Fraud Charges Against JPMorgan Over Housing Market Investment, Mortgage-backed Securities

Jack Humphrey, Regulatory journalist
June 21, 2011 /

American multinational banking firm JPMorgan has agreed to pay $153.6 million to settle the charges filed by the US Securities and Exchange Commission (SEC) connected to US housing market.

In a separate lawsuit in Europe, JPMorgan and the Royal Bank of Scotland are facing allegations of misrepresenting the value of the mortgage-backed securities they sold in recent years. This allegedly caused five credit unions to crash. The $800 million suit was filed by the National Credit Union Administration in Kansas City federal district court.

On the other hand, the SEC claimed that JPMorgan had misled investors in a complex mortgage securities transaction just as the housing market was starting to plummet.

The SEC’s complaint filed before the U.S. District Court for the Southern District of New York seeks compensation for harmed investors.

Robert Khuzami, Director of the Division of Enforcement, said: “JPMorgan marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests.

“What JP Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection. With today’s settlement, harmed investors receive a full return of the losses they suffered.”

CDO or collateralized debt obligation “known as Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities whose value was tied to the U.S. residential housing market,” the SEC explained.

Marketing materials stated that the Squared CDO’s investment portfolio was selected by GSCP (NJ) L.P. – the investment advisory arm of GSC Capital Corp. – which had experience analyzing CDO credit risk.

These marketing materials were allegedly void of information about Magnetar Capital LLC’s significant role in selecting CDOs for the portfolio, standing to benefit if the CDOs defaulted.

According to SEC’s complaint, JPMorgan structured and marketed a synthetic CDO without informing investors that Magnetar Capital helped select the assets in the CDO portfolio and had a short position in more than half of those assets.

By the time the deal closed in May 2007, Magnetar held a $600 million short position, dwarfing its $8.9 million long position.

When the housing market showed signs of distress in March and April 2007, JPMorgan was aware that it was facing financial losses from the Squared deal. Subsequently, the firm “launched a frantic global sales effort” during those perids that “went beyond its traditional customer base for mortgage securities,” the SEC claimed.

The SEC added that JPMorgan sold approximately $150 million of so-called “mezzanine” notes of the Squared CDO’s liabilities to more than a dozen institutional investors who lost nearly their entire investment.

The investors included Thrivent Financial for Lutherans, a faith-based non-profit membership organization in Minneapolis; Security Benefit Corporation, a Topeka, Kan.-based company that provides insurance and retirement products; and General Motors Asset Management, a New York-based asset manager for General Motors pension plans.

Also included were financial institutions in East Asia such as Tokyo Star Bank, Far Glory Life Insurance Company Ltd., Taiwan Life Insurance Company Ltd., and East Asia Asset Management Ltd.

JPMorgan agreed to a permanent injunction from violating Section 17(a)(2) and (3) of the Securities Act of 1933, on top of the financial penalties, including $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million fines.

$125.87 million of the $153.6 million will be returned to the mezzanine investors through a Fair Fund distribution, and $27.73 million will be paid to the U.S. Treasury.

The settlement further orders JPMorgan to change how it reviews and approves offerings of certain mortgage securities.

In addition, J.P. Morgan’s consent notes that it voluntarily paid $56,761,214 to certain investors in a transaction known as Tahoma CDO I. The settlement is awaiting court approval.

Meanwhile, the SEC filed a separate suit against Edward Steffelin, who headed the team at GSC, claiming that he allowed Magnetar to select and short portfolio assets.

The complaint alleged that Steffelin “rafted and approved marketing materials promoting GSC’s selection of the portfolio without disclosing Magnetar’s role in the selection process.”

Unknown to investors, Steffelin was seeking employment with Magnetar while working on the transaction.

Steffelin violated Sections 17(a)(2) and (3) of the Securities Act and Section 206(2) of the Investment Advisers Act of 1940, the SEC claimed, seeking injunctive relief, disgorgement of profits, prejudgment interest, and penalties against Steffelin.

Separately, GSC’s bankruptcy trustee has agreed to a cease and desist order for committing Sections 17(a)(2) and (3) of the Securities Act and Section 204 and 206(2) of the Advisers Act and Rule 204-2 thereunder.

GSC’s settlement is subject to approval by the bankruptcy court.


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