Saturday, February 9, 2008
With the subprime mortgage meltdown undermining the balance sheets of companies ranging from bond insurers to banks and brokerage firms, the possibility that fraud crept into the market is being explored by the SEC, the FBI, and the Department of Justice. According to various media reports, the United States Attorney's Offices for the Southern and Eastern Districts of New York have begun to look at Merrill Lynch and UBS related to their pricing of CDOs tied to mortgages, if the firms issued false information about the value of the securities they were peddling. The SEC has bumped up its inquiries into the companies' practices to formal investigations, which means subpoena authority for the Commission staff. More broadly, the FBI disclosed that it is looking at fourteen companies for their roles in the subprime mortgage market, including possible insider trading. (See articles from MarketWatch here, the Toronto Star here, and CNN.Money here)
With all these federal resources being brought to bear on the subprime market, should we expect a cascade of criminal and civil enforcement actions in the near future? The government never moves all that quickly, of course, so "near future" could be anywhere from one to two years from now. The investigations themselves are at a fairly early stage at this point, with the SEC still gathering information. The Department of Justice usually waits until the Commission is fairly well along in the investigation before jumping in because the SEC can help winnow down the mountain of documents such investigations generate. Even then, I would not expect to see many criminal cases come out of these investigations, and it's unlikely any company would be charged. At most we might see a few deferred or non-prosecution agreements, because no one wants to risk a prosecution that could put a major financial firm out of business -- the Arthur Andersen effect once again.
Trying to track down the appropriate price of CDOs and other mortgage related securities is probably just this side of impossible, so proving that prices were inflated might not be achievable. The Wall Street firms were not involved in the actual writing of the subprime or other mortgages, only the process of securitizing pools of mortgages to sell to investors. Regardless of whether any of the firms made misstatements in marketing the securities, or placing clients in inappropriate investments, these investigations will not do anything to provide relief from the rising number of foreclosures that are spreading through the market as housing prices drop. Part of the problem with the subprime market was that it worked so well, encouraging firms to make riskier and riskier loans because they could be sold off quickly to investors. Stupidity is not a federal offense, at least not yet, and losing the game of financial musical chairs by being left with cratering securities on your balance sheet does not mean the company committed fraud. Firms no doubt cut corners, but whether there are real fraud cases that go beyond second-guessing remains to be seen. (ph)