Quelle Surprise! Feds Dust off Old Rogue Traders CDO Case to Burnish “Tough on Mortgage Crime” Credentials

The powers that be are in the process of seeing how they can burnish their “tough on bank crime” credentials while not ruffling anyone really important. And the case featured in the Wall Street Journal, “U.S. Plans Charges on Bond Fraud,” illustrates the sort of enforcement theater we are likely to see over the coming months.

Wow! Charges! Better yet, criminal charges! Finally the Administration is getting tough on crime.

Right. It’s tough on crime against banks. This is shades of the Taylor Bean, the only case of a criminal prosecution of financial firm executives…who were ripping off even bigger financial firms, Deutsche Bank and Paribas.

The story: some traders in 2008 were reported by Credit Suisse to have been mis-marking CDO positions. Frankly, mismarking of CDOs was so widespread that one wonders what these traders did for their activity to be out of line with awfully lax industry norms. This is from a March 20, 2008 Credit Suisse press release:

The Manhattan U.S. Attorney’s office is planning to allege in a criminal complaint that several former traders at Credit Suisse Group AG, a major global investment bank, misled the bank’s investors by booking inflated prices of mortgage bonds to boost their bonuses, despite knowing the values of those securities had dropped, according to the people familiar with the matter.

Final valuation reduction of CHF 2.86 billion is CHF 200 million less than previously estimated….

Following its revaluation review, Credit Suisse has determined that the pricing errors were, in part, the result of intentional misconduct by a small number of traders. These employees have been terminated or have been suspended and are in the process of being disciplined under local employment law. The review also found that the controls put in place to prevent or detect this activity were not effective.

So…nearly four years later, this incident is suddenly worth prosecuting? Past rogue traders, such as Nick Leeson and Jerome Kerviel were arrested and put to trial on a fast pace. For instance, UBS’s Kweku Adoboli, who was discovered to have lost over $2 billion at UBS, was arrested September 15 of last year and is scheduled to go to trial in September of this year.

So here we have an almost four year lapse in filing charges against (per the Financial Times) two low level employee-miscreants that allegedly produced $2.8 billion in losses. And the clever bit here is that even though no one now expects the employees to be able to shift blame to management, as in prove that their conduct was sanctioned, or at least not hidden, it will be a foreign bank and not an American one that would be embarrassed by the revelations.

From the Wall Street Journal (note it suggests more traders may be implicated):

The Manhattan U.S. Attorney’s office is planning to allege in a criminal complaint that several former traders at Credit Suisse Group AG, a major global investment bank, misled the bank’s investors by booking inflated prices of mortgage bonds to boost their bonuses, despite knowing the values of those securities had dropped, according to the people familiar with the matter.

The article then goes on at some length to discuss how misvaluations of “mortgage securities” played a role in the crisis. Now perhaps I am being a bit of a finance pedant, but nowhere in this article do you see mention of the fact that these mis-marks took place in a CDO group, and may well have involved CDOs, and not the simpler MBS used as a major constituent in CDOs. In fact, I read the emphasis on “mortgage securities” as an effort to make this prosecution sound more relevant to issues at hand, since CDOs are clearly so 2008.

The WSJ story also emphasizes that misvaluations are about to become the new insider trading:

Federal prosecutors have begun to get more active in the area of asset valuations.

In December, the Manhattan U.S. Attorney’s office criminally charged a London asset manager with overstating the value of sovereign debt held by his hedge fund during the financial crisis. A complaint filed by the SEC at the same time accused Michael Balboa, a former managing director at London’s Millennium Global Investments Ltd., of overstating the value of securities issued by the Nigerian government, boosting his bonus by millions of dollars. A lawyer for Mr. Balboa declined to comment.

The SEC has filed several cases in the past 18 months, and more are in the pipeline, according to people familiar with the matter.

In September, the SEC filed civil charges alleging that hedge-fund manager Corey Ribotsky misled investors about the value of the fund’s investments in certain non-exchange-traded securities. A lawyer for Mr. Ribotsky, manager of Long Island-based NIR Group, declined to comment.

In October 2010, the SEC charged two hedge-fund portfolio managers and their investment advisory firms with defrauding investors in the Palisades Master Fund LP by overvaluing illiquid fund assets they placed in a “side pocket.” The fund managers have denied wrongdoing and are fighting the charges.

The SEC filed civil fraud charges in June 2010 against a New York-based investment adviser ICP Asset Management LLC, and its president, Thomas Priore. The agency alleged that ICP had intentionally inflated the value of trades to collect millions of dollars in advisory fees. ICP and Mr. Priore have denied wrongdoing and are fighting the charges.

There is plenty of incentive to inflate the values of portfolios because employees’ bonuses are tied to the value of their holdings.

This effort is terrific, right? After all, the integrity of pricing is crucial to investors.

Yes and no. The problem is that the focus is on lower level employees and relatively small firms. Yet Sarbanes Oxley made (at a minimum) CEOs and CFOs certify the adequacy of internal controls, and asset and liability pricing is a strong focus. If the controls are bad enough that traders can play games that result in $2.8 billion loss bombs, that would suggest they’d have a wee Sarbox problem. Note Credit Suisse has US ADRs, and a quick Google search suggests that does require issuers to comply with Sarbox. If the traders really were playing valuation games with MBS, which are not at all hard to value, rather than CDOs, that would make it pretty hard to believe than management was not either grossly incompetent or aware of the mis-marks (as in not wanting to show losses immediately in the hope that the market might come at least partway back).

And more generally, we’ve read and heard about SO many stories of valuation abuses that it seems hard to believe that a serious investigation would not implicate most of Wall Street. For instance, in 2007, it was reported repeatedly that big firm dealers were doing small trades of CLOs in very small sizes with cooperative hedge funds so they could use inflated marks to avoid showing the full extent of losses. Readers have reported on end of year pressure from the top to either dress up balance sheets or create a bit more profit by engaging in creative valuation of positions. There were also repeated reports during the crisis of firms using different valuations of mortgage securities for internal purposes than the prices they were giving to customers. Yet we have the authorities going after only one case that a foreign bank has already investigated years after the fact.

This is justice Obama style: theater for the masses, free passes for the people at the top.

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  1. YankeeFrank

    Pathetic. Of course the usual suspects will trumpet the bold and decisive prosecutors leaving no stone unturned.

    1. YankeeFrank

      This reminds me of the other bold prosecutors who managed to go after a dude who apparently lied on his loan application. Never mind the thousands of mortgage brokers, mortgage originators and bank purchasers lying and obfuscating the lies in millions of mortgages. But they really got that guy good!

        1. Walter Wit Man

          And in that case the mortgage broker that assisted Mr. Engle in lying on that liars loan* is serving a slightly less severe sentence than Mr. Engle.

          Countrywide and Mr. Mozilla, who were responsible for creating tens of thousands of these liar loans, paid a pittance of a fine and did not have to face criminal charges. The government had a hunch and wiretapped and surveilled Mr. Engels and built a case. The government had the case against Mr. Mozilla drop in its lap but instead of surveilling or doing any wiretaps the government decided to collude with Countrywide and Mozilla and make the problem go away.

          *The NYTimes story raises doubt about the strength of the case against Mr. Engele and I wonder if he accepted a plea bargain because the prosecution was threatening to send him to prison for much longer.

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  2. bmeisen

    Speaking of unprosecuted crimes, has IPO underwriting been cleaned up in the last 15 years? Anything we should be noting on the Facebook IPO? Or is it in every day-traders interest to ride that wave?

  3. Jesper

    Its a numbers game – having a high number of prosecutions is seen as better than having a low number of prosecutions.

    Not too dissimilar to promoting a boxer for the championship by quoting his impressive wins and knock-outs stats. It doesn’t matter much to the promoter if the matches has all been against no-hopers as long as the stats builds up and his boxer is seen as a genuine tough contender.

    1. sleeper

      Exactly –

      Federal prosecutors generally focus on the less well to do, the prosecutors routinely threaten defendants with draconian punishment to force a plea deal thus polishing their conviction rate.

      For those that are connected through congressional bribes (contributions), through the revolving door, or through political office the federal prosecutors give a free pass.

      Equal justice for all except that some are more equal than others.

  4. charles sereno

    “This is justice Obama style: theater for the masses, free passes for the [people at the top].”
    With a 2 syllable finish, girl, you be rappin’.

  5. Susan the other

    Wouldn’t it be stupefying if the financial class actually told the truth. If they stood up and took the blame for the real estate bubble and crash. They might even confess that they did it with all good intention so that an inflated market could “reprice” (Hank Paulson estimated it would only take a few months) and all the hot money could come swooping in and gobble up the good deals. I mean – since we all know markets no longer function by themselves anymore, why continue to pretend?

  6. Max424

    “And in that case the mortgage broker that assisted Mr. Engle in lying on that liars loan* is serving a slightly less severe sentence than Mr. Engle.”

    Yeah, that’s what really burns. It takes two to tango, so why is only one of the tango partners in jail?

    “I wonder if he accepted a plea bargain…”

    Good question. I read several articles about Mr. Engle at the time, but I don’t remember any mention of a plea bargain.

    21 months seems like a fairly penal sentence to me, given the offense, so my guess is he wasn’t offered one.

    1. Walter Wit Man

      My bad. On a closer reading it looks like it went to trial:

      “Even the jurors seemed confused about how to think about Mr. Engle’s supposed crime. When it came time to pronounce a verdict, the jury found him not guilty of providing false information to the bank, which would seem to be the only fraud he could possibly have committed. Yet it still found him guilty of mortgage fraud. “I think the prosecution convinced the jury that I was guilty of something but they weren’t sure what,” Mr. Engle wrote in an e-mail.”

  7. Lambert Strether

    Best lead EVAH on Credit Suisse. Reuters:

    In a rare criminal prosecution to emerge from the financial crisis…

    Rare. As in “endangered specie.” BWA-HA-HA-HA-HA-HA-HA!!!! Stop it, you’re killing me!

  8. Unprecented Times

    Open Message of apolgy to my former ex-professor of
    Advanced Real Estate Finace at USC. He recently finished serving a 6 (six) year sentence for running a real estate development ponzi scheme (using color of authority the investors in the rip off were former students and their family). I was not happy that at the time in 2006, the feds were only recommending for the Judge to sentence him for 3 yrs for mail wire fraud. I spoke at his hearing this was not long engough. Judge after hearing from the other victims increased the sentence to
    6 yrs (at a club fed).
    THis ex professor is a choir boy compared to what I have discovered in 30 months of litigation against the banksters! This lawsuit is on behalf of my 86 year old deceased dad; his case has “all the pieces of the puzzle”. Link at end of this blog article comment
    shows where I educated the judical process and Onewest bank
    was ordered to pay sanctions to me when their intention was to get sanctions ($2300) against me for failure to respond to Robosigned authority showing assignment of the DOT. What is ironic is
    I have been able to effectivley fight the fraud of the banksters in Court up to this point from what I learned in Barry Howard Lanreth class about securitization the spring of 2005.


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