Michael Brush

Company Focus11/7/2007 12:01 AM ET

Preying on investors' subprime fears

When market manipulators sense weakness, they make their move and make tons of easy money. Here are four recent examples of insiders winning at the expense of everyday investors.

By Michael Brush

Whenever investors get a bad case of the jitters because intense fears grip a sector, you can bet that scam artists will come out of the woodwork to make some easy money by playing on fears to manipulate stocks.

By the looks of things, the fraudsters have been hard at work over the past few weeks with a few financial stocks -- a group haunted by fears of the next big stock-killing write-down related to subprime mortgages gone bad.

Exhibit A: some highly suspicious trades in Lehman Bros. (LEH, news, msgs) options as rumors swirled in late October -- at a moment when fears of subprime-related write-downs were running thick because Merrill Lynch (MER, news, msgs) had just announced a whopping $7.9 billion write-down.

By some estimates, scam artists made more than $5 million that day manipulating Lehman Bros. stock with false rumors, just one of several recent examples. Market watchdogs say these kinds of games proliferate in times of intense fear in the market.

"Any climate of volatility creates opportunities for fraudsters to try to disrupt the market and profit by it," says Walter Ricciardi, a deputy director at the Securities and Exchange Commission's Division of Enforcement. Ricciardi declined to comment on the suspicious trading in Lehman options around the time of the rumor -- or any other cases in this column.

But he warned scam artists not to think that they can carry out these kinds of schemes and get away with them. "That's why we have people who are being led away in handcuffs, and there will be more," says Ricciardi. "We are watching. Anybody who sleeps well at night because they think they can get away with this is misleading themselves."

The reverse pump-and-dump

Here's a look at how fraudsters may have gamed market fears for some quick profits in options on Lehman Bros. stock.

Shortly after the market opened Oct. 24, traders bought two suspiciously large blocks of put options on Lehman Bros. stock. Options give investors the right to buy or sell a stock at a preset price. If you are planning to game the market, options are the best instruments, since they can quickly change value by 100% or more when the underlying stock moves by just 10% to 15%.

And for anyone plotting to profit by spreading negative rumors about a company, put options are the way to go. That's because put options increase rapidly in value when the underlying stock declines, since put options grant owners the right to sell a stock -- or "put" it to another party -- at a prearranged price. As the stock declines, the right to sell that stock at a prearranged price naturally becomes more valuable.

Early in the trading day on Oct. 24, alarm bells went off at OptionMONSTER, which scans the markets regularly for unusual volume to look for trading signals, because of two large purchases of put options on Lehman stock.

While Lehman Bros. stock traded at around $58, someone purchased 1,000 put options that gave them the right to sell Lehman stock at $55. Then someone bought an additional 2,000 of the same kind of put option.

Besides the sheer size, something else made these trades suspicious, says Jon Najarian of OptionMonster. The buyers purchased options set to expire right away in November -- probably for good reason. These so-called "near-term" options are precisely the ones that change in value the most when the underlying stock moves.

And Lehman Bros. stock was about to move big time -- because about an hour after the purchases, rumors began circulating that Lehman Bros. would announce a $7 billion write-down because of exposure to dodgy subprime-mortgage instruments. The rumor was reported by Bloomberg, a financial news service certain to impact the market because it is widely used by professional traders.

Lehman Bros. stock tanked to $54.07 from $58.54 in a half-hour on the rumor. As Lehman put options shot up in value by 150% or more, "the selling hit these puts fast and furious," says Najarian. Assuming the same people who had just purchased the November $55 put options were among the sellers, they made a quick $630,000 in about an hour, by Najarian's estimates.

"Whoever bought those puts looks to have sold them out and profited handsomely as we approached the noon hour," says Najarian. "We call it reverse pump-and-dump, when the put buyers leak a rumor to their conduits in the press and then sell those pumped-up puts as the panic hits."

But that $630,000 in profits may have just been the tip of the iceberg. Trading in put options was nearly double the normal volume that day, and Najarian estimates that total profits on put options around the rumor could have exceeded $5 million. Lehman Bros. later denied the rumor, and the stock recovered.

Wall Street wins; you lose

So who was behind this scheme? I can't tell because I don't have the investigative powers that market regulators have. But Najarian says the scheme bears the fingerprints of professional traders, perhaps at a well-heeled hedge fund. He cites the large size of the trades and the quickness with which the trades were executed.

It also looks like retail investors may have been the ones to get hosed in the deal, says Najarian. That's because the profitable positions were sold off in small blocks -- indicative of retail buyers. After they bought the put options, they declined sharply in value as Lehman Bros. denied the rumors, and its stock recovered.

Continued: Three more scams

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