WASHINGTON — With their arrest Thursday on a nine-count indictment, two former investment fund managers for banking titan Bear Stearns are now the public face of the nation's mortgage finance meltdown.
FBI agents made the first high-level arrests of Wall Street executives in connection with the nation's sub-prime meltdown, parading the handcuffed fund managers in front of cameras as the sun came up over Manhattan.
The U.S. Attorney's Office in Brooklyn brought the securities and wire fraud charges against Ralph Cioffi, 52, and Matthew Tannin, 46, respectively the founder of two Bear Stearns hedge funds for ultra wealthy investors and the funds' manager. The two were also charged with conspiracy, and the Securities and Exchange Commission brought civil charges against the pair Thursday.
The indictment alleges the two deceived investors into believing the hedge funds, which held special mortgage bonds that were backed with now-toxic sub-prime home loans, were healthy when they knew clearly they were not. The end result was that well-heeled investors like the one described in the indictment, Major Investor #1, collectively lost more than $1.5 billion.
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"Hedge fund investors, like all investors in our national markets, are entitled to rely on those to whom they entrust their investment dollars," Benton Campbell, U.S. attorney for the Eastern District of New York, said in announcing the charges. "Honesty and fair dealing are at the foundation of this relationship of trust and confidence. These defendants chose to breach that trust, and they will now be held to account."
The indictment reads like a Hollywood script, citing e-mails in which the defendants allegedly concur that the "sub-prime market looks pretty damn ugly" and speculating that the entire market for sub-prime loans — which are given to the borrowers with the weakest credit histories — was "toast."
Despite that assessment, the pair allegedly told investors the market downturn was an "awesome opportunity" to buy, when in fact Cioffi transferred $2 million of his own money out of the fund, allegedly without disclosing that to investors who believed the pair had their own money at stake, too.
"The Bear Stearns indictments present a remarkable trail of emails regarding what the Bear Stearns managers knew, when they knew it, and what they told investors. The tale the alleged emails tell, if true, should make an investor's blood run cold," Kurt Eggert, a law professor at Chapman University in Orange, Calif., said in a written analysis of Thursday's indictment.
Although the case involves rich investors losing big sums, it has a great importance for ordinary Americans. It's a milepost in an unfolding national saga.
The collapse of the Bear Stearns hedge funds was the opening act of today's economic crisis, marked by the worst housing slump in modern times and a credit crisis gripping the banking sector that's crushing consumer lending and seems far from over.
At the core of today's economic slowdown are the sub-prime mortgages that were underwritten for virtually anyone, citizen or not, with a pulse. These began souring in 2006, reaching a crisis point in spring of 2007, and today are the reason for record foreclosures and mortgage delinquencies.
The indictment alleges that on March 3, 2007, Cioffi warned Tannin that "the worry for me is that sub prime losses will be far worse than anything people have modeled" in their risk assessments.
That comment proved prophetic. U.S. and foreign banks have been forced to write off more than $300 billion in bad loans. Some financial experts fear the worst is still ahead if other types of lending like credit cards and car loans begin to experience growing default rates.
In the aftermath of the collapse of the two Bear Stearns hedge funds between June and August 2007, it became clear that problems in mortgage finance — and lending more generally — were far deeper than virtually anyone could have imagined.
On March 16, in an unprecedented move, the Federal Reserve brokered the fire sale of Bear Stearns to JP Morgan Chase. The Fed feared that an investor run on Bear Stearns could have sparked a wider run on the banking system and led to a global financial collapse.
That's why the images of handcuffed Wall Street executives took on greater significance Thursday. The savings and loan crisis of the 1980s had villains like banker Charles Keating, the collapse of energy giant Enron Corp. had the unsympathetic CEO Kenneth Lay, and now the sub-prime meltdown has Cioffi and Tannin.
Lawyers for the two fund managers cried foul.
"Matt Tannin is innocent. He is being made a scapegoat for a widespread market crisis," Susan Brune, a defense attorney, said in a statement.
Cioffi's attorney said in a statement that the Federal Reserve and the Treasury Department were caught off guard by the sub-prime crisis, and his client was swept up in the same downturn that caught competitors and regulators by surprise.
"Ralph Cioffi's funds lost money in exactly the same way. Because his funds were the first to lose might make him an easy target but doesn't mean he did anything wrong," said attorney Ed Little.
FBI Director Robert Mueller told reporters in Washington on Thursday that authorities have 19 ongoing investigations into Wall Street firms, with an eye toward fraud, deception and accounting irregularities.
Federal authorities are known to be looking at credit-rating agencies like Moody's, Standard & Poor's and Fitch Ratings, investigating whether they failed to properly police the companies whose financial instruments they were rating.
Legalities aside, financial markets have already doled out broad punishment.
The largest underwriters of troubled sub-prime loans — New Century Financial Corp. and Ameriquest Mortgage Co. — are bankrupt. The company that bought up a lot of the assets of dying sub-prime lenders — Countrywide Financial — is being absorbed by Bank of America, which in turn just booted its CEO because its stock is slumping due to the deeper foray into mortgage finance.
The investment banks that took these sub-prime loans and turned them into mortgage bonds have also been punished. Bear Stearns was sold to JP Morgan Chase and Lehman Brothers is perceived on Wall Street as on the verge of being forced into a similar sale.