Federal prosecutors, working with securities regulators, are conducting a preliminary criminal probe into whether several major Wall Street banks misled investors about their roles in mortgage-bond deals, according to a person familiar with the matter.
The banks under early-stage criminal scrutiny — JPMorgan Chase & Co., Citigroup Inc., Deutsche Bank AG and UBS AG — have also received civil subpoenas from the Securities and Exchange Commission as part of a sweeping investigation of banks' selling and trading of mortgage-related deals, the person says. Under similar preliminary criminal scrutiny are Goldman Sachs Group Inc. and Morgan Stanley, as previously reported by The Wall Street Journal.
The Manhattan U.S. Attorney's office and SEC are working hand-in-hand. At issue is whether the Wall Street firms made proper representations to investors in marketing, selling and trading pools of mortgage bonds called collateralized debt obligations, or CDOs.
Many major Wall Street banks created CDOs at the behest of players that made bets against the deals — and banks themselves sometimes bet against the deals. Bearish bets paid off when the mortgage market crashed.
Representatives of the Manhattan U.S. Attorney's office, the SEC, Goldman, Citigroup, Deutsche Bank and UBS all declined to comment. Morgan Stanley said it hadn't been contacted by prosecutors and has done nothing wrong. A JPMorgan spokesman said the bank "hasn't been contacted" by federal prosecutors and isn't aware of any criminal investigation.
The criminal probe marks an important juncture in the fallout from the financial crisis and highlights the severity of the scrutiny for Wall Street.
Prosecutors have brought just one major criminal case stemming from the crisis, against two Bear Stearns Cos. traders, and lost it. Lawmakers are calling on prosecutors to do more.
Prosecutors so far are simply gathering evidence. They haven't issued criminal subpoenas, nor have they homed in on the outlines of any potential case.
To win a criminal case, they would have to prove beyond a reasonable doubt that a firm or its employees intentionally misled investors.
It's possible the probe could end with no charges being brought against any of the firms. It is unclear whether any individuals are of particular interest to the authorities.
As part of the joint probe, the SEC has asked the banks for a range of documents, including final and draft prospectuses, final and draft offering documents and investor lists associated with mortgage-related deals, the people say.
Last month, the SEC sued Goldman in a New York federal court, alleging that the firm and one of its mortgage traders created a product designed to fail for the benefit of a favored hedge-fund client without disclosing the client's role in picking investments for the deal.
Goldman has vigorously denied the allegations but recently began settlement talks with the government, people familiar with the matter say.
It isn't known which specific deals investigators are focusing on. Nearly every major Wall Street bank created and traded CDOs, with different twists.
Wall Street firms issued a total of $1.08 trillion in CDOs between 2005 and 2007, according to research firm Thomson Reuters. Merrill Lynch & Co. (now part of Bank of America Corp.), Citigroup and Deutsche Bank issued the largest dollar amount of CDOs in those years.
JPMorgan, Morgan Stanley, UBS and Goldman were ranked Nos. 5, 7, 10 and 14, respectively, Thomson Reuters says.
Morgan Stanley shares fell 2% Wednesday following a Journal article saying the Manhattan U.S. Attorney was investigating whether the firm misled investors about mortgage-derivatives deals it helped design and sometimes bet against.
Citigroup, Deutsche Bank and UBS created mortgage CDOs named after constellations such as Cetus, Carina and Virgo at the behest of a hedge-fund client, Magnetar Capital, according to people familiar with the matter.
Magnetar bought a risky piece of the deals and placed bearish bets against other parts of the same CDOs or similar deals, the people say. Those bets enabled the fund to profit in a housing downturn.
In the few years before the housing downturn, Morgan Stanley designed, created and sold CDOs that its own traders sometimes bet against, traders say.
Among CDOs the firm created and bet against were deals called ABSpoke in 2005 and 2006, according to traders. Morgan Stanley sold about a dozen of these deals in that time, according to Thomson Reuters.
Another such deal Morgan Stanley marketed to investors in mid-2006 and also bet against was called Baldwin 2006-I, according to people familiar with the matter.
People familiar with Morgan Stanley say the firm's roles on Baldwin and ABSpoke were "fully disclosed' to investors who were betting on mortgage assets holding up.
A feature of the Morgan Stanley deals was a structure that could increase bullish investors' exposures to the underlying mortgage bonds. This made it more likely such investors could lose money if the bonds performed poorly.
Morgan Stanley took the bearish side of these transactions in what turned out to be the more profitable bets, say traders.
Across Wall Street, disclosures in CDO deals were inconsistent. Banks often provided pages of potential conflicts and risk factors about each deal in offering documents.
But there sometimes was spotty disclosure about the possible involvement of institutions with bearish market views in the deals' creation and design.
Some CDO offering documents indicated that mortgage assets selected for the deals may have factored in the interests of market players whose interests were "adverse" to other investors.
But none went as far as to state that hedge funds or banks' trading desks were making bets against the deals for their own accounts, according to documents reviewed by the Journal.