Preying on investors' subprime fears

"This looks like classic market manipulation," agrees James Angel, an associate professor of finance at Georgetown University's McDonough School of Business. "You take a position, you spread bad news, and then take profits when the share price tanks. This is clearly bad behavior."

3 more scams

Unfortunately, the Lehman Bros. case isn't the only example of scam artists apparently gaming the market fears for profits.

1. In early trading on Oct. 25, the purchase of put options in the insurer American International Group (AIG, news, msgs) shot up dramatically. The buying included familiar purchases of a block of 1,000 options and a block of 2,000 put options on two separate exchanges -- similar to the buying in Lehman Bros. options ahead of rumors that tanked its stock. These buys were followed by several other large purchases executed in rapid succession -- again suggesting professional traders at work. AIG was trading for around $63.50 while put options were being snapped up.

Then around 11:30 a.m. a rumor of a multibillion-dollar write-down hit the market. The rumor was then reported by news wires, driving the insurer's stock below $59. That move inflated the value of put options by 100% or more, and a wave of selling hit these options. All told, trading in put options hit 132,000 that day, exceeding normal levels by 13 times. Najarian estimates fraudsters spreading market rumors could have made at least $2.5 million.

"This is obviously a lucrative practice if you can get into the circle of people who are doing it," he says. AIG declined to comment on the rumor, but its stock recovered later that day when CNBC reported that the rumors were false.

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2. There was similar buying in Countrywide Financial (CFC, news, msgs) put options ahead of negative rumors on Oct. 25, says Najarian, followed by apparent profit-taking in those positions as the stock declined.

3. Suspiciously, someone also bought large blocks of Washington Mutual (WM, news, msgs) puts on Nov. 2 just minutes before a scheduled 11 a.m. press conference by New York Attorney General Andrew Cuomo announcing a lawsuit that would take down Washington Mutual stock. In a suit against the home-appraisal unit of First American (FAF, news, msgs), Cuomo alleges Washington Mutual was involved in a scheme to cherry-pick appraisers who would inflate the estimated value of homes.

Although Washington Mutual responded that it has "absolutely no incentive to have appraisers inflate home values," the news weighed on its stock. By the end of the day, those put options purchased minutes before the Cuomo press conference had increased 60% or more in value, for paper profits of $650,000. "That smells really bad," says Angel. A spokesman for Cuomo declined to comment on the put-option purchases.

This latest round of apparent insider wrongdoing comes at a time when insider trading appears to be "rampant" again among Wall Street professionals, according to statements by the SEC's enforcement director, Linda Chatman Thomsen, in late October. The SEC's Ricciardi acknowledges that the number of suspicious cases reported by exchanges to the SEC has gone up significantly in the past year.

No memory of Boesky

Why is this happening? "Some people think we have a new generation on Wall Street that doesn't have as strong a memory of the people being led out in handcuffs back in the Boesky era," speculates Ricciardi. Ivan Boesky was a high-profile Wall Street investor whose late 1980s conviction for using insider information to place profitable bets ahead of corporate takeovers epitomized the rampant illegal insider trading of that era.

Whatever the causes, rampant abuses in the market claim a variety of victims. "Of course it bothers me. I don't have the kind of information that those slime buckets have," says one former professional options trader who now invests for his own account in retirement.

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But the potential damage goes well beyond those who may be on the losing side of the trades. "Our markets depend on having a reputation for trust and integrity," says Angel.

"If you let people get away with these games it will destroy the credibility of our capital markets, and that will cause capital to dry up for all companies."

Still, it may be tough for regulators to get a conviction in the market manipulation cases because of the need to prove intent, which is hard to do, says Allen Overby, a partner at the law firm Bass, Berry & Sims in Tennessee. Players who profited from the rumors may have heard them from someone else and believed them, says John Coffee, a professor at Columbia Law School. "If you believed the rumor, you are not manipulating the market," he says. "They might have believed these things, too, and then pushed the rumors even harder."

At the time of publication, Michael Brush did not own or control securities mentioned in this column.

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