Corporate & Securities Law

Securities fraud, 10b-5: 

Material Misrepresentation, 

a textbook example.

• WALL STREET BANKERS SAID THEIR COMPANIES WERE IN 'THE MOVING BUSINESS, NOT THE STORAGE BUSINESS.'  NOT QUITE.

Translation?  For so many years, investment banks thrived by transferring risky assets off their balance sheets as fast as they could.  During the housing and credit bubbles, Bear Stearns, Lehman Brothers, Merrill Lynch, Morgan Stanley and others entered the storage business in a big way.  Then, one by one, the investment banks died.

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• Intermediary Role Abandoned

For the majority of its successful run, the Wall Street investment banking model was based on a simple rule. Investment banks were NOT investors. They were intermediaries. They brought sellers and buyers together. This means that investment banks did not hold risky securities on their balance sheets any longer than was absolutely necessary. In "Wall Street-speak," i-banks liked to say they were in the moving business, NOT the storage business. 

During the credit / housing bubble, most of the former investment banks got into the storage business in a big way. They drank their own cool aide, buying high risk mortgage-backed securities, cdos, and related instruments for their own proprietary trading accounts. The investment banks stopped acting as intermediaries, and started acting as buyers and sellers. This was one of two major reasons why Bear Stearns, to cite one example, wound up with a balance sheet clogged with illiquid toxic waste. 

The other reason Bear Stearns ended up with a huge volume of mortgage-backed securities and related products was greed. Bear Stearns was so determined to milk every penny of profit from the bubble that it built up a massive inventory of mortgages to feed into its securitization machine. When the market froze, Bear Stearns was stuck with tons of loans. Bear Stearns also had a huge portfolio of mortgages it securitized but could not sell before demand for mortgage-backed securities completely disappeared. In short, Bear Stearns was left holding the bag. 

The principle of risk transference required the former investment banks to get rid of virtually all securities (except securities that are considered "cash equivalents") as rapidly as possible. Once the investment banks got rid of the mortgage-backed securities they produced - and collected fat fees - they no longer had to worry about default. The risk of default would be fully transferred to investors. On Wall Street, this is how it was supposed to work. At some point, the enormous fees from acting as an intermediary were insufficient to satisfy Wall Street executives. If Wall Street had stayed in the moving business, the meltdown of the investment banks would have been far less severe. Instead, investment banks violated their cardinal rule. They got into the storage business in a big way, and we all are paying the price.