In an e-mail to a colleague in March 2007, Bear Stearns executive Ralph Cioffi lamented the markets, describing them as “either a melt down or the greatest buying opportunity ever.”
“I’m leaning toward the former,” wrote Mr. Cioffi.
But federal prosecutors say Mr. Cioffi, and fellow executive Matthew Tannin, never shared those fears with investors of the billion-dollar hedge fund they managed. Even as Mr. Cioffi withdrew $2 million of his own money from the fund, prosecutors said, investors were encouraged to invest more.
On Thursday, Mr. Cioffi, 52, and Mr. Tannin, 46, were arrested and charged with defrauding investors by failing to disclose the impending collapse of hedge funds invested in subprime mortgages with soaring default rates.
In separate cases related to the mortgage meltdown, the department also announced Thursday that it has arrested almost 400 mortgage and real-estate agents throughout the country on suspicion of smaller incidents of mortgage fraud on individual loans.
These more minor crimes - typically involving lying on loan applications and inflating home values - contributed to the soaring default rates that caused the subprime crisis. The default rate on subprime loans stands at more than 20 percent today and foreclosures have hit record levels, hurting communities and wiping out the value of trillions of dollars of mortgage securities worldwide.
Attorneys for the two Bear Stearns executives insist that both their clients are innocent.
In written statements, the attorneys hint at defenses that reference the same issue mentioned in the Cioffi e-mail: No one could have known how bad things would get.
“The subprime crisis took everyone by surprise, including the Fed and Treasury, and dozens of the largest financial institutions have lost over $300 billion to date on the same investments,” Cioffi attorney Ed Little wrote. “Ralph Cioffi´s funds lost money in exactly the same way. He did not and could not have profited by doing anything the government now claims he did.”
Tannin attorney Susan Brune took a similar tone: “He is being made a scapegoat for a widespread market crisis. He looks forward to his acquittal.”
The indictment by a federal grand jury in New York was the first securities-fraud lawsuit arising from the subprime debacle that wiped out much of the private mortgage market last year and led to the sudden implosion of Bear Stearns, in a crisis that continues to reverberate through the economy.
In the indictment of Mr. Cioffi and Mr. Tannin, prosecutors charged that the executives knew the surge in defaults was causing a meltdown in the subprime market, and that their hedge funds “were in grave condition and at risk of collapse.”
But instead of disclosing “the full extent of the fund’s deepening troubles” to investors, as securities law requires, the executives conspired to deceive them with assurances that the funds would ride out the crisis rapidly developing in financial markets, the indictment charges.
As early as February 2007, four months before the funds imploded, the executives told staff that they had “averted disaster” and barely survived a difficult month in the markets, and led a “vodka toast to celebrate surviving the month” while cautioning staff to keep the matter under wraps, the indictment said.
According to prosecutors, the executives told investors just one month later that the big drop in the funds’ price presented an “awesome” buying opportunity, and urged them to put more money into the subprime funds. Yet within days, Mr. Cioffi withdrew $2 million of the $6 million he had invested in one of the funds - a fact he also failed to disclose as required to investors, the indictment said.