Fair Game: The Problem With Wiggle Room in Securities

Still, the case against Javier Martin-Artajo and Julien Grout, two of the bank’s traders, has larger lessons for investors and regulators. One has to do with the risks inherent in opaque, over-the-counter markets, where securities’ prices can’t be seen and so can be easily manipulated. Another involves the fairly significant leeway that financial firms have in valuing the securities they trade and hold.

According to prosecutors in the Southern District of New York, Mr. Martin-Artajo and Mr. Grout hid or understated losses in credit derivatives trades held by JPMorgan’s chief investment office during 2012.

Lawyers for both men say that they did nothing wrong and would be exonerated.

But the complaints against both men, laced with e-mails and transcripts of phone calls, indicate that the traders ignored the bank’s protocol for valuing the complex bets and chose instead to mark them in a way that would mask and minimize ballooning losses.

The bets were made on indexes that reflected the performance of a group of corporate debt obligations; the trader in charge of the portfolio had gambled that defaults among these debt issuers would rise. They did not.

It was an outsize bet. By the first quarter of 2012, the so-called synthetic credit portfolio had a total exposure of $157 billion, up from $51 billion in 2011. When the trade was finally and disastrously unwound, it cost the bank more than $6 billion in losses.

The exotic instruments that made up this portfolio did not trade on an exchange and so were harder to value than a stock, whose prices reflect actual market transactions. Because the credit derivatives traded privately, in a so-called dealer market, the traders had to get bids and offers from market participants to value the positions. Bids and offers are not the same as actual transaction prices, of course, but the standard procedure is to assign a value that is somewhere near the middle of the bids and offers.

When the trades went against them, the men deviated from that procedure to cover up some of the losses, prosecutors said.

“None of these trades were done on an exchange or exchangelike platform,” said Dennis Kelleher, president of Better Markets, a nonprofit organization that promotes the public’s interest in financial markets. “That’s how they were allowed to do two things — one, build up such a huge position with no one knowing and, two, misprice the securities.”

Indeed, Wall Street has fought to prevent the open trading of instruments like the ones at issue in the JPMorgan situation. Why? Profits are higher when instruments trade one-on-one rather than on an exchange. Customers who don’t know the price of a complex instrument can be easily overcharged.

Despite Wall Street’s objections, the Dodd-Frank law now requires many of these derivatives to be traded on exchanges or similar platforms. When the rules go into effect in coming months, prices and positions will be more apparent, reducing the possibility and surprise of a whalelike loss.

While the regulations have been written, there are still ways for Wall Street to water them down, like seeking certain exemptions, Mr. Kelleher said. And even the toughest laws and tightest rules can’t protect the financial system and taxpayers from risks posed by a major bank with lax internal controls.

ONE of the failures noted by prosecutors in the JPMorgan cases was the bank’s reliance on a single person in its valuation control group to serve as an independent check. That person was responsible for monitoring the values assigned to the chief investment office portfolio, which held tens of billions of dollars in positions. “In practice,” the complaint said, the control group “was neither independent nor rigorous.”

DealBook: Government Sues Bank of America Over Mortgage Securities

DealBook: UBS Reaches Settlement on Mortgage Securities

Fabrice Coffrini/Agence France-Presse — Getty ImagesA branch of UBS in Lausanne, Switzerland.

UBS, the Swiss banking giant, said on Monday that it had reached an agreement in principle with a United States regulator to settle claims related to mortgage-backed securities issued between 2004 and 2007.

The Federal Housing Finance Agency sued UBS and 17 other big banks in 2011, accusing them of misrepresenting the quality of mortgage securities they assembled and sold at the height of the housing bubble, and seeking billions of dollars in compensation. UBS was the first, and the agency said it owned $4.5 billion worth of mortgages, with losses totaling $900 million.

While the company did not disclose the amount of the proposed settlement, UBS said in a statement that it was booking about 865 million Swiss francs ($919 million) of pretax charges related to the settlement and a tax agreement between Switzerland and Britain.

UBS is booking about 700 million francs in charges at the business that focuses on its portfolio of noncore and legacy assets, and about 100 million Swiss francs in its wealth management division related to the tax agreement, which requires banks to collect taxes on accounts of British citizens.

The full cost of the settlement will be covered by previous provisions and those taken in the second quarter, UBS said.

The announcement of the proposed settlement came at the same time UBS reported preliminary results for its second quarter. The bank reported that profit rose to about 690 million francs from 425 million francs in the period a year earlier. The company is to report full results on July 30.

Securities Law: Amgen a Victory for the Investing Public

In an important vindication of shareholder rights, the U.S. Supreme Court in February's Amgen v. Connecticut Retirement Plans and Trust Funds, on a 6-3 vote, held that securities fraud plaintiffs have no obligation to prove that defendant's misrepresentations and omissions were material at the class certification stage.

DealBook: How Pennies Add Up in a Securities Fraud Case

We are used to hearing big numbers thrown around in securities fraud cases, like the purported $64 billion in losses from the Ponzi scheme perpetrated by Bernard L. Madoff or $7 billion by R. Allen Stanford. What sometimes gets overlooked is how conduct involving relatively small amounts can add up to millions of dollars if allowed to go on long enough.

Charges filed by the Justice Department last week accuse two former brokers at the New York office of Linkbrokers Derivatives, Marek Leszczynski and Benjamin Chouchane, of securities fraud and conspiracy for secretly adding a few pennies to the cost of securities trades processed by the firm to generate $18.7 million in gains.

A sales trader and middle-office assistant at the firm, Henry A. Condron, entered a guilty plea and is cooperating in the government’s case. The Securities and Exchange Commission also filed civil charges against the three men, and added another broker as a defendant who was not named in the criminal case.

Linkbrokers, which was not named in the suit, executed high-volume trades on behalf of institutional customers, including hedge funds. The key is getting the best price for clients while quickly executing their orders.

Criminal complaints filed in Federal District Court in Manhattan accuse Mr. Leszczynski and Mr. Chouchane of charging a slightly higher price for a trade, or lowering the sale price, and then hiding the actual cost from the clients. According to the S.E.C., more than 36,000 trades from 2006 to 2010 involved pricing issues, with the amounts ranging from a few dollars to as much as $228,000 in one instance.

The tinkering came on days of higher volatility in the market because of greater price fluctuations. Institutional investors carefully scrutinize order executions and trading costs, so volatility helped provide cover for any mispricing.

“These brokers stole millions of dollars by overcharging customers for trades involving stocks with high trading volumes and price volatility, which are characteristics they wrongly thought would conceal their illicit pricing scheme,” Robert Khuzami, the head of the S.E.C.’s enforcement division said in a statement.

Mr. Leszczynski’s lawyer stated that his client was “astonished and shocked he was charged with a crime. He still doesn’t know why.”

While the trading gains went to Linkbrokers, the defendants were accused of benefiting through higher bonuses based on the profits they generated. According to the criminal complaints, Mr. Chouchane received bonuses ranging from $1.2 million to $2 million from 2007 to 2009, while Mr. Leszczynski’s bonuses ranged from $600,000 and $2.4 million during that period.

The transactions outlined in the criminal complaints generated modest profits. Mr. Leszczyncki is accused in one trade of marking up the purchase price of 20,000 shares by 1.2 cents a share, generating a profit of $240. A transaction involving Mr. Chouchane had a mark-up of 1.24 cents on an order for 43,000 shares that resulted in a profit of $533.20.

The S.E.C. complaint also indicates they took a slice of profitable trades. According to the agency, a client would submit a limit order, which specified the price at which the securities would be bought. If the price moved higher after the trade, they then sold off some of the shares at a profit and informed the client that the order could not be completely filled.

Proving the case will not be an easy task. With over 36,000 trades potentially at issue, the government will have to introduce records from all of them to establish the pattern showing a fraudulent scheme. Imagine trying to put together a puzzle with that many pieces.

Mr. Condron, who pleaded guilty to securities fraud and conspiracy, was in charge of entering the prices into the trading records, playing a crucial role by controlling the flow of information. His cooperation will be important since he was, in effect, the bookkeeper of the operation. He could give perspective to the mass of paper by explaining how trades were executed and how the system could be gamed.

To bolster their case, prosecutors tried to use Mr. Condron, while wearing a recording device, to entice Mr. Chouchane into making incriminating statements. According to the complaint, a few weeks ago Mr. Condron met with Mr. Chouchane and asked if his current employer engaged in marking up trades. Mr. Couchane replied, “No, you know, they used to do it when it was good, like us … Now you can have an investigation from the S.E.C., from the bank, from the hedge fund … I don’t think it’s worth taking the risk. You know, to be honest, it’s annoying for me.”

Those comments are far from the kind of incriminating evidence presented at the recent insider trading trials, when jurors heard confidential information being passed from sources to traders. Trying to pull an admission out of someone two years after the fact is not easy. But having Mr. Condron wear a wire shows how much prosecutors now value recorded evidence in building a securities fraud case because it can show knowledge far better than a mass of trading records.

The prosecution of Mr. Leszczynski and Mr. Chouchane involves an area of the market largely hidden from public view. Like so much else on Wall Street, conduct involving even fractions of a penny can be significant if it is done often enough.

Suit Accuses JPMorgan Unit of Broad Misconduct on Mortgage Securities

The civil suit against Bear Stearns & Company, now a unit of JPMorgan Chase, was brought in New York State court by Eric T. Schneiderman, the state attorney general, who is also a co-chairman of the task force, known as the Residential Mortgage-Backed Securities Working Group.

The complaint contends that Bear Stearns and its lending unit EMC Mortgage defrauded investors who purchased mortgage securities packaged by the companies from 2005 through 2007. The firms made material misrepresentations about the quality of the loans in the securities, the lawsuit said, and ignored evidence of broad defects among the loans that they pooled and sold to investors.

Moreover, when Bear Stearns identified problematic loans that it had agreed to purchase from a lender, it was required to make the originator buy them back. But Bear Stearns demanded cash payments from the lenders and kept the money, rather than passing it on to investors, the suit contends.

Unlike many of the other mortgage crisis cases brought by regulators such as the Securities and Exchange Commission, the action does not focus on a particular deal that harmed investors or an individual who was central to a specific transaction. Rather, the suit contends that the improper practices were institution-wide and affected numerous deals during the period.

A spokesman for Mr. Schneiderman declined to comment on the filing. A representative of JPMorgan, which acquired Bear Stearns in a fire sale in March 2008, said it would contest the allegations. “We’re disappointed that the New York A.G. decided to pursue its civil action without ever offering us an opportunity to rebut the claims and without developing a full record — instead relying on recycled claims already made by private plaintiffs,” said Joseph Evangelisti, the bank’s spokesman. He added that the allegations all predate JPMorgan’s acquisition.

To be sure, the allegations in the suit against Bear and EMC are not new. The task force complaint closely echoes legal arguments made in recent years by numerous private litigants trying to recover losses in mortgage securities. Most of these cases continue to inch their way through the courts.

Late last week, for example, JPMorgan lost a round in one of these battles when Jed S. Rakoff, a federal judge in Manhattan, rejected the bank’s request to dismiss a complaint brought by Dexia, a Belgian-French bank. The European bank had bought $1.6 billion in mortgage securities issued by Bear Stearns and Washington Mutual, another institution taken over by JPMorgan during the credit crisis.

Nevertheless, some lawyers who are battling the large banks and investment firms on behalf of mortgage investors said they welcomed the action by the task force. Jerry Silk, a lawyer at Bernstein Litowitz Berger & Grossmann in New York, said: “The government’s action represents a complete validation of the cases brought by investors who were duped by the fraudulent sale of mortgage-backed securities by JPMorgan, WaMu and Bear Stearns.”

The suit encompasses work begun by Mr. Schneiderman’s office in the spring of 2011, according to people briefed on the investigation. The attorney general subpoenaed documents from JPMorgan Chase and from large mortgage insurers that had also brought cases against the banks for failing to live up to their promises about the types and quality of mortgages placed in loan pools and sold.

New York investigators also capitalized on a cooperation agreement struck by Andrew Cuomo, the previous attorney general, with Clayton Holdings, a major firm in the business of evaluating mortgages. The firm provided documents and e-mails showing that Bear Stearns routinely ignored major defects on loans it was purchasing and pooling so that it could preserve its relationship with mortgage originators.

After the mortgage fraud task force was created in early 2012, Mr. Schneiderman’s office combined its efforts with the Department of Housing and Urban Development, the S.E.C., the inspector general of the Federal Housing and Finance Agency, the Federal Bureau of Investigation and the Department of Justice.

The lawsuit’s filing, just days before the first presidential debate and a little over a month before the election, may be a way for the Obama administration to try to convince voters that it is working to hold mortgage miscreants accountable for wrongdoing. But, lawyers say, filing a case is not the hard part; winning it is.

The complaint contends that Bear Stearns defrauded investors when it assured them of the stringent reviews being made of the loans the firm was bundling. “Rather than carefully reviewing loans for compliance with underwriting guidelines,” it said, “defendants instead implemented and managed due diligence review that was superficial and that often, and improperly, gave way to originators’ demands.”

Bear Stearns and EMC took other steps to keep mortgages flowing and their originators happy. Even after the loans it was bundling began failing at monumental rates, the complaint said, Bear Stearns did not require originators to buy them back as they were obligated to do. Instead, the firm allowed the originators to settle the put-back claims confidentially “by making cash payments that were a fraction of the contractual repurchase price,” according to the lawsuit.

During 2007 and the first quarter of 2008, the complaint said, Bear Stearns resolved claims relating to $1.3 billion of unpaid mortgage principal balances; it received $367 million in recoveries from the sellers.

The suit was brought against Bear Stearns under New York’s Martin Act, the state law that gives the attorney general wide latitude to bring fraud cases without demonstrating a defendant intended to defraud. The lawsuit does not seek specific damages but asks for restitution for investors victimized by the deceptive practices and disgorgement of money received in connection with the fraud.