“When will they start going to jail?”
That’s the question I’m frequently asked by friends, family, or just people who have watched me on CNBC and know I’ve covered the financial meltdown that has devastated the economy. These people believe, rightly I might add, that Wall Street’s greed, arrogance, and, possibly, fraud were the root causes of the banking crisis and for that Wall Street must be held accountable.
But the answer is hardly reassuring; to date there has been one formal case brought against Wall Street executives in connection with the implosion of the financial system—and it isn’t Bernie Madoff.
The actual “culprits,” as the government would have you believe, are Ralph Cioffi and Matthew Tannin, who ran two hedge funds for the now-defunct securities firm Bear Stearns. Their trial set to begin in September, and The Daily Beast has learned their plan is not to go down quietly; both are looking to fight the charges by pointing the finger at their old firm. In other words, they plan to put Bear itself on trial as a possible co-conspirator if any crimes were committed.
They will argue that any disclosure that they made in official company documents about the size and scope in the funds’ investment in risky mortgage bonds was approved by compliance officials and management as well.
Hedge funds like the kind Cioffi headed bought risky bonds tied to the housing market, so-called mortgage-backed securities known as collateralized debt obligations. For several years, the funds produced strong returns for investors, but when the housing market collapsed, so did the funds' value.
After the hedge funds went down, the prices of mortgage-backed securities began to decline significantly. Slowly but surely, investors came to understand that Cioffi wasn’t the only investor in this risky debt. As it turns out, the balance sheets of big banks like Citigroup, Merrill Lynch, Lehman Brothers, Bear Stearns, and even the mighty Goldman Sachs and Morgan Stanley held much of the same junk Cioffi had packed into his hedge funds, all under the noses of regulators, analysts, and, of course, investors—who thought their holdings of bank stocks were safe and secure when these institutions of high finance were actually being run by the financial equivalent of riverboat gamblers.
Like the Bear Stearns hedge funds, those risky holdings propelled shares of the banks to new heights, particularly during the first half of the decade when the profits of the big banks soared, as did the compensation of its senior management. In 2006, when the risk-taking reached its peak, Merrill Lynch CEO Stan O’Neal, Lehman Brothers chief Dick Fuld, and Jimmy Cayne, the CEO of Bear, each took home at least $40 million in compensation.
But the profits were a mirage—nothing more than a snapshot of an “asset”; in this case, volatile mortgage debt—that was destined to dissolve once the housing market corrected. All three of the CEOs just mentioned were forced to resign because of the meltdown, their firms forced to close down or, in the case of Merrill, sell itself before liquidation. And yet not one has given back even a penny of his enormous 2006 paycheck.
So it’s pretty hard to believe that Ralph Cioffi and Matthew Tannin are the only ones responsible for this financial Armageddon. Prosecutors allege that Cioffi misled investors in private meetings and in official documents to the funds’ ties to the risky mortgage-bond market. They have a suitcase full of allegedly incriminating emails showing that Cioffi and Tannin privately questioned their investment philosophy when they were telling investors the market for mortgage securities would come back.
But Cioffi and Tannin will argue that every disclosure they made was approved by Bear Stearns management; that compliance officials sat in on meetings with investors where these assurances were given and never raised an eyebrow. They will argue that any disclosure that they made in official company documents about the size and scope of the funds’ investment in risky mortgage bonds—the type tied to once-high-flying but now debilitated subprime loans—was approved by compliance officials and management as well.
“There were 540 people at Bear Stearns Asset Management,” said one person close to Cioffi’s defense team. Bear Stearns Asset Management was the unit of the big investment bank where the funds were located. “Now, obviously they weren’t all working on the funds. But there was a chief compliance officer, a chief risk officer, and they all knew what was in the fund and signed off on outgoing statements to investors. So if there was fraud, it would have to be a firm-wide deal.”
The trial should be a doozy, particularly if Cioffi and Tannin can rope in senior management at Bear, which this source says is an option. Keep in mind, the Justice Department had been loath to issue firm-wide indictments following widespread criticism of its indictment of Arthur Andersen, Enron’s auditor back in 2003. That case led to big job losses because Andersen, like Drexel Burnham in the 1980s, was forced to liquidate, as would have Bear Stearns if it had been indicted before becoming the first casualty of the financial crisis, essentially liquidating itself in March 2008. But with Cioffi possibly telling the world his supervisors were involved in a larger fraud, it would have been hard for prosecutors to ignore the larger crime.
I can’t tell you whether Cioffi’s defense could or should work. Cioffi and Tannin have both pleaded not guilty, so presumably they will also argue they did nothing wrong. And even if it turns out the Bear Stearns compliance department gave the OK to blow smoke up the rear ends of investors doesn’t mean Cioffi should have been blindly following orders, or looking for ways to spin the truth within the confines of what a couple of dopey compliance officers think is proper.
What I can say with complete certainty is that even if every charge against Cioffi and Tannin are proven in court, a bigger scandal is going unpunished, and seemingly ignored by regulators. Put simply, every major Wall Street firm misled investors about its business model before the financial crisis hit in late 2007, and investors began to see how the Wall Street business model devolved into a high-stakes gambling den. The deception not only led to massive losses for those holding the stock of the financial companies, but it can be blamed for the credit crisis and the severe recession it has unleashed.
Wall Street firms finance their operations through “leverage” or borrowing; since at least the early 1990s, that borrowing was huge. Leverage is like an air pump—it literally pumps up profits when the markets rise, but when investments turn sour just the opposite occurs, massive losses and possible collapse. The riskier of those allegedly fraudulent Bear Stearns hedge funds was leveraged 12-to-1, meaning it borrowed $12 for $1 it had in capital or cash. Yet, the typical Wall Street firm would borrow about $25 for every $1 it had in capital before the financial meltdown. Some firms like Lehman Brothers and Bear Stearns had borrowed $30 or more for every $1 in capital, yet where was the disclosure? Where were the regulators?
Even worse were the securities that the Street was leveraged with: the same risky mortgage-backed securities that were found in the Cioffi-Tannin hedge funds. Now consider this: For nearly a year before the firms confessed to holding tens of billions of dollars in this illiquid mortgage debt, they assured the world that their exposure was minimal. Merrill Lynch was possibly the most egregious of the lot, pointing out in repeated public disclosures through the summer of 2007 that its holdings were hedged with insurance and other means. By the end of October, Merrill finally woke up and realized that those hedges were anything but—the firm was bleeding red ink, and had to account for tens of billions of dollars in losses, which in the following year forced the firm to sell itself to Bank of America.
But not before the damage was done. Investors who bought and held onto Merrill stock when company said its finances were strong took massive losses when the truth came out, losses that dwarf anything produced by the Bear Stearns hedge funds, not to mention the damage done to the financial system as a similar scenario played out at Citigroup, Lehman Brothers, and Bear Stearns. Bear kept on assuring investors that its hedge funds were separate from the larger firm, which it said was financially sound nearly up until the day it imploded in March 2008.
I don’t know if that constitutes the legal definition of fraud, but it should.
Sources tell The Daily Beast that the Securities & Exchange Commission had begun to snoop around a year ago on the larger issue of whether Wall Street as a whole misled investors about its massive leverage and massive investment in the very securities that brought down the financial system. Merrill came under particular scrutiny, according to people with knowledge of the investigation, and, according to one source, so did Citigroup.
But then the investigation seemed to peter out; former Merrill executives who were slated to speak to regulators had their appointments canceled, and their lawyers haven’t heard from regulators for months. Maybe the SEC and the Justice Department have bigger fish to fry, like Ralph Cioffi and Matthew Tannin.
Charles Gasparino is CNBC's On-Air Editor and appears as a daily member of CNBC's ensemble. He is a columnist for the Daily Beast and a frequent contributor to the New York Post, Forbes, and other publications. His forthcoming book about the financial crisis, The Sellout, is scheduled to be published later in 2009.