The $154 million settlement the Securities and Exchange Commission wrested from JPMorgan Chase involved only one of more than two dozen mortgage securities deals that the hedge fund Magnetar helped create. As we detailed last year, many banks in the waning days of the boom created collateralized debt obligations, or CDOs, with the help of Magnetar, which also bet against many of the same investments.
So, is the SEC going to do anything about any of the other deals? The answer to that question reveals as much about the difficulties in policing Wall Street as it does about the excesses committed in the lead up to the financial crisis.
In the SEC's complaint [PDF] released yesterday it accused JPMorgan of misleading investors in a complex mortgage deal it peddled in 2007. Neither the bank, nor the manager of the deal had disclosed to the investors that Magnetar not only helped choose the assets in the deal, called “Squared,” but also bet against much of the deal.
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Magnetar participated in at least 28 similar deals, worth more than $40 billion. Other hedge funds, such as Paulson & Co., asked Wall Street banks to design billions worth of other similar deals, crucial aspects of which were not clearly disclosed to investors.
While the SEC may yet reach a few more settlements over similar conduct at other banks, it's likely that only a fraction of those responsible on Wall Street will be caught in the dragnet.
“It is impossible for the SEC to sweep the Street on every one of these bum deals,” says Charles Landy, a partner at Pillsbury who was a former attorney in the SEC's enforcement division.
The largest stumbling block may be lack of resources. The SEC spent two years investigating Squared. A special group within the agency that helps the enforcement staff examine these complex securities was formed in January 2010 and wasn't fully staffed until May of that year. To cut through the complexity of the deals and the legal defenses of the banks takes time and knowledge.
Understanding the mechanics behind Squared was no easy matter. It was a collateralized debt obligation, usually the last stop for mortgages on an assembly line of slicing, dicing and repackaging. But Squared took the process a step further; it was a CDO consisting entirely of other CDOs. To make it even more confusing, it didn't consist of actual cash bonds but side bets on those bonds, credit default swaps, so-called synthetics that mimicked the physical bonds. Neither CDOs nor CDSs received much regulatory attention in the lead-up to the crisis. CDSs were private transactions, outside the SEC's traditional jurisdiction. Congress specifically prohibited the SEC and other regulators from regulating derivatives such as CDSs. As the financial crisis was hitting, “there wasn't one piece of paper on file relating to a CDO” at the agency, says one SEC official. That meant “we couldn't see the forest or the trees.”
The banks generally swathed their prospectuses for these deals in dense legalese detailing all kinds of risks, real and imagined. These warnings became so standard and voluminous that they lost any power to help investors. The banks might seek to use them as a legal defense when regulators come calling. In the case of “Squared,” however, the SEC wrote in its complaint that a generic disclosure covering the possibility that an investor might bet against the deal was inadequate because it didn't disclose that Magnetar was involved in the asset selection process. Since JPMorgan settled, that theory was never tested in court. The banks also argue that they sold these bonds only to “sophisticated investors” who should have been fully aware of what they were buying.
Once they unwrapped the deals, regulators needed to identify the players and the nature of their relationships. This required poring over months of email traffic from multiple parties. In the case of Squared, in addition to JPMorgan, the banker, and Magnetar, the hedge fund whose small purchase got the deal started, there was also GSC, an asset manager. CDO managers like GSC served as the referee between the investor and the bank. They selected the assets and had a fiduciary duty to ensure the investment was described fairly to potential buyers. The SEC alleges that GSC failed in this duty, and it is pursuing charges against Edward Steffelin, the manager who worked on the deal. GSC did three other Magnetar deals in the same time period with similar characteristics. The bank was Citigroup, which has said its activities are under investigation by the SEC.
Steffelin denies the charges, and his lawyer has said he will contest them. Citigroup declined to comment.
But many of the CDO managers, while at the heart of the worst excesses of the CDO business, were fly-by-night shops that disbanded in the wake of the financial crisis and are unlikely to be seen as worthy scalps for a resource-starved SEC.
Since the SEC is incapable of targeting each and every malefactor, its strategy typically is to lay down markers for the civil litigants who follow. Once the details behind the settlements become public, investors and plaintiffs' attorneys can often use those cases as templates for future litigation.
“Historically the SEC enforcement division has always looked for help from class-action lawyers,” says former enforcement lawyer Landy.
For at least one of the Magnetar deals, the process might be reversed. The Financial Times has reported ($) the agency is looking at a $1.5 billion Magnetar CDO called Norma. The CDO was the subject of a lawsuit against Merrill Lynch, the bank behind the deal, by Rabobank, a Dutch firm that lost money on it. The lawsuit was settled for an undisclosed sum. Merrill is now owned by Bank of America, which declined to comment. Despite the parties' shutting the door to further discovery, the Financial Crisis Inquiry Commission obtained emails from the lawsuit between the parties involved in the deal.
The emails paint a similar picture to what happened with Squared. In this case, the CDO manager was a small firm called NIR Capital.
“When one Merrill employee learned that Magnetar had executed approximately $600 million in trades for Norma without NIR's apparent involvement or knowledge, she emailed colleagues, 'Dumb question. Is Magnetar allowed to trade for NIR?',” according to the FCIC's report.
“NIR abdicated its asset selection duties to Magnetar with Merrill's knowledge,” the FCIC report states.
NIR declined to comment.
In a letter to the commission, a Bank of America lawyer stated that NIR had ultimate responsibility for asset selection and it was common for investors like Magnetar to have input in that process.
The SEC's complaint involving Squared makes it clear that Magneter's true aim was to bet against the deal, and that JPMorgan and GSC employees knew it. While Magnetar has consistently maintained that it had a market-neutral strategy and was not betting on a housing market collapse, the SEC complaint paints a different picture. A Magnetar employee explained in an internal email that its investment in Squared was “basically nothing,” and that the firm was “just doing it … to buy some protection,” or shorts. A JPMorgan salesperson wrote on Feb. 13, 2007, a year and a half before the financial crisis: “We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.”
Did Merrill and NIR employees have similar knowledge? An SEC action may reveal the answer. As with Squared, Magnetar's role in Norma was never disclosed to investors.