Bringing Down Bear Began as $1.7 Million of Options
By Gary Matsumoto
August 11, 2008
On March 11, the day the Federal Reserve attempted to shore up confidence in the credit markets with a $200 billion lending program that for the first time monetized Wall Street's devalued collateral, somebody else decided Bear Stearns Cos. was going to collapse.
In a gambit with such low odds of success that traders question its legitimacy, someone wagered $1.7 million that Bear Stearns shares would suffer an unprecedented decline within days. Options specialists are convinced that the buyer, or buyers, made a concerted effort to drive the fifth-biggest U.S. securities firm out of business and, in the process, reap a profit of more than $270 million.
Whoever placed the bet used so-called put options that gave purchasers the right to sell 5.7 million Bear Stearns shares for $30 each and 165,000 shares for $25 apiece just nine days later, data compiled by Bloomberg show. That was less than half the $62.97 closing price in New York Stock Exchange composite trading on March 11. The buyers were confident the stock would crash.
``Even if I were the most bearish man on Earth, I can't imagine buying puts 50 percent below the price with just over a week to expiration,'' said Thomas Haugh, general partner of Chicago-based options trading firm PTI Securities & Futures LP. ``It's not even on the page of rational behavior, unless you know something.''
The 57,000 puts that traded March 11 at the $30 strike price and the 1,649 that traded at $25 were collectively worth about $1.7 million, Bloomberg data show. Each put is equal to 100 shares of stock.
``That trade amounted to buying a lottery ticket,'' said Michael McCarty, chief options and equity strategist at New York-based brokerage Meridian Equity Partners Inc. ``Would you buy $1.7 million worth of lottery tickets just because you could? No. Neither would a hedge fund manager.''
During the next four days, New York-based Bear Stearns unraveled in the swiftest investment-banking failure in Wall Street history. Speculation about a cash shortage proved self- fulfilling, causing customers and lenders to demand their money back. Bear Stearns's stock sank 47 percent to $30 on Friday, March 14. That's when the Fed moved to stave off a panic by helping the U.S. Treasury arrange JPMorgan Chase & Co.'s purchase of the company for $2 a share, a price unimaginable to the firm's 14,000 employees.
Wall Street Seizure
In the aftermath, Bear Stearns Chief Executive Officer Alan Schwartz told Congress that the firm was toppled by rumor- mongering and abusive trading. Regulators have begun peeling back trading records, hunting for suspects.
Schwartz and officials at the SEC declined to comment for this story.
The fire sale of Bear Stearns was the climax of a nine- month credit seizure that started with the failure of two Bear Stearns hedge funds, caused more than $490 billion of losses and writedowns in the banking and securities industry and ousted the CEOs of Citi group Inc., Merrill Lynch & Co., and UBS AG. Never in its 95-year history had the Fed done so much to rescue Wall Street during its worst financial crisis in at least two decades.
Evidence of any scheme to bring down Bear Stearns is most likely buried in options data, according to former government investigators. Options, contracts to buy or sell shares by a certain date at a specific price, can offer forensic evidence of market manipulation and insider trading, said Brent Baker, a former U.S. Securities and Exchange Commission Enforcement Division lawyer who helped prosecute Anthony Elgindy, the stock- picker convicted in 2005 on 11 counts of securities fraud, wire fraud, extortion and racketeering.
``On CSI Wall Street, the options are the DNA,'' he said, referring to the television series, ``Crime Scene Investigation.''
While Bear Stearns executives tried to quash rumors about the firm's insolvency with press releases and television appearances by its CEO Schwartz, the number of $30 Bear Stearns put options held by speculators soared 10,768 percent from Monday March 10 to Tuesday March 11, Bloomberg data show.
On March 11, when the Fed said it planned to make up to $200 billion available through weekly auctions and for the first time lend cash in exchange for debt that included the devalued mortgage-backed securities that contributed to the credit seizure, one or more unidentified traders requested the Chicago Board Options Exchange list the even deeper out-of-the-money strike at $25.
Stock in Freefall
Bear Stearns also was rocked that week by failed trades, a problem associated with naked short selling. Failed trades in Bear Stearns soared more than 10,800 percent during the week of March 10, according to data released by the SEC.
Bear Stearns fell 11 percent to $62.30 in the first trading day of the week on speculation that the firm had insufficient liquidity, or enough funds to cover any sudden withdrawals. The 58-year-old Schwartz, who was in Palm Beach, Florida, at an industry conference, was puzzled by the rumors, according to people who talked to him. He was told by associates that the firm had no shortage of cash. Clients weren't pulling their money, trading counterparties weren't refusing to do business with Bear Stearns, and short-term credit lines weren't being cut.
To quell the speculation, the company issued a two- paragraph statement at the end of the day, saying its financial position was ``strong.''
Hedge funds, concerned about losing their money, weren't convinced. Eagle Asset Management Inc. moved to other prime brokers, according to Managing Director Todd McCallister. Investors who had credit default swap contracts with Bear Stearns turned to Goldman Sachs Group Inc. and other Wall Street firms, asking them to buy the contracts.
On Wednesday, March 12, Schwartz appeared on CNBC, live from Florida, saying the company had ample resources to weather the credit crunch. While for the moment, at least, that assuaged concerns in the market, the capital flight began again the next day. Many of Bear Stearns's traditional creditors reduced or halted their lending to the 85-year-old company founded by Joseph Bear and Robert Stearns.
By the end of the day, Bear Stearns's cash was almost depleted and its stock closed at $57. As Schwartz realized the company couldn't function on Friday without access to overnight borrowing, he called government officials, regulators and JPMorgan CEO Jamie Dimon.
Fed Steps In
After discussions late into Thursday night, the Fed agreed to provide cash through JP Morgan, the second-biggest U.S. bank by market value, because Bear Stearns didn't have direct access to the Fed as a lender of last resort.
Then, on March 14, the CBOE listed a series of put options with less than five days to expiration. The lowest strike price, $5, was more than 90 percent out-of-the-money in what options traders refer to as a ``bankruptcy put.'' Bear Stearns slumped 47 percent that day to $30 in NYSE trading.
The out-of-the-money Bear Stearns puts point to a raid, said Baker, who's now a securities lawyer whose clients include companies that have filed complaints over naked short selling.
The $25 Bear Stearns puts, and others obtained March 14 involving the right to sell 630,000 shares at a strike price of $5 by March 22, were ``bizarre,'' according to Haugh, the PTI partner who spent 18 years as a CBOE options-market maker.
``An incredible amount of bearish activity could have been generated by just 10 to 15 people,'' Haugh said. ``Other people then pile in, because they think somebody knows something.''
John Olagues, who started trading options 30 years ago, said he has never experienced anything like it. Olagues, who runs a New Orleans consulting company called Truth in Options, also manages more than $1 million for a client who had a stake in Bear Stearns, which plummeted 94 percent in value on March 17. The drop prompted Olagues to start poring over options trading records and call officials at the CBOE.
``In just one tick, the company's share price lost nearly all its value, a steeper drop than Enron's right before its de- listing in 2001,'' said 63-year-old Olagues, referring to the bankruptcy of Houston-based energy trading company Enron Corp. ``I've never seen a stock perform like that in my life.''
Olagues, who was an options market maker at the Pacific Exchange and then the CBOE from 1976 to 1984, said he knows all about so-called time decay, implied volatility, arbitrage and the complexities of options trading. The former all-conference pitcher at Tulane University, who started Truth in Options in 2003, said he has found options transactions that convince him Bear Stearns was the victim of insider trading.
``I would stake my reputation on that,'' he said.
Olagues said he was able to avoid losses for his client on Friday, March 14. His hedged position -- a so-called vertical put spread designed to absorb losses as great as 50 percent -- made money by the closing bell that day. The hedging failed the next trading day, March 17, when the stock opened at $3.17.
``Nobody prepares for the stock going from $57 to $3 in just two days,'' he said.
Schwartz told the U.S. Senate Banking Committee on April 3 that there are ``lots of reasons why people could have a financial motivation to induce panic'' and ``a lot of trading would point to that.''
Bear Stearns has forwarded options data to the Senate Banking Committee and the SEC, said a person close to the firm, who declined to be identified.
SEC Chairman Christopher Cox told Congress last month that the agency is probing whether illegal trading spurred the collapse of Bear Stearns and the 72 percent drop this year in Lehman Brothers Holdings Inc.'s market value. The inquiry focuses on investors suspected of seeking to profit by intentionally spreading false information about the companies.
The SEC subpoenaed Wall Street's largest firms and hedge funds for trading records and communications, including e-mails. The agency also enacted an emergency limit on so-called naked short sales in Freddie Mac, Fannie Mae and 17 brokerages as it prepares broader rules to thwart stock manipulation. That limit expires at midnight tomorrow.
Naked shorting, which can be illegal, occurs when short sellers who intend to profit from a decline in securities prices fail to borrow stock by the settlement date. Traders can use that method to drive down prices by flooding the market with sell orders.
The strategy can ``turbocharge'' the effect of false rumors on a stock price, Cox said on a July 16 conference call with reporters. The SEC will consider new rules to prevent improper short selling, Cox told Congress on July 24. It also may force investors to disclose ``substantial'' bets on falling stocks, he said.
On Tuesday, March 11, when Federal Reserve Bank Chairman Ben Bernanke attended a luncheon with Wall Street executives at the New York Fed and the CBOE listed its $25 Bear Stearns put option, McCarty of Meridian red-flagged Bear Stearns in his ``MEP Noteworthy Option Activity'' memo.
What got McCarty's attention that day was the volume of put trading in strike prices of $35 and below. Investors traded 84,109 puts at strike prices that would require a calamitous drop to make money, he said.
``Somebody placed some big bets that day that paid off,'' McCarty said. ``The question is, did they make it pay off?''
On March 14, when Schwartz sought emergency funding, Bear Stearns opened at $54.24 in NYSE trading. That day, the CBOE listed eight new put options that expired in five days with strike prices that ranged from $22.50 to $5. The lowest was 90.7 percent below the opening stock price.
Gail Osten, a spokeswoman for the CBOE, declined to say who placed the order for the options.
``Nobody in their right mind would buy that put unless you knew what was going down,'' said Ray Wollney, Olagues's partner at Truth in Options. On Friday, March 14, a total of 6,303 of the March $5 Bear Stearns puts traded.
That night, Schwartz got a call from Treasury Secretary Henry Paulson making it clear that Bear Stearns had until Sunday evening to find a buyer because the Fed planned to withdraw its financial backing. Paulson, who didn't want the government to appear to be bailing out a Wall Street firm, then brokered the sale to JP Morgan.
Convincing the Board
Schwartz and Bear Stearns Chairman James ``Jimmy'' Cayne convinced fellow board members by explaining that their only alternative was to accept the deal or face bankruptcy. The agreement was announced Sunday night.
Options bets that looked irrational on Friday proved brilliant on Monday, when the shares traded between $3 and $5. By Wollney's calculations, the traders who spent $35.8 million on the deep out-of-the-money puts reaped an estimated $274 million windfall from the plunge in Bear Stearns.
Peter Chepucavage, a former general counsel for compliance at Nomura Securities and onetime SEC lawyer, said the Bear Stearns bets were neither smart nor lucky.
``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,'' said Chepucavage, who's now with Washington-based Plexus Consulting.
`Riddled With Bullets'
John Welborn, a London School of Economics-educated economist who works at Haverford Group investment firm in Salt Lake City, has been analyzing data released by the SEC on Bear Stearns shares sold but not delivered to buyers within the required three-day limit.
From March 10 to March 14, SEC data show that the failed Bear Stearns trades jumped to 2.1 million from 19,424, Welborn said. The failed trades correlate with increases in the firm's put volume. The volume of Bear Stearns puts soared to 237,770 on March 11 from 32,081 on March 7. Put contracts doubled again to 445,635 on March 14.
``It looks to me like Bear Stearns got riddled with bullets,'' Welborn said.
The question is whether the trading was premeditated and designed to ruin Bear Stearns, Chepucavage said. If there is a link between these separate activities, only subpoena power will be able to establish it, he said.
``Track the rumors,'' Chepucavage said. ``Follow the puts.''
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