RISKY BUSINESS IS (usually) OK IF CLEARLY DISCLOSED TO INVESTORS.
HOWEVER, MATERIAL MISREPRESENTATIONS ABOUT RISK APPETITE and APPROACH TO RISK MANAGEMENT are a whole different story...
By Brett Sherman, The Sherman Law Firm
Deception is the essence of fraud. Bear Stearns deceived investors (and the markets generally) about crucial facts, including (a) the firm's management philosophy and approach to risk management, (b) performance of Bear's core mortgage businesses, and (c) the financial condition of the former investment bank.
Today, Wall Street Law Blog looks at one aspect of fraud at Bear Stearns - The Executive Committee lied time and again about risk management at the former investment bank.
Risk Management LIES:
Please note that time and space limitations require us to list only a few material misrepresentations. But we assure you that we can, if necessary, go on for hundreds of pages and thousands of years (a little hyperbole is ok now and then)-
- The risk management infrastructure and processes remain conservative and consistent with past practices. This structure and strong risk management culture has allowed the firm to operate for all of its history as a public company without ever having an unprofitable quarter.
- By maintaining a strict approach to risk, and by allocating capital wisely, we have achieved one of the lowest levels of trading revenue volatility on Wall Street. At Bear Stearns, we know we cannot predict the future, but mitigating the risks ahead this part of the foundation upon which this firm was built...
- True to our culture, we continue to search for ways to run our business more efficiently, always balancing risk and reward.
- Our commitment to excellence and measured approach to balancing risk and reward has kept Bear Stearns focused...We continue to avoid short term trends by staying focused on the long term strengths of our businesses.
- Our culture of risk management -- I just want to emphasize it is central to everything we do...So, risk management comes first and then growth.
- The philosophy of creating value over the long term also drives our approach to product innovation and entering new businesses... This philosophy is evident in the disciplined approach we take to managing the firm's risk...
- We're very proud of the way we do risk management. It's an integral part of our culture
- dedication to risk evaluation and management that has given us the ability to expand carefully and conservatively.
- The strict risk discipline imposed on our trading desks is reinforced by the strong sense of ownership that permeates the culture of the corporation.
- You can expect us to continue to adhere to our core values, including this consistent and deliberate approach to risk...
As noted, above, we could go on and on and on.
Risk Management TRUTHS:
AT THE SAME TIME BEAR STEARNS WAS BUSY REASSURING INVESTORS HOW GREAT THE FIRM WAS AT MANAGING RISK, SENIOR MANAGEMENT KNEW BEAR'S RISK MANAGEMENT SYSTEM SUCKED.
THE EVIDENCE (some of it)
February 4, 2008 - internal Bear Stearns email to members of Bear's management committee, with reminder of meeting with outside consulting firm Oliver Wyman and attached risk presentation entitled: "RISK GOVERNANCE DIAGNOSTIC, RECOMMENDATIONS, AND CASE FOR ECONOMIC CAPITAL DEVELOPMENT PLAN"
(Note - For brevity, Wall Street Law Blog made an editorial decision to post only a few pages from the actual presentation).
Really, the slide called "Gaps in Risk Management" - reproduced below - says it all.
On that slide, consultant Oliver Wyman described a risk management system that was about as bad as it gets. Some of the risk management lowlights, according to the Wyman Report-
- Bear Stearn's did not have any formal system for determining the company's risk-appetite. It seems to us that it just may be kind of hard to manage risk when there is no guidance about how much risk a business is willing to assume.
- No uniform requirements or system for approval of trades.Again, it sure seems like a firm with 15,000 employees would need formal systems for things like trade approvals.
- Risk management personnel frequently had little advance notice of proposed transactions. Worse, Bear's traders and business desks apparently did not feel compelled to provide very much information to the firm's risk managers.To us, this suggests that few people really wanted input from Bear's risk managers.
- Bear's internal risk limits were often ignored or overridden by management without regard for additional risk exposure. To us, this suggests that risk limits were put in place to placate regulators rather than to actually manage risk.
- Bear Stearns had no formal policies or procedures to evaluate risks of its business operations. Oliver Wyman used the term "ad hoc" to describe how Bear made strategic risk decisions.
- Risk management personnel at Bear Stearns lacked "stature" (i.e., respect and authority). They were second class citizens with little influence over actual business practices.
In sum, Bear Stearns management did not articulate a risk-appetite for the company (or at least no specific guidelines for risk tolerance were communicated throughout the company); Bear Stearns did not listen to or respect its risk managers; Bear Stearns had no formal procedures for risk managers or business units to follow; and there was no real methodology for making risk management decisions.
Other slides from the presentations show that Bear had poor channels of communication regarding risk-taking and no effective plan for matching capital to risk (i.e., Bear did not determine its capital needs based on its risk exposures) -
FEBRUARY 3, 2008 BEAR STEARNS EMAIL, AND PORTIONS OF OLIVER WYMAN RISK DIAGNOSTIC REPORT:
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CONCLUSION
The Wyman Report is an exhibit introduced by the Financial Crisis Inquiry Commission during the FCIC's May 5-6, 2010 FCIC hearing dates. In May, five former Bear Stearns senior executives gave testimony before the FCIC (FCIC.gov), about the shadow banking system and the collapse of Bear Stearns.
In a recent post, Phil's Stock World reacted to the hearings so perfectly that, despite our best efforts, Wall Street Law Blog could not top Phil's summary. So, with all due credit given, we excerpted part of the post. Phil's Stock World pointed out that, during their testimony, Bear's former honchos seem to have blocked out some relevant stuff, including:
[Bear's ] insanely high leverage (up to 42:1), large holdings of MBS, poor risk management, and overnight borrowing from the repo market ($50 to $60 billion) had nothing to do with their collapse. They did nothing wrong and were the victims of a conspiracy of evil traders who seized upon their temporary lack of liquidity and sent them over the edge when investors irrationally lost confidence. Talking about an alternate universe, these folks should be sent to St. Helena to think about cause and effect for a while. Jimmy Cayne would probably just play bridge there.
The post from Phil's (you can read the rest here) had us hooked at "St. Helena." Wall Street Law Blog is always a sucker for allusions to exiled French emperors. But we digress.
Bottom line here - Bear Stearns deliberately promoted a supposed commitment to high quality risk management that, during the 2000's at least, was a total fiction. In other words, Bear Stearns constant touting of its risk management prowess was material and false.
Our favorite synonym for material misrepresentation is a word we like to call fraud. And - as we will show in future posts - Bear's fraud went much deeper than its false claims about risk management.
