The Securities and Exchange Commission is investigating a $1.1 billion deal sold by J.P. Morgan Chase & Co., as part of a wider probe by the regulator into complex mortgage securities at the heart of the financial crisis, people familiar with the matter said Monday.
The SEC is looking at the role played by Magnetar Capital, an Illinois-based hedge fund, in the "Squared" subprime mortgage-linked security, known as a collateralized debt obligation, that was sold by J.P. Morgan Chase in early 2007.
The probe, which was reported by ProPublica, is one element in a wider informal investigation by the regulator into several banks' sales of CDOs.
The SEC inquiry bears some clear parallels to its civil lawsuit against Goldman Sachs Group Inc., its highest-profile action to date following the financial crisis. Goldman this summer agreed to pay $550 million to settle allegations that it defrauded investors in the way it marketed the 2007 Abacus CDO by failing to disclose that Paulson & Co., a hedge fund that was betting against the mortgage market, had helped to select the securities in Abacus. The bank settled the civil case without admitting or denying wrongdoing.
Here are the details:
The ruse at the heart of their transactions was creating subprime (so called "mezz" or mezzanine) collateralized debt obligations by investing in the riskiest layer, the so-called equity tranche. This kind of CDO consisted almost entirely of not just any subprime risk, but that of the dodgiest layer that could be sold short, the BBB tranches, via a combination of actual bonds and credit default swaps.
But Magnetar's true objective was not to invest in this toxic waste, which its role as funder of the CDO would lead most to believe. While Magnetar paid roughly 5% of the total deal value for its equity stake, it took a much bigger short position by acting as a protection buyer on some of the credit default swaps created by these same CDOs. This insurance in turn was artificially cheap because over 80% of the deal was rated AAA. Most investors did not understand what Magnetar recognized: this concentrated exposure to the very riskiest type of bond associated with risky mortgage borrowers, each of these CDOs was a binary bet. It would either work out (in which case Magnetar would still show a thin profit) or it would fail completely, giving Magnetar an enormous profit and wiping out even the AAA investors who mistakenly believed they were protected by having other investors sit below them and take losses first. Thus the AAA investors were only earning AAA returns for BBB risk.
As the equity investor, Magnetar could further stack the deck in its favor through the influence it gained over the deals' parameters. It was able to ensure that the CDOs held particularly dubious BBB exposures, and pushed for, and often got, "triggerless" structures, which stripped away another protection most deals had. When CDOs start to show significant losses, the payments to the lower-tier investors, including the equity tranche, are cut or halted to defend the AAA layer, much the way the human body, when exposed to severe cold, will restrict blood flow from the extremities to save the brain and organs. But triggerless deals, even as they started to fail, kept paying the lower tranche holders, including, in this case, Magnetar itself.
While these transactions may sound similar to the widely decried Goldman synthetic CDO program, Abacus, by which the firm went short various real estate exposures, effectively dumping the risk on customers, the Magnetar program was not only much larger, but also produced far more devastating systemic consequences, thanks to the distinctive structure of its CDOs.
As I explain at greater length in my book ECONNED: How Unenlightened Self Interest Undermined Democracy and Corrupted Capitalism, the use of cash bonds turned mezz CDOs from a dumping ground for otherwise unsellable mortgage bond risk to a breeding ground for demand. Ex Magnetar-inspired appetite, it is hard to find an explanation for the widely-discussed phenomenon of 2006 and 2007, of the mortgage securitization pipeline screaming for more subprime product, precisely when Federal Reserve interest rate increases should have stanched demand for risky loans above all others.
Market participants have estimated that Magnetar's CDOs drove over 50% of demand for subprime bonds during the market's toxic phase, 2006 and 2007. With the input of a team including professionals who have worked on some of these trades, ECONNED, we've performed repeated, conservative analyses that indicate the true figure is probably at least 35% of demand, and perhaps as high as 60%. And that's before allowing for the fact that Magnetar's strategy was imitated by the proprietary trading desks of major dealers. And for good reason. Magnetar made billions, some observers contend as much as subprime kingpin John Paulson, whose fund earned over $20 billion on its short strategy.
And Rahm Emanuel's connection to this fraud?
The head of Magnetar only gave to one politician's PACs.
Litowitz and his wife had never before made significant political donations. In 2005, they started giving to Rahm and his PACs, and only PACs connected to Rahm, just before the Magnetar CDO program began, and continued through the first quarter of 2008, when the trade would have started to pay out handsomely. The Litowitzs gave a total of $8,000 to Emanuel and $10,000 to his Our Common Values PAC in May 2005. In 2006 and 2007, they contributed $51,700 to the Democratic Congressional Campaign Committee, while Emanuel was chairman. We have been advised by individuals involved in political fundraising that the amounts given would be considered significant, and the way the payments were distributed across the PACs is sophisticated. Put it another way: this money was not given impersonally.
If I were running a rival campaign in the Chicago mayor's race, I certainly would be having the opposition research team looking into this so more.
Then I would nail the smirking Emanuel with the "Culture of Corruption" tag he used against the GOP in 2006.
Over and over again.
I'd run commercial after commercial, tying Emanuel to the hedge fund industry and to Magnetar in particular and ask voters "Haven't we had enough corruption? Haven't we had enough government by the hedge fund managers, for the hedge fund managers, of the hedge fund managers? Haven't we had enough of Rahm Emanuel's backroom deals?"
Who knows, maybe Chicago voters will shrug at this.
But if Emanuel can drop a dime on Jesse Jackson Jr. and get him out of the race, I think somebody else can drop a dime or two on him.