regulators appear to be doing most that they’re in reality doing least.

Andrew Smith is the author of "Totally Wired: on the Trail of the Great Dotcom Swindle" and "Moondust: In Search of the Men Who Fell to Earth." You can follow him at @wiresmith.

Article Tabs

A new bill provides two years of tuition at a community college for participating high school grads who might otherwise face a 7.5 percent unemployment rate – and other states are already following suit.

Rent-backed securities are the direct descendants of the mortgage-backed securities that crashed the economy in 2008.

Al Gore, Leo DiCaprio, Sting and hundreds of thousands of others swelled New York City's streets to demand climate justice.

In one of the most controversial “terror” cases in modern U.S. history, supporters rallied on the 16th anniversary of the arrest of the Cuban Five to demand the remaining three incarcerated men be released.

Community leaders, activists and residents affected by this summer's water shutoffs in Detroit are rallying at the Federal Bankruptcy Court on Monday to demand an immediate Water Affordability Plan.

If you're planning to take to the streets in New York City or elsewhere this week, know that today's IMSI technology used by police or the FBI could greatly affect the privacy of your cell phone and protest communications.

Posted 5 days 21 hours ago

Shifting toward community-based renewable power is a strong thread running through Scotland's Radical Independence Campaign, and a free Scotland could inspire other countries to relinquish their fossil fuel addiction.

Posted 6 days 17 hours ago

The history of resistance movements shows that when 3.5% of a population mobilizes on an issue, no government can withstand it – and organizers hope the climate justice movement can reach that level.

Posted 4 days 19 hours ago

Using social media and alternative news networks, activists and citizen journalists have found new ways to tell Americans the real story – it's immediate, it's personal, its electronic and its everywhere.

Posted 5 days 21 hours ago

This weekend I won’t be marching for the climate, but I won’t be sitting around doing nothing either – I’ll be at the sixth annual Australian Climate Action Summit in Queensland delivering some inconvenient truths.

Posted 4 days 19 hours ago

After a cunning political maneuver, the Council overrode Kauai Mayor Bernard Carvalho’s veto of Bill 2491, forcing big ag companies to disclose when and where they spray pesticides and what genetically engineered crops they grow on Kauai.

Former prosecutor Patrick Nightingale says he and his colleagues may have been unwitting pawns in the federal government’s effort to deceive defendants and the court system, thereby violating citizens’ constitutional rights.

Fighting BAC

We don’t want Bank of America to fail - but it already has failed, and only our tax dollars and our government’s continued protection is keeping that failure from becoming common knowledge.

Occupy Fort Lauderdale's Rock Star

Occupy Fort Lauderdale may not be as active now as it was before the holidays, but the music lives on, thanks to Dr. Bob, also known as Robert Mitchell.

Two congressmen are trying to investigate toxic spills caused by massive flooding in Colorado, where oil and gas well drilling has doubled since 2006.

Sign Up