Tuesday, June 24, 2008
Guest Blogger Professor Peter Henning (Wayne State Law School & Blog Editor Emeritus):
Two former Bear Stearns hedge fund managers were paraded in handcuffs through Brooklyn while the FBI touted charges against 406 defendants for mortgage fraud. This must mean that those to blame for all the problems caused by declining home prices and mortgage foreclosures are finally being called to account – right? Unfortunately, it is only a crime to lie to the government, so don’t believe everything you hear about efforts to find a few scapegoats for the current economic problems in the housing market.
On June 19, Ralph Cioffi and Matthew Tannin were arrested at their homes and brought to Brooklyn to take part in an unseemly perp walk before a media throng hungry to give a picture for all that is wrong with the economy. At the same time, an FBI press release linked those charges to the inartfully named Operation Malicious Mortgage that has resulted in 144 mortgage fraud cases since March 1. These two events have absolutely nothing to do with one another, other than the fact that the government chose to announce them together, but it provides an opportunity for prosecutors to tout the "cop on the beat."
The indictment of Cioffi and Tannin at best is only coincidentally related problems in the mortgage market. The two hedge funds they manages into oblivion were heavily invested in securities tied to the subprime mortgage market, but that just happened to be the vehicle they chose – the could just as easily have invested in junk bonds or natural gas futures (think Amaranth Advisors and its $6 billion meltdown). The charges against them allege conspiracy, securities and wire fraud for what they told their customers, not what was done with the underlying securities.
The charges under Rule 10b-5 and the wire fraud statute (18 U.S.C. § 1343) require the government to prove more than just dissembling. Fraud is a type of larceny, so the defendants have to make misstatements or omit to disclose information to gain something from their victims. A false hope that the hedge funds would pull through, no matter how misguided, can be a defense to a fraud charge. Showing that Cioffi and Tannin were of two minds, or conflicted about where the market was headed, does not mean that their statements to investors were part of a fraudulent scheme.
As a Wall Street fraud case, the charges seem a bit thin to me. Hedge fund managers are essentially salesmen, touting their wares in much the same way that the man on the used car lot has a great deal for you. Tannin is accused of telling investors that he was investing more in the hedge funds when in fact he did not. When the car salesman tells you his daughter drives the same car and he wouldn’t put her in a shoddy vehicle, do you actually believe him? Perhaps credulity among the so-called sophisticated investors in hedge funds is higher than the caveat emptor every used car buyer must possess.
The indictment brings us interesting tidbits, like the vodka toast before Cioffi warned Tannin and others not to discuss the funds’ difficulties. Speaking of toast, Tannin wrote in an e-mail that "the subprime market is toast" yet only three days later said nothing of the sort to investors on a conference call. The fact that Wall Street salesmen talked out of both sides of their mouths is nothing new. Didn’t former Bear Stearns CEO Alan Schwartz go on CNBC a few days before the firm’s collapse and say he was not aware of any imminent threat to its liquidity?(see here) Whether Cioffi and Tannin are guilty of fraud remains to be seen.
Cioffi’s withdrawal of $2 million from one of the funds gives an economic motive that is otherwise missing from the alleged scheme. However, withdrawing your own money is not the type of theft one expects to see in a fraud case. The case against Cioffi and Tannin essentially charges them with crossing the line between aggressive salesmanship and fraud, but where is that line? Hedge fund managers whose assets are struggling had better be careful about what the do – and don’t – say lest they too be accused of defrauding investors who lose money. And, of course, be careful what you write in an e-mail.
Operation Malicious Mortgage, on the other hand, involves the classic type of fraud we’re used to seeing. [Personal aside: Who thinks up these stupid names? I’ve never heard of a mortgage being malicious, even if it does come back to bite you one day.] But the victims are not, for the most part, those who are suffering from foreclosures or underwater mortgages with ballooning principal balances. Instead, they are the banks, commercial lenders, and other creditors who got taken in scams involving false documentation and inflated appraisals for the most part.
There is an old adage that every generation thinks they discovered sex, and the same seems to be the case in the current mortgage fraud crackdown – this not a new type of crime. Does anyone remember the Savings & Loan Crisis, when the collapse of the real estate market brought to the surface any number of lending abuses? The fact that scam artists took advantage of the housing price bubble should not come as a startling revelation, and charging 406 defendants in a three-month period is a nice start but nothing to trumpet from the rooftops.
Mortgage-related fraud is a serious problem, in much the same way that insurance fraud and shoplifting causes all of us to pay higher prices. The FBI’s assertion in a press release that Operation Malicious Mortgage will help "to combat the threat mortgage fraud poses to the U.S. housing industry and worldwide credit markets" is more than a bit overblown. Even the billion dollar loss caused by the alleged mortgage frauds is surely just a drop in the bucket in the international credit markets.
Cioffi and Tannin risk becoming the poster children for a perceived crackdown on abuses in the mortgage markets, but the charges against them have virtually nothing to do with increased foreclosures and declining economic prospects for a number of Americans. Operation Malicious Mortgage shows the government’s concern with a type of fraud that raises the cost of home mortgages, but it will not make the lives of people who are losing their homes any better. But maybe we can all sleep a bit better at night knowing the cop is on the beat, ready to arrest corporate executives and parade them in handcuffs. Maybe.