Inside Job (14 page)

Bear Stearns gives us a lurid peek at a white-shoe investment bank turned boiler room, using a succession of strategies to extract money from the bubble in every possible way. We know about it
because of a lawsuit filed by the Ambac Financial Group, a bond insurer now in bankruptcy. Ambac’s suit against Bear Stearns and its successor company, JPMorgan Chase, is one of the few cases
in which plaintiffs were able to obtain the internal documents, e-mails, and loan files of defendants to use in evidence.
⁵

The history of the lawsuit indicates the banks’ strategy, and their ferocious opposition to every attempt to shed light on their conduct. Ambac filed suit in November 2008, and as of this
writing—February 2012—the case has still not come to trial. Bear Stearns and its new owner, JPMorgan Chase, have used a long succession of procedural tactics to delay the case. They
also tried hard to prevent Ambac from being able to subpoena records and depose witnesses, but eventually lost. They are still trying to delay the trial, presumably hoping that Ambac’s
bankruptcy trustee will eventually give up or run out of money to pursue the case.

Of course, what follows is a partisan account based on materials assembled by Ambac’s attorneys. During the bubble, Ambac and the other major insurers (MBIA and AIG) were not angels
themselves; their former executives and salespeople (now long gone) had the same toxic incentives and destroyed their own firms, just like everyone else. But now, an independent bankruptcy trustee
appointed by the courts is trying to recover as much as possible. Ambac’s lawsuit is part of a gigantic post-crisis food fight in which dozens of firms are trying to recover money, often
while being sued themselves for their own highly unethical behaviour. And JPMorgan’s answer to the Ambac suit, when
it becomes available, may cast some of the quotes
below in a different light. But the accuracy of the quotes has not been challenged, and they make for interesting reading.

Ambac is suing to recover losses from payouts it made on failed Bear Stearns securitizations; Ambac argues that it agreed to insure them only due to gross misrepresentations by Bear Stearns.
Many of the loans in the securitizations came from a wonderful company called American Home Mortgage, Inc. (AHM), also now bankrupt. We can get a taste of AHM’s enthusiastic approach to home
lending from the official description of its “Choice” loan programmes:

Now, over to Bear Stearns. Its mortgage securitization programme was run by four executives: Mary Haggerty and Baron Silverstein, coheads of Mortgage Finance, and Jeffrey Verschleiser and
Michael Nierenberg, coheads of mortgage trading. Haggerty and Silverstein underwrote the suitability of mortgages from originators, and pushed them through the steps to get to a sale. Verschleiser
and Nierenberg traded loans in and out of Bear Stearns’s portfolio and also constructed the securitizations. These people were emphatically
not
obscure file clerks whose machinations
went unnoticed by management. All four were senior managing directors—in all of Bear Stearns, a fourteen-thousand-person company, only ninety-eight people were at that level. They would have
all been paid millions of dollars per year.

The first thing they did, of course, was simply to package and sell a lot of trash (while concealing this fact). The record shows that loan delinquencies were already rising sharply in early
2005. John Mongelluzzo, the due diligence manager in Mortgage Finance, and therefore
junior to Haggerty and Silverstein, was pushing for stricter standards and tighter
underwriting reviews. The response to his actions indicates the futility of being ethical in American investment banking during the bubble. Instead of tightening standards, in February 2005 Mary
Haggerty ordered a
reduction
in due diligence “in order to make us more competitive on bids with larger sub-prime sellers.” She reduced the size of the loan samples used to test
compliance and, most important, postponed the due diligence review until
after
Bear had bought the loans, and often even after the loans had been bundled into securities.
⁷

This change in procedure was made almost by stealth. A year later, in March 2006, a conduit manager wrote that “until yesterday we had no idea that there was a post close dd [due
diligence] going on.” Loans “were not flagged appropriately and we securitized many of them which are still to this day not cleared.” In other words, loans were going out with no
due diligence at all.
⁸

Later that spring, Mongelluzzo wrote to Silverstein, “I would strongly discourage doing post close [due diligence] for any trade with AHM. You will end up with a lot of
repurchases”—a “repurchase” was a buyback from a sold securitization, and was always expensive. The advice was ignored. Two pools of 1,600 loans were purchased from AHM and
quickly securitized. A review the following year showed that 60 percent were delinquent, and 13 percent had already defaulted.
⁹

At the same time, Verschleiser was pushing hard for more volume. One of the conduit managers e-mailed her staff:

Later that year, the same executive e-mailed her staff: “I don’t understand that with weekend overtime why we didn’t purchase more
loans. . . . Our
funding needs to be $2 billion this month. . . . I expect to see ALL employees working overtime this week to make sure we hit the target number.”
¹⁰

An early warning of declining quality was a 2005 spike in EPDs, which Bear Stearns defined as a missed payment in the first ninety days. Bear Stearns’s policy had previously been to hold
purchased loans in inventory for ninety days before securitizing them, in order to ensure their quality. But in 2005 the team decided to shorten the holding period, so loans could be pushed into
securities before an EPD occurred. Verschleiser told the unit that he wanted all “the subprime loans closed in December” to be in securitizations by January—in effect, within a
month of purchase. He confirmed that policy in mid-2006, reminding staff “to be certain we securitize the loans with 1 month epd before the epd period expires.” Later, he demanded to
know why specific loans that experienced early delinquencies “were dropped from deals and not securitized before their epd period expired.”
¹¹

The predictable consequence was a flood of EPDs in securitized loans. Bear assured its investors that they would diligently police EPDs, because these usually indicated a seriously defective
loan. In their presentations to Ambac, Bear Stearns had touted their aggressive followup to assert claims on behalf of investors if a securitized loan went bad soon after the close of a
securitization deal. The usual protocol was to buy back the bad loan from the investor and force the originator either to replace it with a good equivalent or to return the cash.

But you can’t keep a good investment banker from innovating, and in 2006 Bear Stearns came up with another bright idea, initiating a second scam. Whenever Bear Stearns learned of a loan
default, instead of repurchasing the defective loan, it made a cash settlement with the originator at a discount,
without informing the investors
of either the breach or the cash settlement.
So Bear kept the settlement cash, leaving the investors to discover the default later, which likely did not occur until after the investors’ contractual option to return the loan had expired.
When a Bear Stearns manager specifically asked her boss if the policy was to make settlements with lenders without checking for
violations of the representations and
warranties that Bear Stearns had made to the investors, she confirmed that it was.
¹²

At first Bear Stearns was overwhelmed by the flood of loan defaults, but it soon created a system to process them efficiently, generating $1.25 billion in settlements. Bear kept it all, and
investors later learned that they owned securities backed by thousands of loans that Bear had officially listed as defaulted. The entire EPD process and the cash gains from the settlements were
reported in detail to the most senior managers in the firm, so they were fully aware that investment agreements were being flouted and knew how bad the underlying loans were. Both the Bear Stearns
auditor and legal counsel eventually insisted on stopping the one-sided settlements, although it seems that they continued for some months after the order.
¹³

Underscoring that Bear managers well understood what they were selling, the deal manager on an August 2006 securitization called the deal a “shitbreather” and a “
SACK OF SHIT
”. In deposition, he said he intended those phrases as “a term of endearment”.
¹⁴

All of the investment banks tried to maintain an appearance of propriety for a combination of legal and sales reasons. So, like all of them, Bear Stearns did not entirely ignore due diligence on
the loans it bought, and as usual, had contracted with outside reviewing firms. But internal Bear Stearns e-mails mocked the low quality of the reviews, and managers consistently blocked proposals
for tightened reviews. The head of one of the reviewing firms said in deposition that in a 2006 review, up to 65 percent of his rejection recommendations were ignored. Another reviewer said that
about “75 percent of the loans that should have been rejected were still put in the pool and sold.”
¹⁵

In 2006 Bear hired a third outside firm to check a sample of loans that had already been securitized. The review was subject to strict limitations: do not count occupancy violations (i.e., a
declared prime residence not owner occupied); there could be no employment check; no credit report verifications; and no review of appraisals. Even with all those restrictions, 42.9 percent of the
sampled loans were found to be
in breach of the securitization conditions. Bear Stearns did not notify investors of those findings.
¹⁶

By mid-2007 the impending collapse of the subprime housing bubble was becoming apparent. This initiated the third phase of the mortgage unit’s strategy. Instead of warning customers and
investors, the unit went on an all-out drive to clear out its inventory—“a going out of business sale,” one manager called it. A rule against securitizing loans from suspended or
terminated lenders was summarily dropped, without this fact being disclosed. Verschleiser railed about one $73 million batch of loans, three-quarters of which did not meet securitizing guidelines.
He couldn’t understand “why any of these positions were not securitized . . . why were they dropped from deals and not securitized before their epd period.” And another senior
trader demanded to know “why are we taking losses on 2nd lien loans from 2005 when they could have been securitized?????”
¹⁷

In late 2007 Ambac managers became aware of the growing number of defaulted loans in the portfolios they had insured and requested a delivery of detailed loan files. Without telling Ambac, Bear
Stearns hired one of its outside credit reviewers to look at the loans. The review found that 56 percent had material breaches. According to Ambac’s lawyers, Bear did not share this
information with Ambac.
¹⁸

Then came the fourth phase of Bear Stearns’s mortgage strategy—one practised on a far larger scale by others, as we shall see. Verschleiser realized that as the bubble ended, the
resulting avalanche of loan defaults would have a catastrophic effect on Ambac, their insurer. Far from being a disaster, this was an enormous opportunity. Verschleiser realized that he could make
a fortune—
by betting on Ambac’s failure by shorting its stock
. As he recounted in his 2007 self-evaluation:

Bear Stearns took his advice, and by 2008 Verschleiser was consulting with other traders on other banks’ exposure to Ambac, so Bear Stearns could profit from its bad
loans coming and going. In fact, the worse the loans, the more money Bear Stearns made. In mid-2007 Bear Stearns stock peaked at $159 a share, its all-time record.

But all good things must end. On 16 March 2008, Bear Stearns was facing bankruptcy, and its board agreed to sell the company to JPMorgan Chase for $2 a share (later revised to $10 after
shareholder protests).

But if these guys were so good at obscuring the bad loans they were selling, why did Bear Stearns fail? At one level, the answer is simple: Bear Stearns ran out of money. It is very difficult to
forecast with precision the end of a bubble, or the exact rate at which various market participants—banks, rating agencies, investors, insurers, executives—will catch on. So Bear
Stearns got caught holding a lot of junk—bad loans, pieces of securitizations, stocks and bonds of other institutions also being decimated by the crisis—and couldn’t get rid of it
fast enough, at high enough prices, because everybody else was waking up (and going down the drain) at the same time. Moreover, like all the investment banks, Bear Stearns was very heavily
leveraged, dependent on huge quantities of dangerously short-term loans from money market funds and large banks. This funding needed to be rolled over weekly or even daily. When these funding
sources sensed trouble, they stopped lending, and Bear Stearns ran out of cash very fast.