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Harry Newton's In Search of The Perfect Investment Technology Investor.

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6:30 AM EST, Wednesday, December 3, 2008: The Bear Raid. Pick a vulnerable financial. Buy credit default swaps en masse, which drives up the price of those CDSs. Short the financial en masse. Finally, spread rumors the financial is in serious trouble (hence the rising price of the CDSs) and the financial may not survive the week. But you'll made oodles. The Bear Raid drives the stock down, and can destroy the company. Bear Raids have driven down the stock prices of many financials. Fear of a Bear Raid and fear for their survival are two key reasons why Morgan Stanley and Goldman Sachs rushed to become regulated banks.

The Bear Raid destroys the wealth of thousands of shareholders, while making the Bears -- hedge funds and traders billions in profit. The Bear Raid is Wall Street at its most Wild West, its most unregulated -- helped enormously by today's somnolent SEC and the present administration's belief that unfettered markets are best and any form of regulation is bad. Key to a Bear Raid's success is the SEC's recent dropping of the uptick rule. That old rule said you needed to wait for an uptick in the price of the stock before you could short it. Now you can short anything any time you want.

The problem with Bear Raids for you and me investor is they happen in secret. We know nothing about them. We buy a stock thinking it's good value for our 401 (k). Then suddenly there's a Bear Raid and bingo, we just lost 50% of our retirement monies. The good news is that I have been totally consistent in my recommendations in recent months -- stay away from financials. I screwed up once and recommended WaMu. But I'm not the only person who got screwed by Hank Paulson.

The Wall Street Journal spent a small fortune researching what happened with the Bear Raid on Morgan Stanley. You need to understand this stuff. Here's its article:

Anatomy of the Morgan Stanley Panic
Trading Records Tell Tale of How Rivals' Bearish Bets Pounded Stock in September


Two days after Lehman Brothers Holdings Inc. sought bankruptcy protection, an explosive rumor spread that another big Wall Street firm, Morgan Stanley, was on the brink of failure. The chatter on trading desks that Sept. 17 was that Deutsche Bank AG had yanked a $25 billion credit line to the firm.

That wasn't true, but it helped trigger a cascade of bearish bets against Morgan Stanley. Chief Executive Officer John Mack complained bitterly that profit-hungry traders were sowing panic. Yet he lacked a critical piece of information: Who exactly was behind those damaging trades?

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street -- Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG -- were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm's stock by selling it short. The interplay between swaps trading and short selling accelerated the firm's downward spiral.

This account was pieced together from the trading documents and more than six dozen interviews with Wall Street executives, traders, brokers, hedge-fund managers, regulators and investigators.

For years, sales of credit-default swaps were a profit gold mine for Wall Street. But ironically, during those tumultuous few days in mid-September, the swaps market turned on Morgan Stanley like a financial Frankenstein. The market became a highly visible barometer of the Panic of 2008, fueling the crisis that ultimately prompted the government to intervene.

Other firms also were trading Morgan Stanley swaps on Sept. 17: Royal Bank of Canada, Swiss Re, and hedge funds including King Street Capital Management LLC and Owl Creek Asset Management LP.

Pressure also mounted on another front. There was a surge in "short sales" -- bets against the price of Morgan Stanley's stock -- by large hedge funds including Third Point LLC. By day's end, Morgan Stanley's shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

That pattern of trading, which previously had battered securities firms Bear Stearns Cos. and Lehman, now is dogging Citigroup, whose stock fell 60% last week to a 16-year low.

Investigators are attempting to unravel what produced the market mayhem in mid-September, and whether Morgan Stanley swaps or shares were traded improperly. New York Attorney General Andrew Cuomo, the U.S. Attorney's office in Manhattan and the Securities and Exchange Commission are looking into whether traders manipulated markets by intentionally disseminating false rumors in order to profit on their bets. The investigations also are examining whether traders bought swaps at high prices to spark fear about Morgan Stanley's stability in order to profit on other trading positions, and whether trading involved bogus price quotes and sham trades, people familiar with the probes say.

No evidence has emerged publicly that any firm trading in Morgan Stanley stock or credit-default swaps did anything wrong. Most of the firms say they purchased the credit-default swaps simply to protect themselves against potential losses on various types of business they were doing with Morgan Stanley. Some say their swap wagers were small, relative to all such trading that was done that day.

Proving that prices of any security have been manipulated is extraordinarily difficult. The swaps market is opaque: Trading is done by phone and email between dealers, without public price quotes.

Erik Sirri, the SEC's director of trading and markets, contends that the swaps market is vulnerable to manipulation. "Very small trades in a relatively thin market can be used to … suggest that a credit is viewed by the market as weak," he said in congressional testimony last month. He said the SEC was concerned that swaps trading was triggering bearish bets against stocks.

Morgan Stanley had entered September in pretty good shape. It made money during its first two fiscal quarters, which ended May 31. It didn't have as much exposure to bad residential-mortgage assets as Lehman did, although it was exposed to commercial-real-estate and leveraged-loan markets. Mr. Mack knew that third-quarter earnings were going to be stronger than expected.

On Sept. 14, as Lehman was preparing to file for bankruptcy protection, Mr. Mack told employees in an internal memo that Morgan Stanley was "uniquely positioned to succeed in this challenging environment." The following day, the firm picked up some new hedge-fund clients who had fled Lehman.

But rumors were flying as traders worried which Wall Street firm could fall next. The chatter among hedge funds was that Morgan Stanley had $200 billion at risk as a trading partner with American International Group Inc., the big insurer on the brink of a bankruptcy filing, according to traders. That wasn't true. Morgan reported in an SEC filing that its exposure to AIG was "immaterial."

Some brokers at rival J.P. Morgan Chase & Co. were suggesting to Morgan Stanley clients it was risky to keep accounts at that firm, people familiar with the matter say. Mr. Mack complained to J.P. Morgan Chief Executive James Dimon, who put an end to the talk, these people say. Deutsche Bank, UBS and Credit Suisse also marketed to Morgan Stanley's hedge-fund clients, people familiar with the pitches say.

On Sept. 16, Morgan Stanley's stock fell sharply during the day, although it rebounded late. Some hedge funds yanked assets from the firm, worried that Morgan might follow Lehman into bankruptcy court, potentially tying up client assets. In an effort to quell concerns, Morgan Stanley released its earnings that afternoon at 4:10 p.m., one day early.

"It's very important to get some sanity back into the market," said Colm Kelleher, Morgan's chief financial officer, in a conference call with investors. "Things are frankly getting out of hand, and ridiculous rumors are being repeated."

UBS analyst Glenn Schorr asked Mr. Kelleher about the soaring cost of buying insurance in the swaps market against a Morgan Stanley debt default. Protection for $10 million of Morgan Stanley debt had risen to $727,900 a year, from $221,000 on September 10, according to CMA DataVision, a pricing service.

"Certain people are focusing on CDS as an excuse to look at the equity," Mr. Kelleher responded, implying that traders betting on swaps were also shorting Morgan Stanley shares, betting that the stock price would fall.

It's impossible to know for sure what was motivating buyers of Morgan Stanley credit-default swaps. The swap buyers stood to receive payments if Morgan Stanley defaulted on bonds and loans. Some buyers, no doubt, owned the firm's debt and were simply trying to protect themselves against defaults.

But swaps were also a good way to speculate for traders who didn't own the debt. Swap values rise on the fear of default. So traders who believed that fears about Morgan Stanley were likely to intensify could use swaps to try to turn a fast profit.

Amid the uncertainty that Sept. 16, Millennium Partners LP, a hedge fund with $13.5 billion in assets, asked to pull out $800 million of the more than $1 billion of assets it kept at Morgan Stanley, according to people familiar with the withdrawals. Separately, Millennium had also shorted Morgan Stanley's stock, part of a series of bearish bets on financial firms, said one of these people. In addition, the hedge fund bought "puts," which gave it the right to sell Morgan shares at a set price in the future.

"Listen, we have to protect our assets," Israel Englander, Millennium's head, told a Morgan Stanley executive, according to one person familiar with the conversation. "This is not a personal thing."

Those bearish bets, small compared to Millennium's overall size, rose in value as Morgan Stanley shares fell.

That same day, Sept. 16, Third Point LLC, a $5 billion hedge-fund firm run by Daniel Loeb, began to move $500 million in assets out of Morgan Stanley. The following day, Sept. 17, Third Point, after seeing the surge in swaps prices, made a substantial bearish bet, selling short about 100,000 Morgan Stanley shares, trading records indicate. Third Point quickly closed out that position for a profit of less than $10 million, says one person familiar with the trading.

Around the same time, hedge fund Owl Creek began asking to withdraw its assets, and ultimately took out more than $1 billion.

On the morning of Sept. 17, David "Tiger" Williams, head of Williams Trading LLC, which offers trading services to hedge funds, heard from one of his traders that a fund had moved an $800 million trading account from Morgan Stanley to a rival. His trader, who was on the phone with the fund manager who moved the money, asked why. Morgan Stanley was going bankrupt, his client responded.

Pressed for details, the fund manager repeated the rumor about Deutsche Bank yanking a $25 billion credit line. Mr. Williams hit the phones. His market sources told him they thought the rumor false.

But damage already was being done. By 7:10 that morning, a Deutsche Bank trader was quoting a price of $750,000 to buy protection on $10 million of Morgan Stanley debt. At 10 a.m., Citigroup and other dealers were quoting prices of $890,000.

As the rumor about Deutsche spread, Morgan shares fell sharply, from about $26 at 10 a.m. to near $16 at 11:30 a.m.

Before noon, swaps dealers began quoting the cost of insurance on Morgan in "points upfront" -- Wall Street lingo for transactions where buyers must pay at least $1 million upfront, plus an annual premium, to insure $10 million of debt. In Morgan Stanley's case, some dealers were demanding more than $2 million upfront.

During the day, Merrill bought swaps covering $106.2 million in Morgan Stanley debt, according to the trading documents. King Street bought swaps covering $79.3 million; Deutsche Bank, $50.6 million; Swiss Re, $40 million; Owl Creek, $35.5 million; UBS and Citigroup, $35 million each; Royal Bank of Canada, $33 million; and ACM Global Credit, an investment fund operated by AllianceBernstein Holding, $28 million, according to the documents.

The following day, Sept. 18, some of those same names were back in the market. Merrill bought protection on another $43 million of Morgan Stanley debt; Royal Bank of Canada, $36 million; King Street, $30.7 million; and Citigroup, $20.7 million, the trading records indicate.

None of the firms will comment on how much they paid for the swaps, or whether they profited on the trades.

"The protection we bought was a simple hedge, not based on any negative view of Morgan Stanley," says John Meyers, a spokesman for AllianceBernstein. A Royal Bank of Canada spokesman says the bank bought the swaps to manage its Morgan Stanley "credit risk," and was not "betting against Morgan Stanley and conducted no bearish trades on its stock."

King Street, a $16.5 billion hedge fund, bought the swaps to hedge its exposure to Morgan Stanley, which included bond holdings, according to a person familiar with the fund. The fund didn't hold a short position in the stock, this person says.

Spokespeople for Deutsche Bank and Citigroup say their trading was relatively small and meant to protect against losses on other investments with Morgan, and to handle client orders. An Owl Creek spokesman says it bought the swaps "to insure collateral we had at Morgan Stanley at the time," and that it continues to do business with the firm.

Merrill, UBS and Swiss Re declined to comment on the trading.

As Morgan Stanley's stock tumbled, the number of shares sold short by bearish investors soared to 39 million on Sept. 17, nine times the daily average this year, adding to the 31 million shares shorted in the prior two days, according to trading records.

Mr. Mack sent a memo to employees on Sept. 17. "I know all of you are watching our stock price today, and so am I.… We're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down."

The stock and swaps trading were feeding on each other. That afternoon, Mr. Schorr, the UBS analyst, wrote: "Stop the insanity -- we need a time out." In an interview that day, he said "the negative feedback loop of stocks and CDS making each other crazy shouldn't be able to destroy the value of companies."

Scrambling to stop the crisis of confidence, Mr. Mack phoned Paul Calello, investment-banking chief at Credit Suisse, and asked whether he knew what was driving the cost of the swaps up so quickly, say people familiar with the call. Mr. Calello said he didn't.

Morgan Stanley's chief legal officer, Gary Lynch, once the SEC's enforcement chief, called New York Stock Exchange regulatory head Richard Ketchum. He said he was suspicious about manipulation of Morgan Stanley securities, and asked whether the NYSE would support a temporary ban on short selling, according to people familiar with the call.

Mr. Mack called SEC Chairman Christopher Cox, Treasury Secretary Henry Paulson and others. Trading in Morgan Stanley securities, he groused, was irrational and "outrageous," and "there's nothing to warrant this kind of reaction," says a person familiar with the calls. The steps already taken by the SEC to prevent certain types of abusive short selling, he argued, didn't go far enough.

In his memo to employees that day, Mr. Mack had made it clear that he intended to press regulators to rein in short sellers. When word about that got out, hedge-fund managers were up in arms. Some yanked business from Morgan Stanley, moving it to rivals including Credit Suisse, Deutsche Bank and J.P. Morgan. They said the trading represented legitimate protection and speculation.

Hedge-fund veteran Julian Robertson Jr. and James Chanos, a well-known short seller, both longtime Morgan Stanley clients, were both angry. Mr. Chanos says he "hit the roof" when he heard about Mr. Mack's memo.

After the stock market closed that day, Mr. Chanos decided that his hedge fund, Kynikos Associates, would pull more than $1 billion of its money from a Morgan Stanley account.

"It's one thing to complain, but another to put out a memo blaming your clients," says Mr. Chanos, who adds that the development all but ended a more-than-20-year relationship with Morgan Stanley. He says his fund hadn't bought any Morgan Stanley swaps or sold short its stock.

Other Wall Street executives, concerned about their stocks, were also calling regulators. At about 8:15 that night, the SEC said it would require more disclosure of short selling. Late the following day, Sept. 18, the SEC moved to temporarily ban short selling in financial stocks.

Mr. Mack contacted hedge-fund clients to tell them he hadn't single-handedly brought on the ban, and that he was primarily interested in giving the market a temporary "time out" from the volatile mix of rumors and trading.

But within days, more than three-quarters of Morgan Stanley's roughly 1,100 hedge-fund clients had put in requests to pull some or all of their assets from the firm, according to a person familiar with the operation. Even though most kept some money at the firm, Morgan Stanley couldn't process all the withdrawal requests at once, adding to market fear.

Morgan Stanley was in a precarious position. During the Sept. 17 trading frenzy, Mr. Mack had begun merger talks with Wachovia Corp. Four days later, Morgan Stanley shifted course, becoming a bank-holding company and gaining wider access to government funds. Last month, after raising $9 billion from a Japanese bank, it received a $10 billion capital injection from the federal government.

Morgan Stanley must now revise its business strategy to contend with a more risk-averse environment and the more stringent government oversight that comes with being a bank-holding company. Earlier this month, it announced it would fire about 2,300, or 5%, of its employees.

The cost of insuring its debt has come back down from its peak, but its stock remains in the doldrums. On Friday, it was trading at $10.05 a share in 4 p.m. composite trading on the New York Stock Exchange -- less than half of the $21.75 close on Sept. 17.

A month after the mayhem, Mr. Mack said in an interview that he had all but given up trying to get to the bottom of what was driving the trading in his firm's securities during those chaotic days in mid-September. "It's difficult to say what's rumor and what's fact," he said.

Burning Down His House. Is Lehman CEO Dick Fuld the true villain in the collapse of Wall Street? Or is he being sacrificed for the sins of his peers? Read all about it in a cover story in this week's New York Magazine.

How hedge funds can be taken, also. This is from an upcoming issue of Forbes. It tells the story of hedge funds that got taken for an expensive ride. Maybe. There are several lessons here.

First, you need to check out everybody you deal with. There are many places to do this. First Advantage Group is mentioned in the piece. They're a billion dollar sales a year, NASDAQ-listed operation that, on first glance, seems most impressive.

Second, being totally unregulated, hedge funds can, and do, anything they feel like. Most don't do what these guys did. But there's nothing stopping them.

A Plague on All Their Houses
Some hedge funds were taken for a $3 billion ride. Could they possibly be as witless as they claim to be?

Gregory Bell is either the dumbest hedge fund manager ever--or crazy like a fox. His Lancelot Investors of Northbrook, Illinois raised $1.5 billion and bet it all on a plan cooked up by Thomas Petters, a Wayzata, Minnesota businessman. The idea was to spot Petters enough dough that he could buy high-end TVs, Hitachi presentation projectors and other electronic stuff from troubled companies, then resell them to retailers such as Sam's Club. Petters is now being held in jail without bail, charged with fraud. (He has denied the charges.)

Until the scheme collapsed in the fall, Bell posted healthy paper returns since 2003 and taking his cut--2% of assets and 20% of Lancelot's "profit," which totaled $57 million, court documents show. But according to the feds the great returns and the electronic gizmos never existed. What's real, they say, is a trail of bogus purchase orders and fake invoices. Petters, they allege, had been running a $3 billion Ponzi scheme, using new investor money to pay off old debts and, it seems, to finance the purchase of the once valuable brand name Polaroid and a small airline.

Petters was arrested in October after one of his deputies tipped off the feds and before Petters could flee the country. By then $12 billion-plus had flowed through his companies, which relied on capital from hedge funds now out $3.3 billion, according to claims in bankruptcy proceedings involving various Petters entities.

The hedge funds all claim they were duped, but a closer look shows there was plenty of evidence Petters was up to no good. A charming and extravagant entrepreneur, Petters had a past littered with lawsuits accusing him of welshing on debts. In the 1990s, say the feds, he fled Colorado to avoid criminal fraud charges and resolved the matter years later. "Petters had every warning flag you can think of, tons of civil litigation," says Randy Shain, who runs First Advantage Investigative Services and checked out Petters for potential hedge fund investors.

Now there are new lawsuits being filed against Bell and Lancelot by investors like Royal Bank of Scotland (nyse: RBS - news - people ), which lent $50 million to Lancelot and says "at a bare minimum it is clear that the Lancelot funds ... failed entirely to confirm the accuracy and authenticity of the purchase orders and the existence of the underlying inventory." Other investors suing Bell for fraud point out that "a simple telephone call--let alone a regular practice of verifying the purchase orders--would have revealed that the retailers had not issued the purchase orders." Bell refused comment but has sued Petters, claiming Lancelot was conned.

Ritchie Capital, a once high-profile $3 billion Lisle, Illinois hedge fund, is owed $275 million by Petters' entities for notes that carried rates as high as 362%. Rates like that are "beyond the pale" of commercial reasonableness, says a court filing made on behalf of Douglas Kelley, the court-appointed Petters Group receiver. Ritchie, which has sued Petters for fraud, says the rates are high because the short-term loans had a profit-sharing component.

Then there are David Harrold and Bruce Prevost, who set up Palm Beach Finance Partners in 2002 and marketed it as a hedge fund to provide financing of brand-name products to retailers. It raised $1.6 billion and in the last five years reported average annual returns of 12.5%. Most of the cash went to a Petters company that owes Palm Beach $1.1 billion.

Over the years Harrold, 49, has bounced around at least five tiny investment shops. He filed for personal bankruptcy in 1991 and was slapped by the Florida Division of Banking with a $2,500 fine for "fraudulent transactions." Prevost, 48, used to work at a brokerage called Graystone Nash with Richard DeMaio, who got into trouble with the U.S. Securities & Exchange Commission in 1993. While taking no action against Prevost, an sec judge said he had engaged in illegal practices similar to DeMaio's, such as refusing to send cash back to clients. The guy who brokered the deal between Petters and Palm Beach Finance was Frank E. Vennes Jr.--an ex-con sentenced to five years on charges of money laundering, illegally selling a firearm and facilitating the distribution of cocaine, in 1987. Vennes was paid commissions of $28 million by Petters, says an fbi affidavit. Palm Beach says it "had no basis for concern prior to Tom Petters' arrest."

Says Douglas Hirsch, a lawyer for investors who put at least $50 million in Palm Beach: "Petters either found some pigeons in Bruce and David, or they were in on it, as well."

Slumdog Millionaire is great: Please go see it.

Chair Man of the Board
Resolving to surprise her husband, an executive's wife stopped by his office.

When she opened the door, she found him with his secretary sitting in his lap.

Without hesitating, he dictated, "...and in conclusion, gentlemen, budget cuts or no budget cuts, I cannot continue to operate this office with just one chair."

This column is about my personal search for the perfect investment. I don't give investment advice. For that you have to be registered with regulatory authorities, which I am not. I am a reporter and an investor. I make my daily column -- Monday through Friday -- freely available for three reasons: Writing is good for sorting things out in my brain. Second, the column is research for a book I'm writing called "In Search of the Perfect Investment." Third, I encourage my readers to send me their ideas, concerns and experiences. That way we can all learn together. My email address is . You can't click on my email address. You have to re-type it . This protects me from software scanning the Internet for email addresses to spam. I have no role in choosing the Google ads on this site. Thus I cannot endorse, though some look interesting. If you click on a link, Google may send me money. Please note I'm not suggesting you do. That money, if there is any, may help pay Michael's business school tuition. Read more about Google AdSense, click here and here.