Corporate Governance

From the Pages of The Pomerantz Monitor: Suspicions Grow Over the Demise of Bear Stearns

By Carolyn Moskowitz

In the September issue of The Pomerantz Monitor, Adam Prussin reports on growing suspicions over the demise of Bear Stearns. In July, SEC chief Christopher Cox told Congress that the Commission was investigating whether illegal trading spurred the collapse of Bear Stearns and the near collapse of Lehman Brothers earlier this year. The Commission has received trading information from Bear Stearns and has served subpoenas on a slew of other investment banks and hedge funds. Now that some of this information is surfacing, the stench is getting stronger.

Bear Stearns closed at around $30 per share on Friday, March 14, after dropping $27 per share that day. The firm totally collapsed over the weekend and was sold to JPMorgan Chase for $2 per share on March 17 (later raised to $10).

Investigators have discovered that, just days earlier, major bets were made that the bottom was about to fall out from under Bear Stearns. On March 11, when Bear stock was trading at around $63, someone purchased $1.7 million worth of Bear Stearns ?put? options for 5.7 million shares at a price of $30 and another 165,000 shares at $25. These put options were scheduled to expire only 9 days later. This trader was betting big that Bear?s stock would drop by over half within the next few days.

Three days later, on March 14, the CBOE listed a series of new Bear put options that would expire in less than five days. One was for 630,000 shares at a price of $5, a price 90% below the current trading price. As one expert observer was quoted as saying,  ?nobody in [his] right mind would buy that put unless [he] knew what was going down.? Another expert said that ?when you buy $5 strikes when the stock is trading over $50, you either have to be manipulating, or you have to have insider information.?

Put volume also jumped that week: on March 7, 32,081 put options were traded; on March 11, 237,700; and on March 14, 445,635. Almost all of these options were at prices way below Bear Stearns? current market price. Also during that week, failed trades in Bear Stearns stock soared to 2.1 million from 19,424 the prior week. Failed trades often occur when investors engage in ?naked short? selling.

When a trader shorts a stock, he will typically borrow the shares from a financial institution and sell them at the current market price. If the stock price then falls, the trader profits by purchasing the stock later, at the lower price, for return to the lender. A naked short occurs when the trader sells shares that he does not own and has not borrowed, hoping to buy them later in the market in time for settlement of the sale. If too many people do this, there won?t be enough shares around to ?cover? the short positions, and the trades will fail. While shorting stock is legal, naked shorting may not be.

During that same week, the market was flooded by rumors that Bear Stearns was running short of liquidity (i.e., cash). On March 10, CNBC reported the rumors, fanning the flames even higher. The company publicly announced that the rumors were untrue, and that it had a cash reserve of $18 billion, more than enough under normal circumstances. But it was too late. The stampede out of Bear Stearns was unstoppable, and the $18 billion cash reserve was consumed almost overnight. The rumors of liquidity problems had become a self-fulfilling prophecy.

So we have a remarkable coincidence: a sudden explosion in short sales and transactions in put options, accompanied by a sudden avalanche of negative and largely baseless rumors. One estimate is that the investors who bought these deeply discounted puts in the weeks before Bear Stearns? demise sucked up about $274 million in instant profits. A coincidence? A stroke of incredible luck? Of incredible foresight?

If the SEC can connect the dots, showing that the investors who made those bets were also responsible for the market rumors that brought Bear Stearns down, it could be one of the most brazen financial crimes ever.

Full post as published by PomTalk on August 26, 2008 (boomark / email).