Thursday, December 20, 2007

Barclays Sues Bear Syerns Over Sub-Prime Losses - Federal Reserve Might Have Prevented the Mess

It will be interesting to watch and see whether other investors - especially non-US investors - decide to sue the Wall Street firms that packaged and sold these mortgage investment vehicles that have turned toxic for the buyers. Barclays is but one of many foreign investors that purchased these investments and have ended up losing huge sums of money. Among other things, Bear Sterns is accused of fraud and deception. I have no sympathy for lenders and others who recklessly made these dangerous loans and then sold to third parties. Also at fault for this fiasco is the Federal Reserve and the Comptroller of the Currency which had authority to regulate such loan operations and basically did nothing as described in the New York Times piece quoted below. . The perpetrators made out like bandits. Now everyone is suffering directly or indirectly. This story from The Guardian (http://www.guardian.co.uk/business/2007/dec/20/barclaysbusiness.subprimecrisis) describes the lawsuit filed by Barclays. Here are some highlights:
Barclays' exposure to America's sub-prime mortgage fiasco took a dramatic turn last night as the bank sued the Wall Street firm Bear Stearns for fraud and deception over the loss of hundreds of millions of dollars in an ill-fated hedge fund. In a lawsuit filed in New York, Barclays accused Bear Stearns of systematically hiding losses in a fund which swallowed $400m (£200m) of the British bank's money. The fund had to be bailed out in June after reaching the brink of collapse following a disastrous series of investments in mortgage-backed securities.

Barclays described the fund's demise as "one of the most high profile and shocking hedge fund failures in the last decade". The suit alleges that up to the last days before the bail-out, Bear Stearns executives engaged in a cover-up to hide the slump in its value. In addition to Bear Stearns, the suit targets the Wall Street firm's senior managing director for asset management, Matthew Tannin. A third defendant, fund manager, Ralph Cioffi, is already under investigation by US federal prosecutors for withdrawing his own money from the hedge fund while assuring investors not to worry.

"The defendants entered intentionally into a relationship in which Barclays placed trust and confidence in them," the suit says. It describes Bear Stearns' conduct as "wilful, malicious, reckless and without regard to Barclays' rights and interests". According to Barclays, Bear Stearns frequently diverged from agreed guidelines on the type of investments to be made by the fund. Between 75% and 100% of the fund's portfolio was supposed to go into assets with top-notch credit ratings of between AAA and AA minus.

The suit says Bear Stearns and Cioffi "hatched a plan to make more money for themselves" by creating an unauthorised new investment vehicle which they planned to float. Barclays details a series of lunch meetings in New York at which its staff were assured that the fund was going well. But it says detailed updates of performance tended to be provided late and incomplete. Throughout the spring of 2007, it says, Tannin repeatedly used the word "great" to describe progress.
Criminal prosecutors are examining whether Cioffi, who managed the fund, improperly withdrew $2m of his own money while providing bullish updates to clients about the fund's performance - a move characterised as a hedge fund manager "hedging himself". Cioffi recently left the firm, although Bear Stearns has not disclosed the circumstances of his departure.
Here are quotes from the New York Times editorial from yesterday (http://www.nytimes.com/2007/12/19/opinion/19wed1.html?_r=1&hp&oref=slogin):
An article in The Times on Tuesday by Edmund L. Andrews leaves no doubt that the twin crises of the subprime lending mess — mass foreclosures at one end of the economic scale and a credit squeeze afflicting the financial system — are rooted in the willful failure of federal regulators to heed numerous warnings.

The Federal Reserve is especially blameworthy. Starting as early as 2000, former Fed Chairman Alan Greenspan brushed aside warnings from another Fed governor, Edward M. Gramlich, about subprime lenders who were luring borrowers into risky loans. Mr. Greenspan’s insistence, to this day, that the Fed did not have the power to rein in such lending is nonsense.

In 1994, Congress passed a law requiring the Fed to regulate all mortgage lending. The language is crystal clear: the Fed “by regulation or order, shall prohibit acts or practices in connection with A) mortgage loans that the board finds to be unfair, deceptive, or designed to evade the provisions of this section; and B) refinancing of mortgage loans that the board finds to be associated with abusive lending practices, or that are otherwise not in the interest of the borrower.”

Yet, the Fed did nothing as junk lending proliferated — including loans that were unsustainable unless house prices rose in perpetuity, riddled with hidden fees and made to borrowers who could not repay. When all the truth is out, the Fed will have company in the hall of shame. The Office of the Comptroller of the Currency, for example, blocked states from investigating local affiliates of national banks for abusive lending.

If the regulators had done their jobs, there might have been no lending boom and no extraordinary riches for the lenders and investors who profited from unfettered subprime lending. Neither would there be mass foreclosures, a credit crunch and a looming recession.

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