Are Rumors Rather than Reality Feeding Market Behavior?

Is it possible that some of the collapses and near misses in the financial markets over the last six months will ultimately be tied to a few sick and/or greedy people who have used rumors and innuendo to manipulate the market? Government regulators are looking at such a scenario starting with the failure of Bear Stearns in March of this year.

The downfall of Bear Stearns actually started nearly a year earlier, in June 2007, as rumors � and admittedly some very bad investment decisions � forced the 85 year old firm to take two of its hedge funds into bankruptcy. On June 14, the company announced a 10 percent decline in quarterly earnings tied to losses in the mortgage markets, and as reports circulated that Merrill Lynch had seized collateral owned by one of the firms; Bear Stearns committed $3.2 billion in collateral to bail out one of the funds and said that the company's troubles were "relatively contained."

A week after the two hedge funds filed for bankruptcy protection on August 1 and the day after its Co-President and Co-CEO resigned, Bear Stearns sent letters to all of its clients reassuring them that the company was essentially financially sound. Between mid-September and the Christmas holidays, Bear reported a 68 percent drop in income, wrote down $3.5 billion in bad loans, and cut six percent of its work force. Then in January the Wall Street and financial markets began to unravel with wide predictions of a recession. On March 10 rumors were swirling that Bear Stearns might not have enough cash to continue in business. While the firm stoutly denied it had liquidity problems, the Treasury Department and Federal Reserve spent the following weekend contingency planning and on March 16, JPMorgan Chase announced it was acquiring Bear Stearns for $2 per share.

The stock later recovered a bit and Morgan Chase ended up paying around $10 per share, but imagine the windfall for any investor that had sold the stock short at $150 a share a scant year before the firm collapsed. In April the Chairman of the Securities and Exchange Commission told the Senate Banking Committee that it and other regulators were taking "a very active" look at trades of Bear Stearns in the days before the sale.

Bear executives have suggested privately that hedge funds were responsible for the rumours about the bank to try to drive down its share price and force it into bankruptcy.

The executives contend that unfounded rumours about Bear's liquidity, more than any legitimate problems, led trading counter-parties, clients and creditors to abandon the bank, driving it to the brink of failure.

Of course rumors don't have a lot of power unless there are a few facts behind them, and Bear Sterns, Lehman's and others have been shaken by the mortgage fallout. But while scare stories have been everywhere about Countrywide Mortgage, Bank of America, and others these companies have, so far at least, managed to survive even with their stocks battered and bruised.

It is, indeed, counterproductive when greedy and unethical investors drive a company under. It is far more lucrative to send stocks on a rollercoaster ride. And this may be what happened to Freddie Mac and Fannie Mae which have been fighting off speculation about their capital reserves and, most recently about the possibility that the government might have to bail out one or both of the GSEs. Two weeks ago the Bush Administration was scrambling to reassure the markets that Freddie and Fannie would not be allowed to fail while the stock market plummeted on the rumors. Any investors speculating in those two companies had profited nicely as Freddie and Fannie stock whipsawed, sometimes dropping as much as 50 percent in a single day only to roar back, up 25 percent the next.

Two weeks ago the SEC, finally responding to Wall Street pleas, stepped in to temper the short sale frenzy. The temporary fix put in place at that point is due to expire in a few days and the SEC is widely expected to extend the emergency orders both in terms of time and beyond the original 19 financial stocks the order was designed to protect. Hedge funds, their lobbyists and others strongly oppose any extensions.

IndyMac had a slightly different rumor problem. Tales about the bank teetering on the brink did not come from market speculators but from a U.S. Senator who sent a letter to the bank's regulator questioning the stability of the bank. Still, when the contents of the letter reached the public it may have contributed to a very serious run by depositors on the bank and forced the Federal Deposit Insurance Corporation to step in and assume the bank's assets and liabilities a few days later.

This past weekend the FDIC closed two more banks, First National Bank of Nevada and First Heritage Bank of Newport Beach, California, selling their assets to Mutual of Omaho Bank. There was no run by depositors either before or after the closure, but analysts and the media have speculated that 150 to 300 banks will be shuttered over the next several years. Such speculation does nothing to build confidence among investors and customers and, even though the FDIC does an excellent job in transitioning a failed bank, there is a certain level of attendant chaos that no one would choose to go through if they have other places to put their deposits or take out loans, and holders of bank stock generally lose their entire investment when the bank fails.

Now it is Lehman Brothers that suspects it have been the target of manipulation. Executives at the firm forwarded information to the SEC about short-selling of the bank's stock right after Bear Stearns collapsed and the Wall Street Journal reported on Monday that the SEC has subpeoned information from dozens of hedge funds and others focussing on several specific rumors; i.e., on June 3 the bank's stock fell 14 percent on rumors that it had gone to the Federal Reserve to raise money; on June 30 there wasw another 10 percent loss when it was rumored that Barclays Bank was attempting to buy Lehman at a price below where the stock was trading, and on July 10 it was rumored that several of the bank's largest custsomers were pulling their accounts; the stock fell 21 percent before recovering later in the day.

The Journal reported that the SEC is attempting to trace the allegedly false rumors to the original source. It will then take testimony of any traders or brokers involved in the exchanges to determine whether people were spreading false rumors and trading to make a profit.

The subpoenas ask the investment funds for transcripts of phone calls, messages and payroll documents that mention or include references to financial parties involved in the rumors.

Allegations of collusion by hedge funds are notoriously difficult to prove because the funds can claim they acted independently on the honest belief that their target's shares were overvalued.

With thousands of jobs lost, millions of dollars in stock value gone, perhaps forever, it will only compound the tragedy if it is found that some of the financial collapse we have been watching was caused more by greed than by stupidity and/or mismanagement on the part of investment banks and mortgage lenders and investors. But tragedy or not, the SEC, the Department of Justice, the Federal Reserve and other parties must get to the bottom of the rumors about rumors and put in place rules and regulations that ensure that this can never happen again.