The Securities and Exchange Commission said Tuesday that J.P. Morgan Securities LLC would pay $153.6 million to settle SEC charges that it misled investors in a complex mortgage-securities transaction. J.P. Morgan also agreed to improve the way it reviews and approves mortgage securities transactions.
According to the SEC, the transaction took place as the housing market was starting to plummet, and — under the settlement — investors would receive their money back. It entailed a synthetic collateralized debt obligation (CDO),
which was sold to investors without the disclosure that a hedge fund had helped select the assets in the CDO portfolio and had a short position in more than half of those assets. As a result, the hedge fund was poised to benefit if these CDO assets defaulted, the SEC says.
“J.P. Morgan marketed highly-complex CDO investments to investors with promises that the mortgage assets underlying the CDO would be selected by an independent manager looking out for investor interests,” said Robert Khuzami, director of the SEC’s division of enforcement, in a press release.
“What J.P. Morgan failed to tell investors was that a prominent hedge fund that would financially profit from the failure of CDO portfolio assets heavily influenced the CDO portfolio selection,” Khuzami (left) explained. “With [Tuesday’s] settlement, harmed investors receive a full return of the losses they suffered.”
Without admitting or denying the allegations, J.P. Morgan agreed to a payment of $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty. Of the $153.6 million, $125.87 million will be returned to the mezzanine investors through a Fair Fund distribution, and $27.73 million will be paid to the U.S. Treasury.
The settlement also requires J.P. Morgan to change how it reviews and approves offerings of certain mortgage securities. In addition, J.P. Morgan’s consent notes that it voluntarily paid $56,761,214 to certain investors in a transaction known as Tahoma CDO I.
According to the SEC’s complaint, Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities with their valuations tied to the U.S. residential housing market. Marketing materials stated that the Squared CDO’s investment portfolio was selected by GSCP (NJ) L.P. – the investment advisory arm of GSC Capital Corp. (GSC). However, the marketing materials failed to state that Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and stood to benefit if the CDOs defaulted.
The SEC alleges that by the time the deal closed in May 2007, Magnetar held a $600 million short position that dwarfed its $8.9 million long position. In an internal e-mail, a J.P. Morgan employee noted, “We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.”