Immediately below is the from the Table of Contents in the Citigroup complaint. Further below is from Bank of America Complaint.
From Table of Contents of Citigroup Complaint
I. CDOs: THE MARKET, THE INSTRUMENTS AND CITIGROUP’S
ACTIVITIES IN IT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25
A. What CDOs Are . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26
B. Citigroup’s CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42
1. Citigroup’s CDO Exposures: Overview and Categorization . . . . . . . . . . 42
a. Plaintiffs’ Investigation and Conclusions . . . . . . . . . . . . . . . . . . 47
b. Timeline: Citigroup’s CDO Operations and Scheme . . . . . . . . . 52
2. Citigroup’s Commercial Paper CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . 55
3. Citigroup’s Mezzanine CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60
4. Citigroup’s High Grade CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 71
5. Citigroup’s Hedged CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 74
II. CDOs: WHAT THE MARKETPLACE KNEW AND BELIEVED . . . . . . . . . . . . . . . 83
A. The Housing Price Bubble and The Nonprime Mortgages Originated
Under Bubble Conditions . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 88
B. The Bubble Bursts in Early 2006 and Housing Prices Fall . . . . . . . . . . . . . . . . 103
C. Refinancing Becomes Impossible and a Wave of Nonprime
iii
Defaults Inevitable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 119
1. The Mid-2006 Spike in Early Payment Defaults Leads Some
Mortgage Originators to Collapse and Leads All Mortgage
Originators to Tighten Lending Standards . . . . . . . . . . . . . . . . . . . . . . . 119
2. Mortgage Origination Standards Further Constrict Under New
Regulatory Guidance on Mortgage Lending in September 2006
and February 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 131
3. The Final Collapse in Early 2007: Subprime Originators are
Rendered Extinct, Lending Standards Constrict Severely, and the
Possibility of Nonprime Refinancing Ends . . . . . . . . . . . . . . . . . . . . . . 139
D. What The Marketplace Knew and Believed . . . . . . . . . . . . . . . . . . . . . . . . . . . 148
1. The Market Understood, Correctly, That CDOs Would be Devastated
by Nonprime Mortgage Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149
a. Late 2006: Recognition Emerges . . . . . . . . . . . . . . . . . . . . . . . . 150
b. February 2007 - March 2007: Market Consensus Solidifies . . . 159
2. The Market Believed, Incorrectly, that Banks Such as Citigroup Had
Sold Off the CDOs They Had Underwritten and Would Thus Be Spared
from CDO Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172
3. Citigroup Knew Best Just How Precarious Its CDOs Were . . . . . . . . . 175
a. Losses Climb the Securitization Ladder from Mortgage to
RMBS to CDO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175
b. Citigroup’s Degraded “High Grade” CDOs . . . . . . . . . . . . . . . . 179
c. Citigroup Structured its CDOs so that They Could Only Work
Under Boom Scenarios . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 179
d. Citigroup Structured its CDOs By “Assuming” that
Underlying Assets Were Not Highly Correlated, When in
Fact the Underlying Assets Were Largely Identical and
Exposed in the Same Way to the Same Degree to the
Same Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 186
E. Inside the CDO Market - February to June 2007: Loss and Despair . . . . . . . . . 194
1. UBS – March 2007: UBS Conducts Experiment to Find Price at
Which Subprime-Backed Securities Actually Can Be Sold – And
Learns that Market Value of Subprime-Backed Securities is Only
50 Cents on the Dollar . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 194
2. Merrill Lynch: Merrill Tries to Conceal Its CDO Exposures
Through “Parking” Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195
3. Bear Stearns – March 2007 through June 2007: the CDO-Invested
BSAM Hedge Funds Undergo a Private Crisis and Then a Public
Implosion, Resulting in Investor Losses of 100% . . . . . . . . . . . . . . . . . 196
III. CDOs: STRATAGEMS, CONTROLS AND DISCLOSURES . . . . . . . . . . . . . . . . . . 198
A. Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 198
1. Citigroup’s Commercial Paper CDO “Sales”: How to Make $25 Billion
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of Subprime Exposures and Risks (Appear to) Disappear . . . . . . . . . . . 198
a. Further Schemes: How to Make Returning Subprime Exposures
and Risks (Appear to) Disappear Again . . . . . . . . . . . . . . . . . . . 205
2. Citigroup’s CDO Ponzi Schemes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 208
a. Case Study 1: Citigroup’s Tallships Funding CDO and
Citigroup’s Participation in Everquest Financial . . . . . . . . . . . . 208
b. Case Study 2: Citigroup’s “High Grade” Bonifacius CDO . . . 213
c. Case Study 3: Citigroup’s Degradation of its “High Grade”
CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215
3. The Continuation and Culmination of the Ponzi Scheme: Citigroup’s
Falsely Hedged CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220
a. Case Study 4: The Ponzi Scheme Continues in and Culminates
With the Hedged CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 221
b. Citigroup’s False Claim to Have Obtained Insurance Against
Loss Via its Hedged CDO Transactions . . . . . . . . . . . . . . . . . . 223
B. Controls . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224
1. Operational Risk: Defendants Misrepresent the Independence and
Rigor of Citigroup’s Risk Management and Control Functions . . . . . . 227
2. Credit Risk and Market Risk: “We Had a Market-Risk Lens Looking
at Those Products, Not the Credit-Risk Lens Looking at Those
Products” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231
3. Stress Testing . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241
4. Red Flags: AIG, Concerned About Subprime and U.S. Housing Prices,
Stops Insuring Super Senior Tranches of ABS CDOs in Early 2006 . . 242
5. Red Flags: Citigroup’s Failure to Sell Any of the Tens of Billions of
Dollars of Super Senior CDO Tranches that it Produced During
2004-2007 Was a Risk Management “Red Flag” . . . . . . . . . . . . . . . . . 243
6. Red Flags – The Risk/Reward Imbalance: In Order to Support
Hundreds of Millions of Dollars of Annual Underwriting Fees,
Citigroup Was Amassing Tens of Billions of Dollars of Subprime
Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 244
7. Red Flags: Citigroup’s Commercial Paper CDO Scheme Was Premised
on Citigroup’s Willingness to Take On $25 Billion of Subprime Risk
for Lower-Than-Market Payments for Such Risk . . . . . . . . . . . . . . . . . 245
C. Disclosures, Misrepresentations, Omissions . . . . . . . . . . . . . . . . . . . . . . . . . . . 245
1. Citigroup’s Disclosures Were Materially False and Misleading,
Omitted Material Information, Precluded Any Independent Assessment
of Citigroup’s Exposure to Potential Risks, and Precluded Understanding
that Any Material Subprime CDO Risks Existed At All . . . . . . . . . . . . 245
a. What Citigroup Said Throughout the Class Period Until
November 4, 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247
b. Securitizations and Variable Interest Entities . . . . . . . . . . . . . . 249
c. CDOs Were Presented as Distinct From Mortgage Securitizations
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and “Mortgage-Related Transactions” . . . . . . . . . . . . . . . . . . . . 252
d. Citigroup Presented its Mortgage Securitizations as Transactions
That Transferred to Others the Risk of Any Credit Losses from those
Mortgages . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 253
e. Citigroup Presented its CDOs as Instruments that Contained
Diverse Assets to Diversify Risk (rather than as Instruments
that Contained Correlated Assets and Concentrated Risk) . . . . 254
f. Citigroup Represented Its Role with Respect to CDOs as
One of “Limited Continuing Involvement” After Citigroup’s
Initial Warehousing, Structuring and Underwriting Activities . 255
g. Citigroup’s Disclosure of Aggregate CDO Assets Said Nothing
At All As to Citigroup’s Actual Interest in Those Assets
(i.e., the Retained Super Seniors) . . . . . . . . . . . . . . . . . . . . . . . . 257
h. Citigroup’s Reliance on Hypothetical Phrasing Masked
Actual Operations and Risk Exposures . . . . . . . . . . . . . . . . . . . 258
2. Citigroup’s Fundamental Misrepresentation of its CDO Operations . . . 260
3. Citigroup’s Financial Statements Understated and Misrepresented
Citigroup’s Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
a. Citigroup Omitted to Disclose the Material Risk
Concentration . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 262
b. Citigroup Understated Value at Risk and “Risk Capital” . . . . . 263
c. Citigroup Overstated “Return on Risk” . . . . . . . . . . . . . . . . . . . 267
4. Citigroup’s Financial Statements Materially Overstated the Fair Value
of Citigroup’s Super Seniors, and Defendants Ignored Numerous,
Observable, Relevant Indicators that the Fair Value
Was Substantially Impaired . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268
5. Citigroup’s November 2007 Disclosures and Valuations Were Still
False and Misleading . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273
a. Defendants’ November 5, 2007 Explanations Were Not Credible
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 274
b. Defendants’ November 5, 2007 Valuations and Writedowns
Were Not Credible, and Overstated the Value of Citigroup’s
CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278
c. Defendants’ Later, Larger Writedowns Finally Brought Citigroup’s
CDO Valuations in Line with Evident, Observable Market
Realities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 279
6. Citigroup’s Pre-November 2007 Super Senior Valuations Were
Simplistic, Solipsistic and Reckless Reliance on Credit Ratings –
Despite the Fact that the CDO Prospectuses Authored by Citigroup
Stated That Such Ratings Were Not Reliable Indicators of CDO
Value . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 281
a. Reliance on Ratings for Valuation Was Invalid Because it Was
Long Clear that the Ratings Were No Longer Valid . . . . . . . . . 282
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b. Citigroup’s Reliance on Credit Ratings for Valuation Invalid
Because Citigroup Itself Warned Investors in its CDOs Not to
Rely on Credit Ratings for Valuation . . . . . . . . . . . . . . . . . . . . 284
c. Citigroup’s Reliance on Credit Ratings for Valuation Invalid
Because More Timely and Accurate Valuation Information
Was Readily Available . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 286
7. Citigroup’s CDO Valuation Methods, Pre-April 2008, Were Without
Basis and Contradicted Citigroup’s Stated CDO Valuation Principles . 287
IV. STRUCTURED INVESTMENT VEHICLES (“SIVs”) . . . . . . . . . . . . . . . . . . . . . . . . 288
A. SIVs: What They Did, Why They Existed, and What Their Risks Were . . . . . 290
B. Citigroup’s SIVs: Schemes, Omissions, Misrepresentations and False
Accounting . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294
1. SIV Risks Materialize . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 299
2 Citigroup SIV Exposures Are Revealed . . . . . . . . . . . . . . . . . . . . . . . . 304
3. Citigroup SIV Exposures Had Been Concealed, Omitted and Misrepresented
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 312
V. CITIGROUP / CITIMORTGAGE’S MORTGAGE UNDERWRITING AND
MORTGAGE PORTFOLIO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
A. CITIGROUP, DURING THE CLASS PERIOD, HARMFULLY AND
INCREASINGLY EXPANDED ITS AMASSMENT OF TOXIC HOME LOANS
WHICH WERE GENERATED BY LAX OR NON-CONTROLLED
UNDERWRITING AND AS TO WHICH IT, ON A SYSTEMIC BASIS,
LACKADAISICALLY ENFORCED ITS RIGHTS . . . . . . . . . . . . . . . . . . . . . 326
1. General Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 326
2. Citigroup’s Massive Illusory Growth in Mortgage Market Share from 2005
to 2007 Was Only Achieved by the Company’s Deliberate Expansion into the
Subprime Market and Reliance on Risky Correspondent Channel Loans;
Unbeknownst to the Public, as Early as Mid-2006, Citigroup Was Aware of
Significant, Actual Impairments to the Value of These
Risky Loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
a. In Late Summer of 2005, Citigroup Began Consolidating Its
Mortgage Operations, Readying Itself to Expand Its Mortgage
Origination Business and Become One of the Largest Mortgage
Originators in the U.S.
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 328
b. Citigroup Also Expanded Its Offering of Other High Risk Loans Such
as High Loan-to-Value HELOC Loans that, Unbeknownst to the
Public, Became Seriously Impaired by No Later Than Mid-2007
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 330
c. Citigroup Increasingly Relied on Loans Generated by Its
Correspondent Channel to Build and Sustain Mortgage Origination
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Market Share Growth, and Consistent with the Elevated Risk Inherent
in These Loans, Citigroup’s Correspondent Loans, Unbeknownst to
the Public, Became Significantly Impaired in as Early as 2006
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 333
d. Citigroup, Unbeknownst to the Public, Also Added to Its Heightened
Risk Exposure of Poor Quality Loans by Loosening Its Lending
Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 335
3. Citigroup’s Own Filings in Lawsuits Against its Multiple Correspondent
and Warehouse Lenders Evidences its Class Period Knowledge of the
Widespread Fraud and Delinquencies Plaguing the Subprime Loan
Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
a. Citigroup, During the Class Period, Experienced A Multitude of
Various Dramatic Problems Involving Many of its Correspondent
Channel Loan Originators . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
i. Citigroup Recklessly Failed to Implement Meaningful
Underwriting Standards and Recklessly Failed to Conduct
Quality Control Audits or Reviews of the Correspondent
Loans It Was Buying, Contributing to the Vast and Publicly
Undisclosed Accumulation of Actually Impaired Loans
. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 338
ii. Unbeknownst to the Public, As Early As Mid-2006,
Citigroup’s Mortgages Were Increasingly Experiencing
First and Early Payment Defaults – Strong Indicators
of Borrower Fraud – As Evidenced in Citigroup’s
Actions Filed Against Certain Correspondent
Lenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 341
iii. Citigroup Failed to Implement Basic Compliance
Procedures to Detect and Prevent Owner Occupancy
Fraud or Misrepresentation . . . . . . . . . . . . . . . . . . . . . . 343
iv. Citigroup Recklessly Purchased Loans That Failed to
Comply with Fannie Mae Underwriting Guidelines . . . 344
v. Citigroup’s Representative Action Against Silver
State . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 344
vi. Citigroup’s Representative Action Against Certified
Home Loans of Florida . . . . . . . . . . . . . . . . . . . . . . . . . 347
vii. Citigroup’s Representative Action Against Accredited
Home Lenders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350
b. Citigroup Was Alerted, As Early As Mid-2006, of the
Disastrous Performance of Stale Loans Sitting in the
Warehouse Facilities of First Collateral Services,
Citigroup’s Warehouse Lender . . . . . . . . . . . . . . . . . . . . . . . . . 354
i. First Collateral’s Warehouse Lending Business . . . . . . 354
ii. First Collateral's Accumulation of Stale Loans Were a
viii
Key Indicator of Problems and Significant Deterioration
in the Mortgage Market . . . . . . . . . . . . . . . . . . . . . . . . . 356
B. CITIGROUP KNOWINGLY ISSUED FALSE AND MISLEADING STATEMENTS
REGARDING THE QUALITY OF ITS MORTGAGE LOAN
PORTFOLIO . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 361
1. Citigroup, Notwithstanding its Knowledge That Significant Portions
of its Portfolio Were Greatly Becoming Impaired, Issued Numerous
False Statements Touting its Loan Portfolio Quality as Well as its
Overall Financial Success, Misleading Investors into Believing
That Citigroup’s Purported Financial Growth from 2005-2007 Was
Based Firmly in the Origination of Sound Mortgages . . . . . . . . . . . . . . 361
a. July 31, 2006 American Banker Magazine Article . . . . . . . . . . 361
b. November 15, 2006 Merrill Lynch Banking and Financial
Services Investor Conference Presentation . . . . . . . . . . . . . . . . 362
c. December 2006 Mortgage Banking Magazine Article (“CitiMortgage
on the Move”) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363
d. Sept. 12, 2007 Lehman Conference Brothers Financial Services
Conference . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 366
2. Citigroup Issued Materially False and Misleading Financial Statements
That, in Violation of Gaap, Inflated Earnings by Materially Understating
its Loan Loss Reserves and Failing to Disclose Material Weaknesses
in Internal Controls over its Loan Underwriting Practices and
Procedures . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
a. General Accounting Principles Relating to Loan Loss
Reserves . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372
b. Citigroup’s Violations of the Relevant Accounting
Standards . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375
3. As Citigroup Knowingly Used its Own Deficient Loans as the Base
Collateral for its Initial Rmbs Securitizations, Citigroup’s Failure to
Disclose its Massive Retention of Virtually Worthless Rmbs and
Cdo Securities Was a Knowing, Fraudulent Omission . . . . . . . . . . . . . 383
4. Citigroup’s 2008 Reform of its Lending Practices Confirm That
Their Loan Underwriting Was Fundamentally Flawed and
Materially Risky . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 385
5. Citigroup Suffers Severe Credit Losses in 2008 as a Result
of its Risky Lending Practices, Necessitating an Unprecedented
$301 Billion Federal Bailout . . . . . . . . . . . . . . . . . . . . . . . . . . . 387
VI. LEVERAGED LOANS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 391
A. Background on leveraged loans and CLOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . 393
B. Citigroup’s leveraged-loan and CLO machine . . . . . . . . . . . . . . . . . . . . . . . . . 396
C. CLOs ramp up demand for leveraged loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
D. Negative basis trades increase gains/risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 397
ix
E. Synthetics, CLO collateral baskets, and market value deals fuel the fire,
increase the risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398
F. Citigroup’s false statements and omissions concerning its leveraged loan
commitments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 401
G. Citigroup’s write-downs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 403
VII. AUCTION RATE SECURITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 407
A. Citigroup Continues to Issue and Accumulate ARS Even as the ARS
Market Threatens to Collapse . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 409
B. The ARS Market Collapses and Citigroup Is Left Holding the Bag . . . . . . . . . 411
C. Citigroup Fails to Timely Disclose its Massive and Risky ARS Exposures . . . 411
D. The Magnitude of Citigroup’s ARS Holdings is Disclosed . . . . . . . . . . . . . . . . 411
E. The Market Learns that Citigroup’s ARS Assets Were Materially
Overvalued . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 412
F. Citigroup Knew That Its ARS Assets Were Growing and Becoming Riskier . . 414
VIII. ALT-A RMBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 416
A. A Description of Alt-A RMBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
B. The Risks Posed By ALT-A RMBS . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 417
C. The Market Learns of Accelerating Losses in Alt-A RMBS . . . . . . . . . . . . . . . 418
D. Citigroup Fails to Disclose Its Massive Alt-A RMBS Holdings . . . . . . . . . . . . 420
E. Citigroup Finally Reveals $22 Billion in Alt-A RMBS Exposure But
Materially Understates the Extent of Losses Stemming From These Assets . . . 421
F. Citigroup’s $80 Billion Accounting Gambit Hints at the True Extent
of the Company’s Alt-A RMBS Losses; Stock Losses Result . . . . . . . . . . . . . 422
G. The November 23, 2008 Government Bailout Confirms the Market’s
Dire Assessment of Citigroup’s Alt-A RMBS Valuations . . . . . . . . . . . . . . . . 423
IX. SOLVENCY . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 424
X. DEFENDANTS’ VIOLATIONS OF GENERALLY ACCEPTED ACCOUNTING
PRINCIPLES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
A. Overview of GAAP Violations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 436
B. GAAP Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 437
C. Citigroup Failed to Disclose a Concentration of Credit Risk From CDOs, Loans and
Financing Transactions With Direct Subprime Exposure . . . . . . . . . . . . . . . . . 447
D. Citigroup Failed to Consolidate its Commercial Paper CDOs . . . . . . . . . . . . . 441
E. Citigroup Overstated The Fair Value of its CDOs With Direct Subprime
Exposure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 443
F. Citigroup Failed to Consolidate its SIVs on its Balance Sheet . . . . . . . . . . . . . 449
G. Citigroup Overstated the Fair Value of its Total Assets and Stockholders’
Equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 451
x
XI. SCIENTER: CITIGROUP’S OWN ACTIONS FURTHER DEMONSTRATE
CITIGROUP’S SCIENTER . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455
A. Ab Initio: As A Structurer of RMBS and CDO Securitizations, Citigroup
Knew Exactly The Assumptions Used to Structure These Instruments,
and Thus Knew, as the Boom Ended, that Its CDOs Would Go Bust . . . . . . . . 455
B. Late 2006 and Early 2007: Citigroup’s Collaboration with BSAM and the
BSAM Funds Demonstrate Citigroup’s Awareness that CDO Risks were
Increasing and CDO Values were Decreasing . . . . . . . . . . . . . . . . . . . . . . . . . . 456
C. January 2007: Citigroup Recognizes that the Subprime Mortgages Originated
During 2006 Are the “Worst Vintage in Subprime History” . . . . . . . . . . . . . . . 467
D. February 2007: Citigroup's Purchase of Risk Insurance Reflects Scienter . . . . 467
E. February 2007: Citigroup’s Foraois Scheme Evidences Citigroup’s Awareness
of its Exposure to $25 Billion of Commercial Paper CDO Super Seniors . . . . 458
F. March 2007: Citigroup’s Quantitative Credit Strategy and Analysis Group’s
Report Demonstrates Citigroup’s Understanding and Awareness that Even
Super Senior CDO Tranches Were Already Impaired and Were at Risk of
Severe Downgrades and Losses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 459
G. March 2007: Citigroup’s March 2007 Credit Conference in Monaco
Demonstrates Its Awareness of Subprime’s Risks, Their Correlated
Concentration in CDOs, and the Likelihood of Loss for Those Exposed to
those Risks . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 462
H. March 2007: Citigroup’s Collateral Demands on New Century Financial,
and Citigroup’s Withdrawal of its Warehouse Credit Line, Demonstrate
Citigroup’s Awareness of the Devaluation of Subprime Mortgage Assets . . . . 464
I. April 2007: Citigroup’s Insertion of New, Detailed Subprime “Risk Factors”
in Citigroup’s CDO Prospectuses Demonstrates Citigroup’s Awareness of The
Exact Subprime Risks for CDOs At Issue Here . . . . . . . . . . . . . . . . . . . . . . . . 465
J. July 2007: The Introduction of Daily Risk Exposure Sessions Reflects
Scienter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 471
K. July 2007: Citigroup’s Role in the July 2007 Collapse of the Basis Capital
Hedge Funds Evidences Citigroup’s Awareness of the Collapse in Value
of CDOs . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 472
L. Citigroup’s Firing of its CDO, Investment Banking and Risk Management
Executives Further Supports an Inference of Scienter . . . . . . . . . . . . . . . . . . . . 475
M. The Accounts Provided by Confidential Witnesses Further Demonstrate
Scienter . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477
N. Citigroup's ATD Acquisition Supports An Inference of Scienter . . . . . . . . . . . 478
O. Motive: The Particular Acuity of the “Operating Leverage” Problem for
Citigroup and Defendants, and Defendants’ Turn to CDOs As the Purported
Solution to Their Problem . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
1. Citigroup’s Two Tasks: Improve Controls and Generate Operating
Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 479
2. Defendants’ Solution to Their Operating Leverage Problem: Release
xi
Risk Controls on Citigroup’s Investment Bank Division, Expand
CDO Operations, and Thereby Generate the Revenue Needed for
Operating Leverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 486
P. Motive: Insider Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492
From Bank of America Complaint
[From Table of Contents]
IV. OVERVIEW..................................................................................................................... 21
A. BoA Hastily Seizes The Opportunity To Acquire Merrill, And Agrees To
Pay A Significant Premium For The Company .................................................... 21
B. BoA And Merrill Secretly Agree To Pay Up To $5.8 Billion Of Bonuses To
Merrill Executives And Employees Before The Year-End .................................. 23
C. Lewis Presents The Merger To Investors While Concealing The Bonus
Agreement............................................................................................................. 26
D. During October And November 2008, Merrill’s Losses Grow To At Least
$15.5 Billion Before The Shareholder Vote ......................................................... 29
E. BoA’s Senior Officers Were Fully Aware Of Merrill’s Staggering Losses
Before The Shareholder Vote ............................................................................... 31
F. Internal BoA Documents And Sworn Testimony Establish That Defendants
Recognized That Merrill’s Losses Should Be Disclosed In Advance Of The
Shareholder Vote .................................................................................................. 34
G. As Merrill’s Losses Mount, Defendants Acknowledge That Disclosure Of
Merrill’s Losses Would Cause Shareholders To Vote Against The Merger –
And Abruptly Reverse Their Decision To Disclose ............................................. 36
H. As The Vote Approaches, Senior Management Is Informed That Merrill’s
Quarterly Losses Will Exceed $16 Billion, And Ignores Repeated Entreaties
To Disclose The Losses ........................................................................................ 39
I. While Merrill Deteriorates, The Billions In Merrill Bonuses Are Finalized........ 43
J. BoA And Merrill Issue The Materially False And Misleading Proxy.................. 44
K. Almost Immediately After Shareholders Approve The Merger, Mayopoulos
Learns That Merrill’s Pre-Vote Losses Are Materially Higher Than
What He Has Been Told, Seeks To Confront Price About That Discrepancy,
And Is Immediately Fired ..................................................................................... 46
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L. Lewis Secretly Decides To Invoke The MAC And Terminate The Deal,
But Agrees To Consummate The Transaction After Federal Regulators
Threaten To Fire Him ........................................................................................... 47
M. With BoA Unable To Absorb Merrill’s Losses, Lewis Secretly Seeks And
Receives An Enormous Taxpayer Bailout............................................................ 53
N. Internal BoA Emails Establish That, At The Same Time BoA’s Senior Officers
Decided Not To Disclose The Bailout Prior To The Merger’s Close, They
Internally Acknowledged That The Market Was Being Misled As To Merrill’s
True Financial Condition ...................................................................................... 56
O. The Merger Is Consummated While Defendants Lewis And Price Continue To
Conceal Merrill’s $21 Billion Of Losses, The $3.6 Billion In Bonuses Paid To
Merrill Executives And Employees, And The Taxpayer Bailout ......................... 58
P. The Prices Of BoA Securities Plummet As The Truth Emerges .......................... 59
Q. Post-Class Period Events ...................................................................................... 66
[Paragraphs 198 through 217 of the Complaint]
198. The fallout from the revelations described above has been immense, resulting in
additional civil and criminal investigations at both the federal and state levels. In addition to the
New York Attorney General’s investigation, which resulted in a complaint being filed on
February 4, 2010 against BoA, Lewis, and Price charging them with securities fraud, a similar
investigation was initiated by the Attorney General of North Carolina to determine whether,
among other things, Merrill and BoA had violated that state’s laws against fraudulent transfers
and civil racketeering. Neil Barofsky, the TARP Inspector General, also opened a probe.
199. Additionally, in January 2009, although it would not be disclosed to shareholders
until mid-July 2009, the Federal Reserve and the Office of the Comptroller of the Currency
downgraded the overall rating of BoA from “fair” to “satisfactory.” A letter sent by Federal
Reserve officials explaining the action criticized BoA’s management and directors for being
“overly optimistic” about risk and capital. As the letter explained, “Management has taken on
significant risk, perhaps more than anticipated at the time the acquisition was proposed,” and, as
a result, “more than normal supervisory attention will be required for the foreseeable future.” As
a result of these conclusions, in early May 2009, federal regulators imposed a “memorandum of
understanding” on BoA that, among other things, required it to address its problems with
liquidity and risk management.
200. On February 10, 2009, the New York Attorney General wrote a letter to Congress
providing details on Merrill’s accelerated bonus payments. The letter detailed how Merrill’s
accelerated bonus schedule had allowed it to disproportionately reward its top executives despite
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its massive losses – actions which the New York Attorney General described as “nothing short of
staggering.” In particular, the New York Attorney General stated that:
While more than 39 thousand Merrill employees received bonuses from the pool,
the vast majority of these funds were disproportionately distributed to a small
number of individuals. Indeed, Merrill chose to make millionaires out of a select
group of 700 employees. Furthermore, as the statistics below make clear, Merrill
Lynch awarded an even smaller group of top executives what can only be
described as gigantic bonuses.
201. Among the statistics that the New York Attorney General set forth were that
(i) “[t]he top four bonus recipients received a combined $121 million”; (ii) “[t]he next four bonus
recipients received a combined $62 million”; (iii) “[f]ourteen individuals received bonuses of
$10 million or more and combined they received more than $250 million”; and (iv) “[o]verall,
the top 149 bonus recipients received a combined $858 million.”
202. On April 29, 2009, at the Company’s annual meeting, BoA shareholders voted to
strip Lewis of his position as Chairman of the BoA Board in a vote that analysts deemed a rebuke
to Lewis’s conduct in connection with the merger. BusinessWeek reported that the “vote marked
the first time that a company in the Standard & Poor’s 500-stock index had been forced by
shareholders to strip a CEO of chairman duties.” At the shareholder meeting, Lewis conceded
that BoA’s shareholders “have carried a heavy burden” as a result of the Merrill acquisition.
203. On May 7, 2009, the U.S. Government revealed results of certain “stress tests” of
large banks conducted by the Federal Reserve. BoA was deemed to need an additional $33.9
billion of Tier 1 common capital – far more than any other of the 19 banks tested.
204. Beginning in May 2009, several members of BoA’s Board of Directors resigned,
including its lead independent director, O. Temple Sloan Jr., and Jackie Ward, chairman of the
Board’s asset quality committee. Other departures included Chief Risk Officer Amy Woods
Brinkley, and J. Chandler Martin, an enterprise credit and market risk executive.
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205. In June and July 2009, the Domestic Policy Subcommittee of the Oversight and
Government Reform Committee of the House of Representatives held a series of hearings on the
merger, with a particular focus on Lewis’s failure to disclose either Merrill’s mounting losses or
his arrangement to receive a Government bailout. During Lewis’s testimony on June 11, 2009,
Representative Dennis Kucinich told Lewis that, “Our investigation, Mr. Lewis, also finds that
Fed officials believe that you are potentially liable for violating securities laws by withholding
material information in your possession from shareholders before the vote to approve the merger
with Merrill Lynch on December 5th, 2008.” Representatives Peter Welch and Elijah Cummins
both repeatedly pressed Lewis on the lack of disclosure to shareholders. As Representative
Welch put it: “Did you tell your shareholders that you had come upon this information, that the
deal they voted on is not the deal that was going through, because they had a $12 billion hole that
was accelerating?”
206. On August 3, 2009, the SEC filed a complaint against BoA in the United States
District Court for the Southern District of New York, alleging that BoA had violated Section
14(a) of the Exchange Act by misleading shareholders about the Merrill bonus agreement. That
same day, the SEC announced that BoA had agreed to settle the action and pay a $33 million
fine.
207. As the SEC charged in its complaint, although the Proxy had stated that Merrill
would not pay year-end bonuses without BoA’s consent, in fact, BoA had already consented to
the payments as part of the Merger Agreement:
The omission of Bank of America’s agreement authorizing Merrill to pay
discretionary year-end bonuses made the statements to the contrary in the joint
proxy statement and its several subsequent amendments materially false and
misleading. Bank of America’s representations that Merrill was prohibited from
making such payments were materially false and misleading because the
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contractual prohibition on such payments was nullified by the undisclosed
contractual provision expressly permitting them.
208. During the SEC’s investigation, Merrill’s most senior human resources executive,
Peter Stingi (“Stingi”), whose responsibilities included monitoring the annual bonus pay of
Merrill’s competitors, acknowledged that the compensation expense set forth in Merrill’s
financial statements did not disclose Merrill’s bonus plans. Specifically, Stingi testified under
oath that:
We would not be able to see what our competitors’ quarterly [bonus] accruals
were because they like us would report their compensation and benefits expense
[as an aggregate] . . . . [Y]ou really couldn’t make a very exact guess about what
the impact on the annual bonus funding was because there are so many other line
items that go into the aggregate expense.
209. The day after the SEC filed its complaint, Representative Kucinich wrote to Mary
Schapiro, Chair of the SEC, to “request that the SEC expand its investigation into possible
securities law violations committed by Bank of America in connection with its merger with
Merrill Lynch.” Representative Kucinich explained that the House of Representatives’ Domestic
Policy Subcommittee of the Oversight and Government Reform Committee had “reviewed over
10,000 pages of confidential documents obtained from the Federal Reserve” and that “our
investigation has revealed . . . [t]op staff at the Federal Reserve had concluded that Bank of
America knew, as early as mid-November, about a sudden acceleration in the losses at Merrill
Lynch, and [Federal Reserve] General Counsel Scott Alvarez believed that Bank of America
could potentially be liable for securities laws violations for its failure to update its proxy
solicitation and public statements it had made about the merger in light of information Bank of
America possessed about Merrill’s deterioration before the shareholder vote.”
210. On September 8, 2009, the New York Attorney General sent a letter to BoA’s
outside counsel, which summarized the results of the New York Attorney General’s investigation
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and stated that it was in the process of “making charging decisions with respect to Bank of
America and its executives.” The letter provided that, “The facts of [Merrill’s] cascading losses
and bonus payments – and the facts of Bank of America’s senior executives’ knowledge of these
events – are straightforward.” The letter further provided that, “Our investigation has found at
least four instances in the fourth quarter of 2008 where Bank of America and its senior officers
failed to disclose material non-public information to its shareholders,” and did so knowingly,
including their failure to disclose (i) at least “$14 billion” of Merrill’s “losses prior to
shareholder approval of the merger,” about which “Bank of America knew”; (ii) “a goodwill
charge of more than $2 billion associated with sub-prime related losses,” which “was known of
by November” 2008 but nevertheless lumped into Merrill’s “purportedly ‘surprising’” losses
after the shareholder vote; (iii) Bank of America’s determination, “eight business days after the
merger was approved, that it had a legal basis to terminate the merger because of Merrill’s
losses,” which it reversed only “when the jobs of its officers and directors were threatened by
senior federal regulators”; and (iv) Merrill’s “accelerated bonus payments,” which “were not
disclosed in the proxy materials even though they clearly should have been under the
circumstances.”
211. On September 14, 2009, the Honorable Jed S. Rakoff, United States District
Judge for the Southern District of New York, rejected the proposed $33 million settlement of the
suit filed by the SEC against BoA. The Court held that the proposed settlement was “neither fair,
nor reasonable, nor adequate” because no senior BoA executives were sued or contributed to the
settlement. The Court found that the settlement violated the SEC’s “normal policy in such
situations [] to go after the company executives who were responsible for the lie,” and rejected
the SEC’s contention that it did not have grounds for bringing claims against senior BoA
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officials, remarking, “How can such knowledge [of the falsity of the statements in the Proxy] be
lacking when, as the Complaint in effect alleges, executives at the Bank expressly approved
making year-end bonuses before they issued the proxy statement denying such approval?”
212. Following the Court’s rejection of the settlement, the SEC filed a second action on
January 12, 2010, which asserted claims against Bank of America for violating Section 14(a) by
failing to disclose Merrill’s “extraordinary” fourth quarter 2008 financial losses. On February 4,
2010, BoA and the SEC jointly moved for approval of a Final Consent Judgment to resolve both
of the SEC actions, submitting a Statement of Facts establishing that BoA’s senior officers were
aware of the bonus agreement and Merrill’s losses. Significantly, BoA admitted that the SEC
Statement of Facts has an evidentiary basis and agreed to pay a civil penalty of $150 million and
to implement certain corporate governance reforms.
213. On February 22, 2010, Judge Rakoff approved the proposed settlement of the
SEC actions. In his Order approving the proposed settlement, Judge Rakoff noted that “it is clear
to the Court” that:
(1) the Proxy Statement that the Bank sent to its shareholders on November 3,
2008 soliciting their approval of the merger with Merrill Lynch & Co., Inc.
(“Merrill”) failed adequately to disclose the Bank’s agreement to let Merrill pay
its executives and certain other employees $5.8 billion in bonuses at a time when
Merrill was suffering huge losses; and
(2) the Bank failed adequately to disclose to its shareholders either prior to the
shareholder approval of the merger on December 5, 2008 or prior to the merger’s
effective date of January 1, 2009 the Bank’s ever-increasing knowledge that
Merrill was suffering historically great losses during the fourth quarter of 2008
(ultimately amounting to a net loss of $15.3 billion, the largest quarterly loss in
the firm’s history) and that Merrill had nonetheless accelerated the payment to
certain executives and other employees of more than $3.6 billion in bonuses.
S.E.C. v. Bank of America Corp., 2010 WL 624581, at *1 (S.D.N.Y. Feb. 22, 2010).
214. The Court further determined that these omissions were material, holding that, “it
seems obvious that a prudent Bank shareholder, if informed of the aforementioned facts, would
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have thought twice about approving the merger or might have sought its renegotiation.” Id. The
Court further found that, “based on careful review of voluminous materials,” including an
extensive ex parte review of confidential deposition testimony provided by the New York
Attorney General’s office, BoA and its officers acted at least negligently in making these
omissions, and specifically declined to make “any determination” of whether BoA and its
officers acted intentionally because that issue was neither before the Court nor necessary to its
decision. Id. at *3. While the Court noted that “a reasonable regulator” could conclude that BoA
and its officers acted negligently, the Court also found that the facts supported “plausible
contrary inferences” of intentional misconduct. Id.
215. On September 18, 2009, the Charlotte Observer reported that, for the prior six
months, the F.B.I. and the U.S. Department of Justice had been conducting an extensive
“criminal investigation” of BoA in connection with the merger. As part of this wide-ranging
investigation, BoA “provided hundreds of thousands of documents and dozens of hours of
executive time” to answer questions.
216. That same day, Bloomberg reported that, on September 17, 2009, Defendant
Thain gave a speech at the Wharton School of the University of Pennsylvania, during which he
made clear that BoA’s claim that it lacked control over the bonuses paid to Merrill executives and
employees was not true:
[W]hen [BoA] said, “John Thain secretly accelerated these bonuses,” they were
lying and that has now trapped them into a lot of trouble because there is a piece
of paper, there’s a document that says, yes, in fact they agreed to this in
September. So one take away for all of you is it’s really always better to just tell
the truth.
217. Then, on February 4, 2010, the New York Attorney General formally charged
BoA, Lewis, and Price with four counts of securities fraud under New York’s Martin Act,
General Business Law §§ 352 and 353. Specifically, the New York Attorney General alleged that
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BoA, Lewis, and Price made a series of false and misleading statements and omissions
concerning, among other things, Merrill’s massive fourth quarter losses; BoA’s agreement to
allow Merrill to pay billions in bonuses on an accelerated basis before the merger closed, despite
Merrill’s financial performance; and the undisclosed $138 billion taxpayer bailout that BoA
required in order to complete the merger. Defendants did not move to dismiss the New York
Attorney General’s complaint and, instead, answered the allegations on August 18, 2010.
A persistent media-liberal lament—make that a cliché—is that too few
financiers have been prosecuted for the financial crisis. But maybe that's
because when the Obama Administration tries to prosecute a specific individual
for a specific crime, it turns out there was no crime.
The government's latest embarrassments came this month, as one high-profile case collapsed and another was downsized by a federal judge. On November 16, the Securities and Exchange Commission dropped a civil lawsuit against Edward Steffelin. As an employee at GSC Capital, he helped create a synthetic collateralized debt obligation called Squared CDO 2007-1 that was offered by J.P. Morgan Chase JPM +2.63%. It was synthetic because although it allowed investors to bet on the subprime housing market, it involved very little ownership of actual mortgages. Anyone investing in this deal knew he was simply gambling on a continued housing boom.
The government accused Mr. Steffelin of not informing Squared purchasers that another investor in the deal, a hedge fund called Magnetar, had helped select the mortgage pools to be wagered upon while it was simultaneously shorting some of them. Mr. Steffelin argued that Magnetar did not control which assets were in the deal. He also said he had done his job by accurately describing these assets to J.P. Morgan, which as far as he knew had accurately described them to investors. These would be sophisticated institutional investors who were eager to profit from the housing mania but are now cast as victims by prosecutors.
Since the Steffelin prosecution wasn't a criminal case but a civil suit, it presented a much lower bar for prosecutors to clear. But apparently not low enough. Last year U.S. District Judge Miriam Goldman Cedarbaum threw out the SEC's fraud charges, saying that it was a "big stretch" to say that Mr. Steffelin had a fiduciary duty to investors. That left only the accusation of negligence, and Judge Cedarbaum has now allowed the SEC to dismiss its case entirely.
It's true that J.P. Morgan Chase paid $153.6 million of its shareholders' money to settle a related SEC suit for its role in this transaction. But the bank admitted no wrongdoing and sees great value in avoiding adverse publicity. The problem for the government occurs whenever it has to prove that an actual human being has done something wrong.
Memories are still fresh from the SEC's July courtroom loss to Brian Stoker, a former Citigroup C +1.67%employee. The SEC argued that Mr. Stoker had been negligent in assembling a similar mortgage CDO deal, but a jury of his peers decided that he'd broken no securities laws.
Next year will bring the civil trial of former Goldman Sachs GS -0.54%banker Fabrice Tourre, but last Monday U.S. District Judge Katherine Forrest slapped down the SEC's effort to revive a part of the case that was dismissed last year on jurisdictional grounds. So far Mr. Tourre is claiming his innocence, and our guess is that the SEC staff is terrified that "Fabulous Fab" might decide not to settle.
This political prosecution was brought at the height of the Senate debate over Dodd-Frank. Goldman settled by paying $550 million without admitting guilt in a case that also should never have been brought. (See "The SEC vs. Goldman," April 19, 2010.)
The Journal recently reported that another enforcement action against J.P. Morgan will include no charges against individuals. And on Tuesday New York Attorney General Eric Schneiderman sued Credit Suisse CSGN.VX -0.35%over still more mortgage deals, and again with no human defendants. What a concept: wrongdoing by banks that includes no wrongdoing by any bankers.
Speaking of mystery bankers, pundits on the left are now claiming that prosecutors should really be charging people who served at the top of financial firms. So prosecutors are supposed to gather more evidence against the CEO than they can against the employees who crafted the particular deals at issue?
Critics are also blaming incompetence at the SEC or the Department of Justice, as if the quality of prosecutors has suddenly deteriorated. They are no better or worse than ever. The prosecutors have simply been given a difficult assignment trying to find criminality among bankers who were doing what everyone else was doing in a financial mania fueled by government policy.
The Federal Reserve created negative real interest rates and a net subsidy for credit expansion. Washington programs to encourage every American to own a home ensured that the bubble would be concentrated in residential real estate. Government-approved credit-raters, convinced that the U.S. housing market would never suffer a sharp decline, slapped triple-A ratings on bundles of risky mortgages. Federal rules encouraged banks, money-market funds, stock brokerages and other institutions to buy this junk.
The zeal to prosecute bankers is part of the politically convenient narrative that the financial crisis was all created on Wall Street. Bankers were greedy as ever and their risk management was faulty. But the fact that Washington can't find a real criminal should focus public attention back on the real crime. That was Beltway policy.
The government's latest embarrassments came this month, as one high-profile case collapsed and another was downsized by a federal judge. On November 16, the Securities and Exchange Commission dropped a civil lawsuit against Edward Steffelin. As an employee at GSC Capital, he helped create a synthetic collateralized debt obligation called Squared CDO 2007-1 that was offered by J.P. Morgan Chase JPM +2.63%. It was synthetic because although it allowed investors to bet on the subprime housing market, it involved very little ownership of actual mortgages. Anyone investing in this deal knew he was simply gambling on a continued housing boom.
The government accused Mr. Steffelin of not informing Squared purchasers that another investor in the deal, a hedge fund called Magnetar, had helped select the mortgage pools to be wagered upon while it was simultaneously shorting some of them. Mr. Steffelin argued that Magnetar did not control which assets were in the deal. He also said he had done his job by accurately describing these assets to J.P. Morgan, which as far as he knew had accurately described them to investors. These would be sophisticated institutional investors who were eager to profit from the housing mania but are now cast as victims by prosecutors.
Since the Steffelin prosecution wasn't a criminal case but a civil suit, it presented a much lower bar for prosecutors to clear. But apparently not low enough. Last year U.S. District Judge Miriam Goldman Cedarbaum threw out the SEC's fraud charges, saying that it was a "big stretch" to say that Mr. Steffelin had a fiduciary duty to investors. That left only the accusation of negligence, and Judge Cedarbaum has now allowed the SEC to dismiss its case entirely.
It's true that J.P. Morgan Chase paid $153.6 million of its shareholders' money to settle a related SEC suit for its role in this transaction. But the bank admitted no wrongdoing and sees great value in avoiding adverse publicity. The problem for the government occurs whenever it has to prove that an actual human being has done something wrong.
Memories are still fresh from the SEC's July courtroom loss to Brian Stoker, a former Citigroup C +1.67%employee. The SEC argued that Mr. Stoker had been negligent in assembling a similar mortgage CDO deal, but a jury of his peers decided that he'd broken no securities laws.
Next year will bring the civil trial of former Goldman Sachs GS -0.54%banker Fabrice Tourre, but last Monday U.S. District Judge Katherine Forrest slapped down the SEC's effort to revive a part of the case that was dismissed last year on jurisdictional grounds. So far Mr. Tourre is claiming his innocence, and our guess is that the SEC staff is terrified that "Fabulous Fab" might decide not to settle.
This political prosecution was brought at the height of the Senate debate over Dodd-Frank. Goldman settled by paying $550 million without admitting guilt in a case that also should never have been brought. (See "The SEC vs. Goldman," April 19, 2010.)
The Journal recently reported that another enforcement action against J.P. Morgan will include no charges against individuals. And on Tuesday New York Attorney General Eric Schneiderman sued Credit Suisse CSGN.VX -0.35%over still more mortgage deals, and again with no human defendants. What a concept: wrongdoing by banks that includes no wrongdoing by any bankers.
Speaking of mystery bankers, pundits on the left are now claiming that prosecutors should really be charging people who served at the top of financial firms. So prosecutors are supposed to gather more evidence against the CEO than they can against the employees who crafted the particular deals at issue?
Critics are also blaming incompetence at the SEC or the Department of Justice, as if the quality of prosecutors has suddenly deteriorated. They are no better or worse than ever. The prosecutors have simply been given a difficult assignment trying to find criminality among bankers who were doing what everyone else was doing in a financial mania fueled by government policy.
The Federal Reserve created negative real interest rates and a net subsidy for credit expansion. Washington programs to encourage every American to own a home ensured that the bubble would be concentrated in residential real estate. Government-approved credit-raters, convinced that the U.S. housing market would never suffer a sharp decline, slapped triple-A ratings on bundles of risky mortgages. Federal rules encouraged banks, money-market funds, stock brokerages and other institutions to buy this junk.
The zeal to prosecute bankers is part of the politically convenient narrative that the financial crisis was all created on Wall Street. Bankers were greedy as ever and their risk management was faulty. But the fact that Washington can't find a real criminal should focus public attention back on the real crime. That was Beltway policy.