Why the New Bear Stearns Lawsuit Matters

This morning, Teri Buhl provided an explosive piece of reporting on a newly unsealed lawsuit that accuses Bear Stearns of flagrantly cheating its clients through mortgage securities. The alleged behavior described is disgusting. If you haven't read the post yet, you should -- the shenanigans its describes are incredible. The suit may be the closest thing we've seen yet to a smoking gun related to Wall Street misdeeds leading up to the financial crisis.

By now, there's little doubt that much of the public has become numb to these kinds of stories. Many Americans already consider Wall Street bankers crooks anyway. That's a shame, because these allegations are very different from anything else we've seen thus far.

Take, for example, the infamous Securities and Exchange suit against Goldman Sachs from last spring that was ultimately settled. Like the Bear lawsuit, SEC v Goldman included e-mails where bankers gloated about all the money they were making thanks to the suffering of their clients and even suggested an intent to sell toxic securities to their customers. But none of that was clearly fraudulent -- just questionable ethically. Stupidity is legal, and if investors have complete and accurate information to make their own decisions, but buy a stinker anyway, then that's their fault.

The Goldman suit was a stretch. Even if you assumed the SEC's facts were all accurate, it wasn't crystal clear that the bank actually misled its clients. Certainly, it didn't tell them everything it knew about the transaction, but it's not clear it should have provided the information that the SEC believed was material, which was mostly just the name of the investor on the other side of the trade in question. There was never any assertion by the SEC that the data Goldman provided was inaccurate, or that explicit fraud had somehow occurred.

That's why the new Bear lawsuit is different. It has both such claims. First, Ambac alleges that Bear failed to honor the covenants of the bonds it backed. The lawsuit brief claims that Bear put loans into these securities before the the deal's transaction documents said the firm were allowed to do so, based on the loans' ages. And when Ambac and others demanded they buy back the loans that went bad -- as required by the deal terms -- Bear refused to do so.

Second, the alleged double-dipping scheme would be explicit fraud. According to the suit, Bear was first selling loans to investors through securitization. Then, whenever those loans went bad (which was more often than not) it would sell those loans (which it didn't actually have ownership rights to) back to the loan originators at a deep discount. Bear should have been providing the cash it got from those put-backs to the investors who owned the bonds backed by those loans. According to Ambac, Bear pocketed the money instead, inflating its profits.

The good news is that both of these strong accusations should be relatively easy to prove, if evidence hasn't been destroyed. For the first charge, the deal docs should be readily available to check the loan criteria, and the loans' ages at the time of transfer should also be easy to ascertain. Regarding the second allegation, there should be some record of Bear obtaining proceeds from loan putbacks. If that cash never made its way to the investor trust where it belonged, then fraud occurred.

If it turns out that these allegations do have merit, and from the legal brief there certainly appears to be some credible evidence the plaintiff has already gathered, then a criminal investigation should certainly follow. Any bankers or traders associated with such behavior should lose their license and face jail time. As Buhl's article explains, however, some of the most senior bankers allegedly involved in this scheme now hold prominent jobs at firms like Goldman Sachs, Bank of America, and Ally Financial.