BS put the 1000 mortgages in the “High-Grade Structured Credit Strategies Enhanced Fund“ with a face value of $150 million with a 6% return.

BS sold 150 million shares in its fund, face valued at $1.00 per share, to investors for, say, $1.20/share with an annual return for investors of 4.5%.

(Aside: June 19, 2008: two BS fund managers, Ralph Cioffi, 52, and Matthew Tannin, 46, were arrested by FBI agents at their homes in Tenafly, New Jersey and Manhattan, and charged with nine counts of securities, mail, and wire fraud.)

Investors paid $180 million for all the shares in the BS fund. BS pocketed $30 million profit and hoped to pocket the interest differential on the fund‘s face value.

It turned out that lenders over-appraised houses and exaggerated borrowers’ ability to pay in order to facilitate loans. If a professional banker tells me my home is worth $160,000 and that I can afford the payments, who am I to argue?

Along came JP Morgan Chase. Egged on by the federal government, JPM Chase bought what remained of BS, including the mortgage fund, for 10 cents on the dollar.

JPM, having purchased BS’s assets, owns your mortgage for which it paid 10 cents on the dollar or $15,000. But, you and the other 999 borrowers each still owe $150,000.

Financial experts (who have a large stake in keeping us befuddled) explain that JPM Chase took on a big risk and many of the mortgages in the fund may go to foreclosure. They say that the fund JPM bought from BS may only be worth 10 cents on the dollar. So, to insure that the entire fund does not go belly up, everyone must pay their original mortgages.

This, of course, is bunk. Assume 50% of the mortgages in the fund go to foreclosure. This is wildly improbable given the current rate of foreclosures, but we’ll argue from JPM’s point of view to be conservative. The remaining 50%, the “good” mortgages in the fund, are still worth $75 million which is $55 million more than JPM paid for the entire fund. And, JPM still owns the 500 houses on which they will foreclose.

Again, assume worst case that the foreclosed on houses are worth only half their original appraised value; one-half of $160,000 equals $80,000. JPM sells the 500 foreclosure homes at fire sale prices and pockets an additional $40 million.

So, even in the face of a financial cataclysm, JPM obtains $115 million in exchange for its $20 million investment. Every person from the original mortgage broker/banker, managers at BS, and managers at JPM has pocketed huge bundles of money. You, on the other hand, remain fully on the hook for your mortgage obligation.

If JPM said to all 1000 homeowners, “Pay us principle only on your mortgage”, quite possibly none of the 1000 would default. In that case, the homeowner still has a place to live and JPM pulls in $150 million. Not a bad return on a $20 million investment.

But, giving homeowners a break, even though JPM would still make $130 million, would set an ugly precedent. We can “forgive” or write-off the bad debts of institutions because of market risk, but we will never forgive even a portion of a consumer’s debt.

Homeowners’ tax money will bail out some of these institutions, their taxes will go up because corporate taxes went down or were refunded, thousands of financial con men made large money off the mortgages, some financial managers may go to jail for fraud, and your home remains at risk for foreclosure. Is this a scam?

Cioffi (1) started the fund, (2) ran the fund, and (3) pulled his own monies out of it at the same time he kept others from doing so.

If you’re looking for an individual indictment, that’s the lowest-hanging fruit you can find.

But having said that, Cioffi seems a very weird choice for selective enforcement for the reasons raised earlier.

Early on in the meltdown of the firms, the Federal Reserve had tried to take the position that they were independent entities and therefore could sink or swim on their own. The Federal Reserve was forced to relent, and my view at the time was that it was due to the rest of world having considerable leverage (literally, the other firms could cut repo lines or take other punitive action) rather that out of a consideration of legal niceties (exactly how responsible should the Federal Reserve be as sponsor of the firms?).

I hope you’re right, and that this is just a play to start building the case against the bigger fish. That was my first take as well. After all, I bet they’ll be able to find numerous relatively minor SEC infractions in the way that some of these funds were marketed, and if they can use that pressure to establish a trail of communication and coordination with the higher-ups who were desperately trying to wall of their hedge funds from the rest of their enterprise, then the door will be wide open.

That said, I won’t get my hopes up. Enron is one matter. They only had the President and VP in their pocket. Wall St has just about the entire financial regulatory apparatus licking its boots.

Ah, I had forgotten about Everquest, good point, but again, Cioffi didn’t go out and do this like a cowboy. As I am sure you know, you can’t go off and do an offering without going through certain hoops (oh, and using whoever the firm’s designated counsel is for the offering documents). The idea that he would be held personally liable (worse, criminally liable) for actions done in accordance with firm procedures is just wild.

Now I’m not saying there might not be good reason to move to that standard, just as CEOs and CFOs are now held accountable for the accuracy of financial statements, But you can’t impose that sort of standard retroactively.

Or maybe (hey hey) the Brooklyn attorney’s office is after bigger fish and will use Cioffi and Tannin to go after Bear, just as they use lower level Mafiosi to bring down the bigger ones. The Brooklyn DA’s office has no particular loyalty to the securities industry.