Wall Street Banks Brace for Widening Financial Regulatory Probes

UBS, Morgan Stanley are among firms accused in lawsuits of CDO misdeeds.

April 19, 2010, 7:08 PM

April 20, 2010— -- For institutional investors who lost money in questionable mortgage investments sold to them by Wall Street, the Securities and Exchange Commission's new focus on derivatives fraud might seem long overdue. For Wall Street investment banks, it may seem like a witch hunt.

Regardless, industry members and securities lawyers say, a tidal wave of regulatory complaints could soon strike Wall Street's powerhouses, and not just Goldman Sachs. On Friday, the SEC slapped Goldman with a civil suit alleging fraud.

"All of the major banks got their hands dirty," said Lawrence Klayman, a partner at Klayman & Toskes, which specializes in securities litigation. "Where there were structured products, such as collateralized debt obligations, there were investors who weren't given full and fair disclosure. That's at the heart of all these cases."

In bringing its first fraud case following the mortgage securitization market's implosion, the SEC made it abundantly clear that it is also probing other subprime mortgage-pool-tethered deals peddled by Wall Street.

Institutions that bought in -- and got burned -- are already taking matters into their own hands. Over the past few years, from western New York to the eastern Caribbean, institutional investors are filing lawsuits over CDO schemes gone sour.

Since the housing market and credit derivatives markets collapsed beginning in 2007 there have been more than 100 lawsuits tied to $400 billion in losses, according to industry research cited by the New York Times.

Among them:

Trouble in Paradise

"Morgan Stanley was betting the entire investment it was promoting would fail," the complaint said.

A Morgan Stanley spokeswoman declined comment. Last month, the firm filed a motion to dismiss the case.

Before the mortgage market meltdown even began, in early 2008, Merrill Lynch was forced to reimburse the city of Springfield, Mass., more than $10 million following losses in a CDO investment that the firm, now part of Bank of America, conceded had been sold improperly, without the city's permission. Massachusetts Secretary of the Commonwealth William Galvin later filed a separate lawsuit against Merrill.

Merrill, along with UBS and Deutsche Bank, were the largest arrangers of CDOs and are expected to be among the firms targeted by federal regulators in a probe that now shows no sign of letting up any time soon.

"A lot of this stuff would have seemed like fairly standard operating procedure at the time these deals were being sold," said one Wall Street CDO veteran who asked not to be named, citing the possibility of losing his job. "But take it against the backdrop of the meltdown ... and add in some incendiary emails ... it's a problem that is not going away."

Large investment banks earned about $1 billion in fees creating and selling mortgage-laden CDOs, according to the Wall Street Journal. A Credit Suisse report on the largest CDO underwriters during the boom period, 2005-2008, shows that Merrill Lynch, UBS, JPMorgan, Citi and Morgan Stanley were the five largest players, and, combined, arranged more than $50 billion worth of deals.

Klayman said he has more than a half dozen arbitration cases currently pending against Wall Street firms, including UBS, in which sophisticated investors, pension funds and hedge funds, are seeking damages over CDO investments gone bad.

Doug Morris, a UBS spokesman, had no comment.

These cases are pending before the Financial Industry Regulatory Authority.

Goldman Mounts Vigorous Defense

"The Wall Street banks like to say that they sold these to sophisticated investors who knew what they were getting into," Klayman said. "No matter how sophisticated someone is, if they don't have the full story, if things are misrepresented, it's fraud."

Goldman has vigorously defended itself via a slew of written statements reiterating that it made no misrepresentations to clients and that the SEC failed to mention in its complaint that Goldman lost $90 million on the CDO deal, proving Goldman did not deliberately booby-trap the deal by allowing John Paulson, a mortgage market short seller, to handpick mortgages that went into it so as to line the deal with investments sure to fail. Investors surely knew there were investors on the other side of the deal, Goldman stressed.

Klayman, for his part, isn't buying the argument.

"Goldman lost $90 million, so that is supposed to make us think they are innocent? I wonder how much they made facilitating Paulson's trades," Klayman said. "We'll never know. The investors never knew that Paulson, a short seller, helped build the portfolio. If they did, do you think they still would have invested? We all know right from wrong. To me, this clearly was wrong."

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