Probe of Wall Street Banks Expands

May 14, 2010 (LPAC)—The Wall Street Journal reported yesterday that Federal prosecutors, working with securities regulators, are conducting a preliminary criminal probe into whether several major Wall Street banks misled investors about their roles in mortgage-bond deals.

The banks under early-stage criminal scrutiny, J.P. Morgan Chase, Citigroup, Deutsche Bank and UBS, have also received civil subpoenas from the SEC as part of a sweeping investigating of banks' selling and trading of mortgage-related deals. Under similar criminal scrutiny are Goldman Sachs and Morgan Stanley.

The Manhattan U.S. Attorney's office and SEC are collaborating in the investigation. As part of the joint probe, the SEC has asked the banks for a range of documents, including final and draft prospectuses, final and draft offering documents, and investor lists associated with mortgage-related deals.

Among the deals being investigated are a series of mortgage CDOs created by Citigroup, Deutsche Bank, and UBS. These CDOs were named after constellations such as Cetus, Carina, and Virgo at the request of a hedge-fund client, Magnetar Capital. Magnetar bought a risky piece of the deals and placed bearish bets against other parts of the same CDOs or similar deals. Those bets enabled the fund to profit in a housing downturn.

In the few years before the housing downturn, Morgan Stanley designed, created, and sold CDOs that its own traders sometimes bet against. Among the CDOs the firm created and bet against were deals called ABSpoke and Baldwin 2006-1. A feature of the Morgan Stanley deals was a structure that could increase bullish investors' exposures to the underlying mortgage bonds. This made it more likely that such investors could lose money if the bonds performed poorly. Morgan Stanley took the bearish side of these transactions.