Criminalizing Financial Optimism at Bear Stearns

by Kurt Schulzke on June 19, 2008

Cioffi & TanninFortune Magazine, today, features “Crime and Delusion on Wall Street,” in which Colin Barr reports the FBI’s arrest of Ralph Cioffi and Matthew Tannin (pic right), former hedge fund traders at Bear Stearns.

Turns out that the FBI thinks Cioffi and Tannin misled investors by cheerleading for their funds when cheerleading was — in the FBI’s mind — inappropriate. Perhaps we need to examine a bit more carefully the point at which optimism — in an industry that depends entirely on market perception — becomes a criminal act.

As Barr reports,

The case apparently turns on the question of what the men knew when they told investors they were hopeful about the funds’ prospects – at a time when their performance was deteriorating and some investors were trying to withdraw money.

As it did in earlier cases following the collapse of the technology stock boom, the government is expected to rely in part on e-mails that allegedly show the managers had private doubts even as they were publicly expressing confidence.

Though the defendants intend to fight the charges, the notion that something was amiss in mortgage land seems obvious now, in light of the billions of dollars in losses being recognized almost daily by financial firms around the world. . .

“Because his funds were the first to lose might make him an easy target but doesn’t mean he did anything wrong,” said Cioffi lawyer Ed Little. “Indeed, Mr. Cioffi had no motive to do anything wrong. He did not and could not have profited by doing anything the government now claims he did.” Susan Brune, attorney for Tannin, said her client “is being made a scapegoat for a widespread market crisis. He looks forward to his acquittal.”

What did they know?

The case against Cioffi and Tannin will take awhile to play out. But what’s clear today – and may be central to the managers’ defense – is that the Bear Stearns managers were far from alone in failing to warn investors of the sea change in the credit markets. Indeed, top guns on Wall Street have spent a lot of time deceiving themselves about the depth of the mortgage mess.

And here’s the rub. The “top guns on Wall Street” are seen as “deceiving themselves” only after the market melts down. And the market melts down only after it finally dawns on enough other market participants that the whole system — right down the banks themselves — is an elaborate con. And no one except maybe God can tell when that’s going to happen. Isn’t this what “fractional banking” is all about, convincing enough people that they can all withdraw their money at the same time when us insiders know all along they can’t?

What is the duty of players like Cioffi and Tannin? Should they talk down their funds? Not say anything? Or should they do what they can to responsibly prop up investor confidence in hopes that those who keep their money in the fund won’t get burned?

Where does the duty run? Where do we draw the line? And how fair is it to criminalize the kind of optimism that we demand of federal reserve chairman, governors and presidents? There are clear-cut cases of financial fraud. Worldcom, Adelphia, Ahold and Siemens come to mind. But credit markets are different from telcos, grocery chains and infrastructure builders.

I think we’ll find — in the mortgage meltdown aftermath — that overzealous prosecutors (like those who took down Jeff Skilling) will stretch the law beyond its intended boundaries to snare some of its biggest victims. And the crowds will cheer.

But will the market then be better able to do what markets are supposed to do? Maybe Mohammed had it right along, optimism and financial markets are just bad thing. Maybe we should just invoke Sharia law and have done with the hassle.