FBI's Subprime Investigation and Cuomo's "Martin" Move

If the legal departments at our nation's major financial services firms weren't nervous before, they certainly are now. According to news reports, the FBI is looking into potential subprime crimes by 14 companies as part of a wide ranging investigation into the troubled mortgage industry. Apparently they have been doing so since the Spring of 2007. Reading through the tea leaves, the FBI might find that risk disclosures were hid from investors and ratings agencies as well as mortgage lenders and brokers falsifying information on loan applications, among other potential wrongdoings.

The FBI inquiry is extremely important because rather than pursuing these cases civilly through the SEC, we could see federal criminal indictments and jail time. The Feds were successful in prosecuting corporate criminals at Enron, WorldCom, and Adelphia and they have the requisite knowledge and experience to pursue wrongdoing in the subprime mortgage arena.

This is in stark contrast to Eliot Spitzer's strategy who was content to use photo-ops and wrist slaps and call it justice. Mr. Spitzer's performance will hopefully not serve as a case study for the current New York Attorney General, Andrew Cuomo. This is not to say he didn't learn anything from Mr. Spitzer. Attorney General Cuomo apparently is threatening to use The Martin Act to aggressively pursue a case against Wall Street, which also was Mr. Spitzer's legal club of choice.

This is an important development. The Martin Act is quite broad in its scope and can be used to indict a company for virtually anything. No Wall Street firm has ever survived an indictment, so Cuomo will likely garner some settlements. Let's hope that unlike Mr. Spitzer, Mr. Cuomo is hell bent on truly reforming Wall Street and that any settlements involve penalties that might actually serve as painful deterrents to future wrongdoings.

Sub-Prime Crisis and the Ratings Agencies

Sub-Prime Crisis and the Ratings Agencies

Back in August, Fortune ran a story that took the ratings agencies to task for their role in the subprime mortgage crisis. A noted investor named Jim Chanos, the head of Kynikos Associates, acknowledged he had a short position in Moody's stock: "If the rating agencies will downgrade only when we can all see the losses, then why do we need the rating agencies?"

If what I read in the Sunday Business Section is true about Attorney General Andrew Cuomo's investigation and the participation of Clayton Holdings, a company based in Connecticut that vetted home loans for many investment banks, then Mr. Chanos is due for a windfall (he's already at least more than doubled his money). Apparently Clayton Holdings has provided extensive documentation to the attorney general's office in exchange for immunity that shows investment banks allegedly knew many of the loans it was packaging for unwitting investors were more risky than was disclosed. Early on in the subprime crisis when I filed the first hedge fund investor arbitration claims against Bear Stearns, we made the similar allegations regarding the firm's failure to disclose risks.

More shocking is the allegation that the investment banks never turned Clayton's due diligence reports over to ratings agencies. Instead, according to the article, "in these disclosures, underwriters typically said that loans that did not meet even lowered lending standards, called exceptions, accounted for a "significant" or "substantial" portion of the loans contained in the securities, but they offered little hard, statistical information that Clayton promised prosecutors it would provide as evidence."

Wall Street's selective disclosure to the ratings agencies is only half the story. My question is, should the ratings agencies even need such information? I thought the ratings agencies did their own due diligence. If this story is accurate, what value-added are the ratings agencies providing if they aren't able to perform their own analysis?

Later on in The New York Times story, Raymond W. McDaniel Jr., the CEO of Moody's says of the investment bank's reports: "Both the completeness and veracity was deteriorating." My question to Mr. McDaniel is how could Moody's possibly award ratings to securities based on incomplete information?

Ordinarily we would just let market forces deal with such failure. However firms like Moody's, Standard & Poors, and Fitch are granted special competitive advantages because they are part of a select group of eight companies designated as Nationally Recognized Statistical Rating Organization (or "NRSRO"). Based on their record, the government should not be protecting them. If there was more competition the ratings might be more predictive and less expensive. Maybe if investors had gotten their hands on Clayton's reports they would have never invested in the first place.

The fact is ratings agencies have become lagging indicators. Mr. Chanos knows this better than anyone. He was an early short-seller of Enron after investigating the firm and finding accounting irregularities. It wasn't until mid-October of 2001 that three credit-rating agencies started to warn investors of Enron's deteriorating condition, and not until Nov. 28, just days before Enron filed for Chapter 11 bankruptcy protection, that they lowered their debt ratings below "investment grade."

If the only service ratings agencies provide is assigning some combination of the first four letters in the alphabet to a security, then maybe they can be replaced by a smart preschooler.

Chairman Waxman’s CEO Compensation PR Stunt

Next month, Congress will be schlepping in the former chief executives of several financial services firms damaged by the subprime crisis to question them about their compensation packages. House Oversight and Government Reform Chairman Henry Waxman (D-Calif.) has sent letters to Angelo Mozilo, CEO of Countrywide Financial, Charles Price, former CEO of Citigroup and Stanley O'Neil, former CEO of Merrill Lynch. According to reports Chairman Waxman intends to ask them why they "stand to collect tens of millions of dollars in severance payments and other compensation," even as their current and former companies are losing billions of dollars in the subprime mortgage meltdown.

It's certainly understandable to perceive these golden parachutes as obscene. Mr. Mozilo is supposedly getting more than $110 million on top of the $47 million he got last year, while Countrywide Financial erased billions of dollars in shareholders equity. Mr. Prince is allegedly getting more than $29 million in "accumulated benefits" and supposedly even received a bonus for 2007. Mr. O'Neal walked away with more than $161 million in "accumulated benefits." Citigroup and Merrill together have written down more than the GDP of most third world countries.

By any measure, paying these men hundreds of millions of dollars for their recent performance is not justified – which is exactly why Mr. Waxman is calling in the wrong people. It should instead be the corporate board members overseeing the compensation committees that should explain the payouts. Maybe executive compensation consultants hired by corporate boards should face questioning too, such as Hewitt Associates of Lincolnshire, Illinois, and Mercer Human Resources, which were involved in the decision to give Dick Grasso over $100 million. The ones who accepted authorized pay shouldn't be flogged.

The individuals Chairman Waxman should have sent letters to include Harley Snyder, CEO of HSC, Inc., John Finnegan, Chief Executive Officer of The Chubb Corporation and Alan J.P. Belda, Chairman and CEO of Alcoa, who chaired the compensation committees of Countrywide, Merrill Lynch, and Citigroup, respectively. Hopefully not lost on Chairman Waxman would be the fact that all these men hold the title of CEO. In this elite fraternity, sometimes one hand washes the other. For example, Mr. O'Neil was just named to the board of Alcoa. It would of course be too obvious of a conflict for Mr. Prince to serve on Alcoa's board, so Mr. Belda got the next best thing. The point is, those holding the power don't have the motivation to change the status quo.

Chairman Waxman needs to get to the source of the problem which lies squarely with the board of directors and compensation committee members. Not holding them accountable is like patching a leaky roof with duct tape every time it rains. Unfortunately, without their presence next month's hearings are the equivalent to nothing much more than a witch hunt wrapped-up in a PR stunt.

If Chairman Waxman was truly interested in relating compensation to performance, why stop at publicly held companies? He should call in sports stars like Alex Rodriguez, Carl Pavano, and Albert Belle, notoriously over-paid underperformers. I know what you're thinking. Congress holding hearings with professional baseball players sounds ridiculous, doesn't it?

Front Running and Institutional Investors

A few years ago there was a Long Island restaurant that served the most deliciously yummy foods and desserts, all of which were labeled as being ridiculously low in calories and fat. The lines extended out the door. But one night a local television station reported that its testing revealed the restaurant's food was in fact incredibly high in calories and fat. The restaurant issued an apology and reverted to a healthy menu focused primarily on salads, but barely anyone would frequent the place. The trust was gone and the restaurant closed.

You would think that institutional money managers, who have a fiduciary responsibility to their clients, would also avoid doing business with any firms that engaged in organized wrongdoing and ripped them off. But that certainly doesn't appear to be the case. There have been repeated incidents where major Wall Street firms reportedly have traded in advance of major trades they were asked to execute for their institutional clients. This practice, known as front running, gives brokerage firms an unfair advantage because they have insider knowledge that a pending block order will likely cause a significant price swing.

The SEC reportedly is investigating whether Merrill Lynch was front running orders placed by Fidelity Investments, the massive mutual fund operator. If the allegations prove true, it won't be the first time Merrill Lynch has been nailed for this infraction. In 1995 the firm was fined $10,000 and censured by the American Stock Exchange for "the practice of profiting on advanced knowledge of a planned transaction." The piddling fine didn't even cover the losses incurred by Merrill's client and could hardly be considered a major deterrent. Whoever coined the phrase "crime doesn't pay," never worked on Wall Street.

But let's not just pick on Merrill. Front running has long been suspected as a widespread practice at all the big brokerage firms. Yet institutional money managers continue to route the bulk of their trades through them, rather than support the various independent boutiques that have sprung up in recent years offering very sophisticated algorithmic trading capabilities. One of the reasons is that the big brokerage firms offer their institutional clients equity research, but we know that most of that research is hardly worth the paper it's printed on. Another major reason is simply fear: In the words of one institutional money manager, "no one is going to get second guessed for routing an order through Goldman Sachs."

Rest assured, even if the SEC finds that Merrill was front running Fidelity's orders, nothing much will come of it. The matter will be settled by Merrill agreeing to pay a relatively insignificant penalty without admitting any wrongdoing. It will, of course, get to keep most of its ill-gotten gains. The SEC neither has the resolve, or the resources, to take on a big Wall Street firm.

It's about time mutual fund boards acted responsibly and begin questioning how trading in the equities they oversee are executed. Customers betrayed by the Long Island restaurant weren't willing to grant a second chance, and I'm confident that mutual investors would be similarly unforgiving about having their holdings routed through institutions engaged in pervasive wrongdoing.

The Subjective Nature of Wall Street Write-Downs

Fourteen billion. That's the apparent magic number for Merrill Lynch and its new CEO John Thain as formally they announced a write down of $14 billion for the fourth quarter of last year. An equally staggering number was announced by Citigroup and its new CEO Vikram Pandit, which wrote-down $18 billion for the fourth quarter. Together their losses amount to more than the Ecuadorian GDP! It is of course strategically logical for Mr. Thain and Mr. Pandit to write-down such massive losses. As incoming CEOs the losses weren't under their watch and they can ride gains to the upside. No where to go but up from here!

But what is more troubling about Merrill's and Citi's write downs is how it exemplifies the subjective nature of Wall Street's accounting methods. Just one quarter ago the write-down was $8 billion for Merrill and $11 billion for Citi. Both of those write downs occurred during the tenures of the now "retired" CEOs Stan O'Neil and Charles Prince, respectively.

I have a few questions: If the previous CEOs were still in place would the fourth quarter numbers have been the same? Did Mr. O'Neil and Mr. Prince choose to take smaller write downs in an attempt to save their jobs or is Mr. Thain and Mr. Pandit taking a bigger write down than necessary to ensure they receive the full extent of the upward bell curve? Or are you going to believe "uncertain market conditions" are to be blamed?

The point is, strategy shouldn't influence when and how much to write down losses. What Wall Street's earnings environment shows us is that a CEO may have a greater influence on balance sheet than, well… the balance sheet.

In an ideal world we would count on an independent accounting firm to honestly audit Wall Street's books. But accounting firms are anything but independent as noted by Francine McKenna, whose blog re: The Auditors covers the "Big Four" accountancies. In a recent post, she disclosed the lucrative relationship between PricewaterhouseCoopers (PwC) and Goldman Sachs. PwC has been Goldman's sole auditor since the firm went public in 1999, but they deliver a myriad of other professional services to the firm.

Writes Ms. McKenna, "This past year, total audit fees were $43.4 million, audit related fees were an additional 3.3 million and tax fees were 2.6 million. In addition, [PwC] made $19.2 million more by providing services to merchant banking and other funds managed by Goldman Sachs subsidiaries. All of these fees were for audit and tax services. By comparison to prior years' numbers, we can see that over the years, and like other large, complex, global companies, audit and related fees have grown substantially due to Sarbanes-Oxley. But the services to the Goldman Sachs funds have also been part of the package since almost the beginning and add a significant amount to PwC's overall compensation."

What Ms. McKenna delicately touched upon I will say outright: with money like that at stake an accounting firm is not incentivized to interpret accounting rules strictly and universally. More plainly, either Mr. Thain or Mr. O'Neil has some explaining to do because investors should not accept that Merrill Lynch couldn't have written down any of the $14 billion before now.

The game is clearly rigged in Wall Street's favor if a CEO has billions of dollars of leeway when it comes time to pay the piper. With such grey accounting standards, the write-downs are largely meaningless. And therein lies the lesson. When investing in Wall Street, you're on a wing and a prayer.

Stoneridge Decision is NOT Good for Investors

There’s a lot of propaganda circulating about the Supreme Court’s decision in the Stoneridge vs. Scientific Atlanta case. The court completed its trifecta of anti-investor decisions by deciding that third parties (investment banks, law firms, accountants, etc) are not subject to so-called “scheme liability.” In other words, investors cannot recover losses from third parties that contributed to securities fraud.

The decision is extremely unfortunate for the investors in Enron, many of which were employees whose pensions were mostly invested in the firm’s own stock. Because there’s nothing left of Enron, they will forever be left olding the bag regardless of the fact that investment bankers helped Enron managers create sham transactions that eventually led to the firm’s collapse.

Since the Supreme Courts decision yesterday, many pundits have been echoing the arguments of the business lobby. The argument goes that the Stoneridge decision is actually good for investors because litigation expenses drive down corporate earnings. Another creative argument is that diversified investors will be both victims and beneficiaries of fraud so it evens out.

Maybe, but it is the market’s integrity that is its strength in the long run. Not holding all the market’s participants accountable for fraudulent activities essentially grants a license to steal. Not matter how you slice it, that’s bad for investors. Second of all, allowing for investors to recover losses will not harm competition or corporate earnings. Rather it will even the playing field for those companies operating within the confines of the law.

Bear Stearns Announces Third Hedge Fund Collapse; A Sign of Things to Come?

Bear Stearns has dropped another bombshell announcement. A third hedge fund, the Asset Backed Securities Fund, has apparently lost so much money its no longer profitable for the bank to run it...and that’s saying something considering Wall Street’s reputation for squeezing fees out of investors. At its peak, the fund had $900 million of investor assets, which is now valued at $500 million. This brings the grand total of investor loses under Bear Stearns’ watch to well over $2 billion in three hedge funds alone.

This latest hedge fund to shutter, Bear Stearns claims, only had 0.5 percent of is assets tied to sub prime mortgage related securities. This begs the question of exactly what constituted the other 95 percent of invested assets. Were these also illiquid securities or is the market for all asset backed securities (including commercial lending) worse than anyone could imagine? No one has ever accused Bear Stearns as being a pillar of transparency, but if the market is in such jeopardy then a great many more portfolio managers may be going the way of Ralph Cioffi, the now departed portfolio manager who oversaw the other two collapsed Bear Stearns hedge funds.

My inclination is that this is partly another example of the dubious nature of Wall Street’s credit valuation methods. Bloomberg reports that the Asset Backed Securities Fund’s portfolio was valued at $900 million as late as August of 2007, but spiraled downward losing as much as 21 percent in November alone. Would August’s valuation been the same had the funds assets been valued based on more pragmatic (read: honest) method? Did the hedge fund managers’ strategy waver in any way during the funds history? And did Bear Stearns park any of its own bad assets in the funds as it is alleged they did with the other two funds under Cioffi’s supervision? These are the types of questions that investors should be asking.

They say where there’s smoke, there’s fire. And in my thirty years working on behalf of defrauded investors nowhere is that more true than on Wall Street. At Bear Stearns, there’s a raging inferno. Rest assured, we will be paying close attention and working with clients to determine the real story behind the Asset Backed Securities Fund and its spectacular losses.

The Resignation of Jimmy Cayne

The resignation of James E. Cayne as the CEO of Bear Stearns comes as no surprise to anyone following the subprime crisis. Bear Stearns stands out as one of the primary securitizers of subprime mortgage backed securities and many consider the collapse of its two hedge funds this summer the spark that ignited the subprime forest fire. Since the collapse, Bear Stearns has been besieged by investor lawsuits - including those filed by Zamansky & Associates on behalf of institutional and high net worth investors - regulatory investigations and multi-billion write-downs resulting in huge losses in shareholder’s equity.

Many will praise Mr. Cayne’s leadership, and perhaps rightly so, since under his control the firm’s stock price rose from $16 to over $100. But along the way hundreds of investors have filed arbitration cases and Bear Stearns has paid out hundreds of millions of dollars in regulatory fines. Indeed, Mr. Cayne’s legacy will be difficult to spin positively.

Taking his place as CEO will be Alan Schwartz, currently serving as Bear Stearns’ president. It is my sincere hope that the leadership change will also elicit change in the way that Bear Stearns treats its investor clients and belief in strict regulatory compliance.

State Street versus Main Street?

The financial press is reporting today that the State Street Corporation, which manages an astounding $2 trillion for pension funds and other institutions, has set aside over $600 million to cover legal claims stemming from clients whose investments lost money because of exposure to the securitized mortgage arena. It is certainly interesting that even a self-described conservative financial house like State Street drank the mortgage back security cool aid. While $600 million may sound like a lot of money, it's likely only the tip of the iceberg. Indeed, the rest of Wall Street should follow State Street's lead instead of stonewalling.

The cash reserves could amount to a multi-billion exposure to lawsuits brought by pension funds, municipalities, hedge funds and high net worth individuals. Given the interest of the financial regulatory community – it was reported FINRA has finally joined the action and has sent requests to more than a dozen brokerages for marketing and client account information used to steer clients toward mortgage related securities – a settlement along the likes of the $1.4 billion research/investment banking conflicts could also be in the future.

State Street Corp. is indeed where Main Street and Wall Street collide. Pension funds and mutual funds are comprised of the weekly contributions from mom-and-pop investors' paychecks. State Street allegedly took client funds that were suppose to be invested in treasuries and corporate bonds and instead invested them into the mortgage security market. After the client lost $80 million, the response from State Street will go down in annals of Wall Street's stupidest client responses ever (and that's saying something). Allegedly a State Street executive told his client that the firm "forgot there was a lot more risk in the strategy."

Clients are suing State Street under the Employee Retirement Income Security Act (ERISA), which is a relatively new legal strategy. Prior to the last year's Supreme Court decision known as "Tellabs," the standard to prove fraud was easier to meet. Unfortunately the business-friendly Supreme Court decided that a plaintiff must show a "strong inference" of fraud but didn't exactly define what that meant. Because of that risk, ERISA is being used to recoup for investor losses in this case and we will likely see its use increase.

In addition to the billions of dollars tied to litigation, Wall Street will lose billions more due to the collateral damage to brokerage reputations. Confidence in Wall Street's ability to invest honestly is shattered and no amount of rainy day funds can save that.

The Silver Lining in the Subprime Mess

It’s beginning to look like 2000 all over again. The Wall Street Journal reported that the SEC alone has launched dozens of investigations tied to the subprime crisis. The investigations are eerily familiar to those that were held after that tech bubble burst in 2000 and ultimately led to the $1.4 billion global settlement.

But there is a fundamental difference this time around: some of the CEOs who oversaw the subprime mess at their respective firms – namely Chuck Prince at Citigroup, Stan O’Neal at Merrill Lynch – have already been fired. Bear Stearns reportedly is looking to replace Jimmy Cayne.

Flashback to the conflicted research probes where no CEOs – not even Sandy Weill who created the most conflicted financial conglomerate ever – lost their jobs because of Wall Street’s rampant institutional dishonesty.

Although wrongdoing is as pervasive as ever on Wall Street, it’s a progressive step forward when CEOs – and not hapless middle managers – are actually held accountable.