Econintersect: The first big case involving SEC (Securities and Exchange Commission) investigation of fraud in the massive secutization processes that predeeded the financial crisis was settled with a $550 million dollar payment by Goldman Sachs (NYSE:GS) in July, 2010. The case involved alleged misrepresentations about a synthetic CDO security named Abacus 2007- AC1. Because that case did not go to trial it was feared that all the details of what happened with that CDO would not be made public and put a damper on further prosecutions. That does appear to be the case.The Financial Times reports that the SEC is investigating Merrill Lynch for the sale of a complex mortgage-related security it created for Magnetar, an Illinois hedge fund, and the collateral manager in the creation of a CDO product named Norma. Magnetar was a major player in the complex securitzation frenzy from 2004-2007. Merrill Lynch is now part of Bank of America (NYSE:BAC).
Editor’s note: Wikipedia has fairly complete description of CDOs.
This is another “big fish” with importance to advancing the understanding of what exactly was being done in the securitization jungle of the credit bubble. In this case, not only the investment bank is reported under investigation, the CDO manager is also.
A non-profit financial watchdog organization, Pro Publica, conducted an extensive investigation into the Magnetar operations and published critical reports in early 2010.
The following graph and table from Pro Publica show the size and institutional reach of the Magnetar CDOs.
Over a year ago GEI editor John Lounsbury wrote (at Seeking Alpha) about Magnetar and charges against Goldman Sachs involving the Abacus 2007- AC1 CDO mentioned earlier.
Yesterday I wrote about the allegations by ProPublica.org that a Chicago hedge fund, Magnetar, was guilty of double dealing in junk sub-prime mortgages securities. The actions alleged involved charges that Magnetar deliberately sought out the riskiest sub-prime mortgages for CDO formulators to put into securities that Magnetar could then short. The charges are that Magnetar profited from the creation and sale of the mortgage backed securities (MBS) and then again from taking short positions on the same. As stated in the article, Magnetar has issued a detailed denial of the allegations.
If Magnetar was the tip of the iceberg, the berg just rolled over this morning and two icy protuberances are now exposed. The SEC made public civil charges of fraud against Goldman Sachs and 31 year old Vice President Fabrice Touree with regard to specific mortgage securities transactions. Two early reports about this were written by Alan Rappeport at ft.com and Felix Salmon at Reuters.com. Also of interest, there are a number of comments on the Goldman/SEC news at Seeking Alpha Market Currents.
This news does not constitute the start of a new bear market leg, in this analyst’s opinion. It does represent the start of a period of discovery about manipulative activities that led to making a credit bubble inflate to a dangerous level with the disastrous result experienced in 2008-09. Maybe, just maybe, this could be the start of the 10% correction we have been awaiting for nine months now. But a much bigger shock will be necessary to produce a big sell-off of 20% or more.
There is an iceberg here. More of the structure will eventually be mapped. There will be more Magnetars and more people like Fabrice Tourre. Curiously, John Paulson was not charged in the SEC action. That is most likely because, although what he is purported to have instigated may be considered a conspiracy, he may not have done anything within the purview of SEC regulation.
The iceberg is still being explored.
“Magnetar went into the business of creating subprime CDOs on an unheard of scale. If the world had been spared their cunning, the insanity of 2006-2007 would have been less extreme and the unwinding milder.”