Abstract
The collapse of Bear Stearns, at that time a major investment bank on Wall Street, is commonly regarded as the prelude to the global financial crisis. It will long be regarded as a major milestone in the history of corporate moral failure. While millions of customers undoubtedly were hurt—among them homeowners and pensioners, as well as investors, big and small—Wall Street had created a culture of predatory lending that was indifferent to the consequences for its customers. At the end of the day, both subprime borrowers and institutional investors (e.g., retirement funds) were the ultimate victims, while Wall Street principals made billions. Our interest in the Bear Stearns collapse concerns the ethics of fiduciary responsibility or what the investment industry owes its clients and customers in managing their money. Beyond all the complexity and technical innovations involved in the creation of markets for investment products consisting of collateralized debt obligations (CDOs), especially mortgage-backed securities (MBSs), the question is whether markets, even at that abstract level, remain markets in which certain basic assumptions about mutual trust, transparency and accountability, still must be honored if business is to be conducted fairly and benevolently. In order to open this question up to useful discussion, our case study not only recounts Bear Stearns’ involvement in the creation of a market for MBSs but also focuses on the specific actions of two of its hedge fund managers in that market, Ralph Cioffi and Matthew Tannin. When the market they had helped to create in MBSs fell apart, how did they respond? Would you have done any differently?
“To establish your brand name, act as a fair competitor.” (Stephan Rothlin, Eighteen Rules for Becoming a Top Notch Player, 2004)
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Notes
- 1.
Fortune Magazine’s ratings of “America’s most admired companies” could easily be challenged on several grounds. Bear Stearns’ high rankings for those years are only in the category of “securities firms,” and in none of those years did the number one securities firm—Bear Stearns in 2005, and the ill-fated Lehman Brothers in 2006 and 2007—rank among the top 20 companies overall. The write-ups publicizing Bear Stearns’ rankings never mention one key benchmark that supposedly is meant to be typical of “America’s most admired companies,” namely, their leadership in the practice of corporate social responsibility (CSR). Had CSR been an important element in Bear Stearns’ corporate profile, could it have avoided the excesses that led to its sudden downfall? Who’s to say? But the fact remains that the accolades that Bear Stearns received apparently were not related to any CSR activities, but were based exclusively on its bold innovations in financial marketing and egregious success in maximizing profits for its investors. Bear Stearns may have been among the most admired, but was it ever loved, and if so, by whom, and for what reasons?
- 2.
The politics of subprime mortgage lending was premised upon certain characteristics of American culture, primarily, the identification of “the American dream” with home ownership. The need for macroeconomic stimulus, in the immediate aftermath of “9-11,” thus coincided with long-term trends—supported by key leadership elements in both major American political parties—toward deregulating the financial markets, including the fateful repeal of the Glass-Steagall Act (1933). It was the repeal of Glass-Steagall that enabled the merger of commercial and investment banking interests. A shadow banking phenomenon was created where investment bankers could raise funding outside of regulatory scrutiny, which could be used to buy and sell structured finance vehicles like securitized CDOs and MBSs. Within this system, managers like Cioffi and Tannin received enormous commissions while retaining, theoretically, no risk—unless, of course, they had invested their own money in the financial products they were also marketing to others. Had the Glass-Steagall Act still been enforced, the process of “securitization” by which the MBSs were created—along with the opportunities for abuse by unscrupulous managers and brokers—may have been, if not prevented, at least severely inhibited.
- 3.
The process of mixing these CDOs in a structured investment product is known as “credit enhancement” (Investopedia.com 2014c). A “cash flow waterfall” was thus created that directed the first rights to cash flow from the mortgage pool to the investment grade tranches based on very sophisticated mathematical models that allowed the rating agencies, collaborating with the investment bankers, to create the illusion of safety (investment grade tranches). For more on the mathematical models and their role in facilitating the process of credit enhancement, see Stewart (2012).
- 4.
A credit default swap (CDS), simply put, is an insurance against the default of a security. The person purchasing the CDO will pay its issuer an “insurance premium” until the security matures. If the security defaults, the issuer will compensate the purchaser of the CDS (Investopedia.com (2014b). Bond insurers like AIG sold credit default swap insurance that allowed the investment bankers like Bear Stearns to book “fairy dust” profits when the CDOs were created. Using discounted cash flow techniques, the investment bankers showed phantom net present value profits upon which investment banker executives based their bonuses. Bond insurers like AIG, who were not required to put up collateral, ultimately went bankrupt when the subprime mortgage market imploded in 2007–2008 and the CDOs dropped dramatically in value. The credit default swaps supporting the trading of CDOs thus enabled vast sums to be won and lost among investment bankers and their insurers, with only the US government’s bailout capable of preventing a total collapse of the financial system worldwide.
- 5.
As the American novelist, Upton Sinclair, memorably observed, “It is difficult to get a man to understand something, when his salary depends upon his not understanding it!” Remember that like other investment bankers, the Bear Stearns executives received the lion’s share of their compensation through stock options. Therefore, they had every incentive to manipulate the firm’s accounting practices to show short-term profits that would drive stock prices higher. This put enormous pressure on their allegedly “independent” auditors to acquiesce in various questionable schemes that maximized (and exaggerated) short-term profitability, by masking the precariousness of their financial position. Under the circumstances, carrying on with “business as usual” is hardly an innocent choice.
- 6.
“Junk,” or more precisely “junk bonds” describe bonds with the lowest ratings. They are considered to be very risky, but often yield very attractive returns if they don’t default (Investopedia.com 2014e).
- 7.
S&P was sued by the Justice Department over abuses that occurred in this practice (Eaglesham et al. 2013). It is known as the “Issuer Pays” model, in which the ratings agency does not get paid unless an investment grade rating is achieved (Frankel 2013). For a fuller explanation of role of the credit rating agencies in the financial crisis, see “The Council on Foreign Relations’ ‘Backgrounder: The Credit Rating Controversy’” (Allessi et al. 2013).
- 8.
Investopedia defines “Ponzi scheme” as “a fraudulent investing scam promising high rates of return with little risk to investors. The Ponzi scheme generates returns for older investors by acquiring new investors. This scam actually yields the promised returns to earlier investors, as long as there are more new investors. These schemes usually collapse on themselves when the new investments stop” (Investopedia.com 2014f). The Bear Stearns hedge funds probably were not intended as a Ponzi scheme, since the investments were CDOs meant to leverage the real value of mortgages and related financial products. On the other hand, in retrospect, at least, the promised yields to investors seem to have depended entirely on the hedge fund managers’ ability to continue recruiting new investors. When the market for MBSs softened, the hedge funds collapsed, much like a failed Ponzi scheme.
- 9.
Ball’s comment hearkens back to a time when predatory behavior on Wall Street could still be restrained by a shared culture of shame, perpetuated by “the good ol’ boy” network that persisted among seasoned investment bankers. Just as you might be ashamed to bring some of your pals home for dinner, because you knew that your parents wouldn’t approve of them, so there may be some business deals that are so questionable—for one reason or another—that you wouldn’t want your family to know how far you are willing to compromise yourself just in order to make more money. Shortly after Ball made this comment, it became clear that the Wall Street culture of shame that had been enforced by Wall Street’s “good ol’ boys”—however selectively—was fast eroding, as we learned from Michael Lewis’ brilliant cultural analysis, Liar’s Poker: Rising through the Wreckage on Wall Street (New York: W.W. Norton, 1989).
- 10.
It was later split into two, and the additional fund was called “Bear Stearns High-Grade Structured Credit Enhanced Leverage Fund.”
- 11.
Previously BSAM hedge fund investors had only been given notification about the asset/security class, which was remarkably vague. With only bare information about the CDO’s category, one must rely on the assessment of the ratings agency, which proved to be unconscionably unreliable. Subsequent lawsuits, most still unresolved, testify to the difficulty investors had in attempting to obtain sufficient information about the assets they had purchased (cf. Eaglesham et al. 2013).
- 12.
The allegation of Cioffi’s deliberate malpractice is evident from comparing the monthly commentary he issued to BSAM’s investors in March 2007, outlining the steps he had taken to protect them from increasing turbulence in the MBS market, with what the trades he was actually making on their behalf. As William D. Cohan explained, “The problem was that none of it was true. Cioffi had not avoided residential mortgage backed securities, as he had suggested to his investors on their monthly statements. Actually he had done precisely the opposite and had started to load up on these toxic securities at exactly the wrong moment. Since he was no longer trading with Bear Stearns, the firm had no idea of what he was doing” (Cohan 2009: 312).
- 13.
The importance of this statement can hardly be exaggerated. As William D. Cohan explained, “Here, for perhaps the first time in black and white, was the admission – varnished repeatedly with gibberish – that all had not been what it seemed in the funds” (Cohan 2009: 350).
- 14.
The allegation and the evidence in support of it are detailed in the “Administrative Complaint, in the matter of Bear Stearns Asset Management, Docket E2007-0264” issued by the Commonwealth of Massachusetts on November 14, 2007. Retrieved on 2 February 2014 from the Archives of the Massachusetts Secretary of State, http://www.sec.state.ma.us/sec/sct/archived/sctbear/bear_complaint.pdf.
- 15.
See, for example, Michael Lewis’ account of how money was made and lost in the collapse of the subprime mortgage market, The Big Short (Lewis 2010).
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Rothlin, S., McCann, D. (2016). Customers: Marketing Ethics. In: International Business Ethics. Springer, Berlin, Heidelberg. https://doi.org/10.1007/978-3-662-47434-1_7
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