Seven Signs of Fraud – How do you know your Stock isn't the next Bear Stearns?

By Nancy Zambell, Contributing Editor

Last month, many investors were again caught unaware when Bear Stearns, the fifth-largest U.S. investment bank, and one of the street's blue bloods, announced that it was being rescued by JP Morgan Chase and the Federal Reserve Bank of New York.

Stunned investors couldn't believe it! It was the first time since the Great Depression that the Fed has stepped in to give credit to a non-bank to keep it on its feet.

After being a force to reckon with for more than 80 years on Wall Street, the bank was a few days from bankruptcy, leaving many folks shaking their heads and asking what the heck happened?

This debacle is simply another domino in a long list of failed companies that allowed greed to get in the way of good sense. Enron, Long Term Capital, WorldCom, Tyco (and now, Bear Stearns) were all poster children for executives to find new ways to grab as much money as they could with no regard to the ultimate consequences for their shareholders or their more than 15,000 employees.

Then the house of cards collapsed when the firm's large investors as well as its bankers said "no more." They lost confidence in Bear, began stopping trades and withdrawing cash, leading investors to doubt that Bear could repay its obligations, including its complicated, far-from-transparent agreements with other financial institutions and companies.

You may recall that just the week before, Bear's chief executive, Alan Schwartz, said the rumors of liquidity problems were absolutely not true. We know, of course, that statement wasn't true. And while many times rumors are unfounded, as my father used to say, "where there's smoke, there's often fire," so it's a lesson for investors that when rumors arise, it pays to delve deeper to make sure they are just rumors and not an omen of very bad events to come. That's flag #1.

There were plenty of signs that led to those rumors:

• Bear wrote down more than $2 billion in exposure to mortgage securities in recent months.

• Chief executive James Cayne resigned in January.

• In June 2007, Bear announced that two of its hedge funds that had invested heavily in sub-prime mortgages were in trouble and the bank had to give them a handout of $1.6 billion to keep them from failing. That rescue didn't last long, as the following month, Bear began to clean them up and boot them out.

• A little more than a year ago, Bear shares were trading higher than $160. Even before the bailout news, they had declined to under $60.

Each of those signs contained four more warning flags to watch for: Big write-downs, closing of funds or subsidiaries, important executives resigning, and falling share prices.

That's five flags so far. But along the way, a couple more stood out that may have warned investors. They relate to the business that was the root of the problem — sub-prime mortgages, which were fueled by the housing boom.

I lived in Florida 18 years, and for about 16 of those, I couldn't give away my condo in a golf resort. The housing market was so overbuilt and condo buyers could buy a new unit for about the same price as my older one. Then came the bubble. By the time I left Florida in 2001, my condo had become very attractive and I sold it with no problem, and at what I thought at the time was a good profit. However, had I held onto it for two more years, I would have tripled my money!

That scenario played out across the country, until a year or so ago, when the bubble began to burst. But a few years prior to the bust, housing prices had skyrocketed so much that they should have shut down the market much earlier, except for that little pesky vehicle created by financial institutions, called sub-prime mortgages.

These mortgages extended the bubble because they made loans affordable to borrowers whose credit history or income prevented them from getting approval for a conventional 30-year mortgage. The very notion of extending credit to people who shouldn't have it should have been another warning flag for investors. These loans were in the news long before they began going belly-up, and it was widely-known that the investment banks, including Bear Stearns, were making a fortune from them. Just look at the exec's take-home pay for the past few years. Bottom line: if you were paying attention to the companies in which you invested, this would not have been a great surprise.

For the financial institutions, sub-prime mortgages were a God-send. The banks collected fees, but had no further responsibility for the loans since they sold them to Wall Street, who packaged them into some pretty complex securities and resold them to investors.

The bubble burst when the variable rates on those sub-prime loans started adjusting higher and folks couldn't make their payments. Investors in those complex securities were no longer receiving those handsome interest payments. Lenders became wary of making loans since no one wanted to buy them.

Bear was one of the biggest underwriters of these securities. As I said earlier, it closed two of its hedge funds that were big sub-prime investors last year, and that started the ball rolling further down hill.

Now, for the average investor, you have no way of knowing how deep Bear (or any other investment bank) has its clutches into these types of complicated dealings. That's because unlike a commercial bank whose financial statements are transparent and heavily regulated, investment banks and hedge funds don't get the same steely-eyed stares from regulators. That may change in the future, but for most investors, a warning flag should arise when a company in which you invest makes a good portion of its money from transactions that you don't understand. That alone should be a big yellow caution sign not to invest! Or as Warren Buffett used to say, "I don't buy anything I can't explain to my grandmother!"

I have a close friend who worked for Enron until just about a year before its collapse. When I asked him what he did, all I recall about his response was that it had something to do with "trading weather derivatives." But he couldn't tell me, in plain language, just what that meant and how they made money from it, so I just chalked it up to another company that wasn't transparent enough for me to give them my money.

And Bear is just the latest example in a long line of companies that jumped into opaque investments that served their greed at the expense of their mission — to enrich their shareholders, not just themselves.

Caution is the last word: if you don't understand it, don't buy it. But if you do, make sure you stay on top of your investments. That's not always easy to do, but if you don't have the time, hire a good financial advisor, or stick to mutual funds or exchange-traded funds. You don't want to lose sleep — or your fortune — because of someone else's misdeeds.

This concludes this week's issue of Financially Fit.  We encourage you to visit our website to review past issues of Financially Fit:

http://www.brokeradviser.com/newsletter.cfm


Disclaimer & Important Information

Financially Fit is owned and published by Business Financial Publishing, LLC of Washington D.C.  Business Financial Publishing is neither a registered investment adviser nor a broker/dealer.  Readers are advised that this electronic publication is issued solely for information purposes and should not to be construed as an offer to sell or the solicitation of an offer to buy any security.

The views expressed herein are based upon our analysis of the issuer's public disclosures, and assumes both their accuracy and completeness.

The opinions and statements included herein are based on sources (including the companies discussed and public sources) believed to be reliable and in good faith, but no representation or warranty, express or implied, is made as to their accuracy, completeness or correctness. We have not independently verified the information contained herein. This information is not intended to be used as the sole basis of any investment decisions, nor should it be construed as advice designed to meet the investment needs of any particular investor. We encourage you to consult with independent financial advisors with respect to any investment in the securities mentioned herein. You should review a complete information package on all companies, which should include, but not be limited to, the Company's annual report, quarterly reports, press releases and all regulatory filings. All information contained in Financially Fit should be independently verified with the subject company. The foregoing discussion contains  statements which are based on current expectations, estimates and projections, and differences from such expectations, estimates and projections can be expected.

Financially Fit is intended only for residents of the United States. Financially Fit is not for residents of the United Kingdom and is not an approved publication by the Financial Services Authority in the UK.

The information contained in this newsletter is not intended to be a complete discussion of information regarding all of the current and/or intended business activities of the covered companies. Any opinions expressed in Financially Fit are statements of judgment as of the date of publication, are subject to change without further notice, and may not necessarily be reprinted in future publications or elsewhere.

Business Financial Publishing and its members, managers, writers and employees do not accept compensation from the companies discussed within Financially Fit, nor any of our individual newsletter publications (Growth Report, Rising Star Stocks, and Top Stock Insights).

====================
====================

Financially Fit  is a free email newsletter from BrokerAdviser.com (http://www.brokeradviser.com)