Bear Stearns a Test of the Case Against Wall Street Government officials say the case against two former Bear Stearns hedge fund managers is vital: It will be a litmus test of whether they can prosecute Wall Street executives for some of the improprieties that took place during the mortgage meltdown.
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Bear Stearns a Test of the Case Against Wall Street

Government officials say the case against two former Bear Stearns hedge fund managers arrested Thursday is vital: It will be a litmus test as to whether they can prosecute Wall Street executives for some of the improprieties that took place during the mortgage meltdown.

The two former Bear Stearns hedge fund managers, Ralph Cioffi and Matthew Tannin, were arrested Thursday and charged with conspiracy, securities and mail fraud. Cioffi, 52, and Tannin, 46, represent the first high-level indictments made in what has been a yearlong FBI investigation into the mortgage crisis. The Securities and Exchange Commission also filed civil charges against the two men.

In the past, the arcane and complicated nature of financial transactions on the Street has made such prosecutions difficult, because juries simply don't understand how the trades work. Officials said they hope to simplify it enough in this case to pave the way for others.

Officials hope simple e-mail exchanges will help them do that. Cioffi and Tannin provided a real-time narration of their concerns in a roster of e-mails that federal authorities say prove the two conspired to mislead investors.

E-Mails Reveal Managers' Concerns

"The subprime market looks pretty damn ugly," Tannin wrote in one e-mail to Cioffi cited in the indictment. "If we believe [our internal modeling] is ANYWHERE CLOSE to accurate I think we should close the funds now."

While Tannin was known as the worrier in the group of investment managers who ran the High-Grade Structured Credit Strategies Fund and its riskier sister offering, the High Grade Structured Credit Strategies Enhanced Leverage Fund, the fund's senior portfolio manager, Cioffi, shared some of Tannin's concerns.

In March 2007, he got gloomy. "Matt said it's either a melt down or the greatest buying opportunity ever, I'm leaning more towards the former," Cioffi wrote, according to the indictment.

One of the hurdles for prosecutors will be proving that the two men intended to deceive their investors. And intention is hard to ferret out of e-mail communications.

The concerns the two men were expressing were not much different from those of investment professionals all over Wall Street at the time. The markets were incredibly volatile, and it was unclear in the spring of 2007 whether this was the beginning of a downturn of epic proportions or just a big correction.

Over the past year, banks and investment houses all over the world have had to write down some $400 billion in losses related to mortgage-backed securities. Cioffi and Tannin's emerging defense is that they were caught on the same side of a bear market as everyone else, and they shouldn't go to jail for being the first high-visibility fund managers to fail.

Publicly Upbeat, Privately Glum?

Federal authorities say they singled out the two men because, while they privately fretted about the future of the funds they were running, publicly, they presented a rosy picture to investors, and they lied about how much of their own money was at stake in the fund.

Case in point: The indictment says Cioffi told a Bear Stearns broker on March 7, 2007, that the funds were an "awesome opportunity"; privately, Cioffi worried about whether they would survive. To another investor a week later, Tannin said that he was going to add more of his own money to the fund.

"If you guys are in a position to do the same, I think this is a good opportunity," he wrote. He allegedly never added more of his own money to the fund.

Two days later, Tannin told an investor that he and Cioffi each had "about 40 percent of our non-real estate net worth in the fund. I am adding more this month." The 40 percent figure wasn't accurate, and Tannin didn't add more of his own money to the fund, prosecutors say.

What is more, the indictment claims that just days later, Cioffi transferred $2 million of the $6 million he had in the enhanced fund into a less risky vehicle. Cioffi never disclosed to outside investors that he'd done that. Prosecutors say the switch was further proof that Cioffi was putting his interests ahead of clients.

Bear Stearns and Cioffi's lawyers said that he moved the money to support another fund in which he was not previously invested and that he managed. In late April, the indictment says one investor tried to pull $57 million from the fund. Cioffi, trying to convince the investor not to do so, said that he himself had $8 million invested. In fact, he had half that much. Investors naturally like to hear that hedge fund managers have their own money invested in the fund, because it is seen as making them have more of a stake.

A little more than a month later, the funds — highly exposed to bonds that were backed by risky subprime mortgages — imploded. Investors lost $1.6 billion. FBI officials, who have been investigating the mortgage crisis for more than a year, said this wasn't just a case of fund managers making a bad call.

"This is not about mismanagement of a hedge fund investment strategy," said FBI Assistant Director Mark J. Mershon at one of several FBI press conferences Thursday. "It is about premeditated lies to investors and lenders."

A Challenge for Prosecutors

The case is far from a slam dunk. Prosecutors have tried to use e-mails against Wall Street officials and high-ranking executives in the past, and it has been hard for them to prove intent.

Take the case of Frank Quattrone, the investment banker who helped bring many tech companies public during the dot-com era. Prosecutors used Quattrone's e-mail to back up their charges that he obstructed a probe into how IPO stocks were distributed. A jury found Quattrone guilty, but an appeals court overturned the conviction.

E-mail evidence was also involved in the case against Citigroup telecom analyst Jack Grubman, also accused of misleading investors. E-mails and memos suggested Grubman upgraded his rating of AT&T in exchange for help with getting his kids into an exclusive Manhattan nursery school. But Citigroup settled with the Securities and Exchange Commission in April 2003, so the e-mail evidence was never tested at trial.

In a statement, Cioffi's lawyer, Edward J. Little, said the meltdown in the mortgage market affected all of Wall Street, not just his client. "Ralph Cioffi's funds lost money in exactly the same way," Little said. "Because his funds were the first to lose, [that] might make him an easy target, but doesn't mean he did anything wrong."

Tannin's lawyer, Susan Brune, echoed the sentiment, saying her client was being made a scapegoat for a much broader market crisis.

Cioffi is out on $4 million bail, secured by houses he owns both in New Jersey and Florida. Tannin's bail was $1.5 million. He put up his Upper West Side Manhattan apartment as collateral.