Andreas Whittam Smith: Buy when stocks are down? Let's explode that myth

As managers at Bear Stearns appear in court, obvious lessons can be learnt

Even British newspapers carried pictures on Friday of two Wall Street bankers being marched into court by agents of the Federal Bureau of Investigation. This American custom of publicly parading white-collar defendants is known as the "perp walk" after the police slang for perpetrator.

The indictment is published at the same time. This document is more than a recital of the charges, in this case various species of securities fraud, it is also a narrative. So it included extensive quotations from emails and bits of remembered conversation. It provided a vivid and instructive account – though I emphasise that no part of the FBI case has yet been tested in court. The defendants have pleaded not guilty.

The case concerns two funds promoted by Bear Stearns, one of the top investment banks in New York. The first was launched in October 2003. But not very long afterwards, in June 2007, the funds' investors were told that they could no longer withdraw their money, and a little later they learnt that they had lost the lot.

The obvious lesson, that you can lose your shirt with prestigious financial institutions as well as with back-street firms, bears repeating. For in practice it is counter-intuitive. Size and history can overawe. In this example, adding to the sense of security were the modest claims that were made for the first of the two offerings, the "High Grade" fund. According to the indictment, investors were told that it would hold only low-risk debt securities. These mainly comprised mortgages. The fund would also borrow in order to enhance the return that investors would receive – the cost being less than the income on the additional securities that were bought. Investors were advised that they could expect annual returns of 10 to 12 per cent. Good enough. The fund was not designed to hit "home runs". The managers, too, would be investing their own money.

A further lesson which again I think worth underlining, albeit obvious, is the importance of identifying the key assumption, often unspoken, that underpins a proposition. In this instance it was that US house prices would continue to be stable or rising. As a result, mortgage-backed securities should maintain their value. But as we now know, US house prices stopped increasing in 2006 and began to weaken.

Inevitably, the performance of the first Bear Stearns fund started to fall short of the promises made. In these circumstances, the managers should straight away have told investors – look, this isn't turning out as we expected, we are going to close the fund, sell the underlying securities and return as much of your original investment as we can.

The Bear Stearns managers didn't do this. They drove right past the exit. What happened next is all too common, with its mixture of the foolish and, as an attorney for New York, Sean Casey, alleges, the criminal. There is nothing especially American and Wall Street about it. Any reader who does business with a financial institution could have a similar experience.

First the managers tried double or quits. They opened a second fund, the "Enhanced Fund", that employed more borrowing but, they said, would carry only limited additional risk because it would hold an even higher proportion of less risky securities. Investors in the first fund were urged to switch. The managers said they were moving their own money. Many followed this advice.

Shortly afterwards, the market in mortgage-backed securities worsened further. The indictment states that one of the managers wrote an email to a colleague that commented: "I'm fearful of these markets. It's either a melt down or the greatest buying opportunity ever. I'm leaning more towards the former." Yet, it is alleged, the managers told some clients that "we are looking at some great possibilities for the coming months. I am adding (personal) capital to the fund. If you guys are in a position to do the same, I think this is a good opportunity."

Be warned, after double or quits comes the age-old refrain, "stocks are down, it must be a buying opportunity". It wasn't. Prices continued to deteriorate, so the managers named in the indictment allegedly tried to publish values for the two funds that were higher than warranted by market information. However Bear Stearns' internal controls were strong enough to prevent this happening. A month later the funds were closed, in the event worthless. Their borrowings exceeded the remaining value of their assets.

By the way, it is alleged that the managers never did invest more of their own money as promised, and that one of them even extracted $2m of his own capital three months before the end. Not a pretty tale. I am afraid that this could happen to any one of us.