Bissinger's Securities and Finance for Trial Lawyers

Good interview of Hedge Fund Manager William Ackman

Click here for an excellent interview with hedge fund manager on the credit crisis.

Morgan Stanley's Snowballs

arFor an interesting type of investment -- and a lawsuit over them -- see the attached complaint.  Download SnowballNotes.pdf   Snowball notes are “hybrid investments” or “structured securities” combinations of straight debt instruments and derivatives.  They are sold as bonds with their own CUSIP numbers.  Their interest payments are tied to the London Interbank Offered Rate. Plaintiffs claim Morgan Stanley systematically defrauded them by false and misleading offerings and failing to disclose material information.  Apparently, Morgan Stanley sold $210 million of “inverse-ratchet snowball notes” in September and October 2004 alone.

Central Bank Intervention, the Credit Crisis, and Bond Data

Professor Becker and Judge Posner have posted an illuminating exchange of comments on their blog questioning the wisdom of the intervention of the U.S. Federal Reserve and other banks in increasing liquidity in the current credit crisis.

Judge Posner's citation to a 2005 Economist story regarding the housing boom probably reminds most of his readers of their awareness of the housing boom at that time. Savvy analysts began to question the financing of the housing boom back then, but one wonders if more information about the relatively opaque bond market (which includes the complex debt derivatives at the heart of the crisis) might have helped avert today's crisis.

Despite the power of the internet, the public has little access to information about mortgage-backed bonds and bond prices.  This stands in contrast to stock price data and public company disclosures, which are widely available at low cost.  Bond data resides in Bloomberg terminals and other proprietary databases that cost around $1500 per month per user. 

Cheaper access to information about collateralized debt obligations, collateralized mortgage obligations, and other derivatives might have led to more rigorous study of these instruments in Congress, academia, the press, and trials and arbitrations.  The costs of dissemination could be charged to industry participants who benefit from participating in these markets.  These costs would seem nominal compared to the costs of imploding hedge funds, collapsing lenders, and central bank intervention.  Saving the stock market from a steep decline and the economy from a recession would be icing on the cake.

In any event, most people agree that free flow of market information lies at the heart of free enterprise in general and the securities industry in particular.  Meanwhile, astute observers question the rating agencies that awarded investment-grade designations to many debt instruments.   

Yet even sophisticated investors have limited ability to scrutinize those ratings.  Perhaps wider availability of bond price data and other metrics would have helped raise questions sooner.

Suits Against Bear Stearns Mulitiply

Bear Stearns faces litigation on several fronts.  Investor advocate Jake Zamansky has initiated at least one  arbitration claim before the former National Association of Securities Dealers, now known as the Financial Industry Regulatory Authority, or FINRA, as reported on CNBC.  At least one institutional investor has initiated legal action against Bear Stearns for losses arising out of its hedge funds.

British banking giant Barclays may bring suit, too, for losses arising out of its investment in Bear Stearns Asset Management's High-Grade Structured Credit Strategies Enhanced Leverage Fund. 

Defense law firms have formed various practice groups to address the subprime mortgage crisis.  According to the Wall Street Journal, Paul Hastings, Patterson Belknap, and Pillsbury Winthrop have all announced formation of teams for this purpose. 

CMOs on Margin, the Collapse of Brookstreet Securities, and the Potential Role of NFS/Fidelity

June 2007 witnessed the failure of a broker-dealer that specialized in trading collateralized-mortgage obligations ("CMOs") on margin.  See Bruce Kelly, "Brookstreet Clients, Counting Losses, Ponder Arbitrations," Investment News, July 9, 2007. 

Published reports indicate that Brookstreet sold clients volatile species of CMOs known as "interest only strips" and "inverse floaters."  These CMOs behave much like the margined investments.  In comparison to less volatile types of CMOs, these instruments deliver compounded returns -- and compounded losses.

A brokerage firm selling inverse floating CMOs on margin would compound that risk even more.  That's what many believe happened at Brookstreet.  Reports indicate that Brookstreet sold these investments, on margin, to elderly and/or unsophisticated investors.  When the CMOs declined in value, these elderly investors suffered not only major losses, but became indebted on their margin interest.  That's generally not the kind of thing firms should be selling to elderly or unsophisticated investors.   

Because many of Brookstreet's brokers operated out of their homes, it's doubtful that Brookstreet brokers did a lot of business with large institutional purchasers for whom these high-risk securities are best suited.

Games may also have been played with the valuation of Brookstreet's CMOs that hurt investors even more by overvaluing the CMOs at the time Brookstreet sold the investments, but undervaluing the CMOs in making margin calls.  This would be like a homebuilder loaning money based on an overvalued house and thereby creating a larger monthly note.  But when the borrower defaults, the homebuilder/lender grossly undervalues the house at foreclosure, leaving the borrower with jumbo liability but shrunken collateral. 

According to a major defense-oriented law firm, that's may have happened at Brookstreet.  In July, Holland & Hart posted an extraordinary blog post criticizing not only Brookstreet, but also its clearing firm, NFS -- owned by Fidelity -- for possible manipulation of the values of the CMOs that Brookstreet sold to retail investors.  See "Brookstreet Securities Collapse: Where Were the Regulators?"   

That sort of conduct could expand the scope investor recovery beyond the failing Brookstreet to the well-heeled NFS/Fidelity. 

What Are CDOs?

The financial press reports delay on the subprime debt crisis and the role of collateralized debt obligations ("CDOs"), collaterized loan obligations ("CLOs"), and many other forms of structured finance.  CDOs encompass most of the other types of debt instruments.  Structured finance experts treat CLOs, CMOs, and so forth as types of CDOs.

CDOs work like mutual funds, except CDOs issue fractional interests in the form of bonds, not shares.  So CDOs are bonds made up of bonds (or other debt obligations like loans, mortgages, and so on).    CDOs will issue bonds to bondholders, and the issuers use the money the bondholders pay to build a portfolio of underlying debt obligations.

For a helpful overview of CDOs from a debt securities analyst, see Nomura Fixed Income Research, "CDOs in Plain English" (2004), http://www.vinodkothari.com/Nomura_cdo_plainenglish.pdf.