JPMorgan Securities LLC will fully reimburse harmed investors, pay a stiff penalty and change the way it reviews and approves mortgage securities transactions.   All told, the settlement will cost JPMorgan $154 million.  

The SEC had alleged that JPMorgan structured and marketed a synthetic collateralized debt obligation (CDO) without informing investors that a hedge fund 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 the CDO assets it was selecting for the portfolio defaulted.  The transaction went off just as the housing market was starting to plummet.

The SEC separately charged Edward Steffelin, who headed the team at an investment advisory firm that the deal’s marketing materials misleadingly represented had selected the CDO’s portfolio. 

SEC's Detailed Allegations.   In its complaint, the SEC charged that the CDO known as Squared CDO 2007-1 was structured primarily with credit default swaps referencing other CDO securities whose value was 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) – which had experience analyzing CDO credit risk. 

Omitted from the marketing materials and unknown to investors was the fact that the Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and stood to benefit if the CDOs defaulted.

Steffelin, who headed the team at GSC responsible for the Squared CDO, allegedly allowed Magnetar to select and short portfolio assets.  Steffelin further allegedly drafted and approved marketing materials promoting GSC’s selection of the portfolio without disclosing Magnetar’s role in the selection process.  In addition, unknown to investors, Steffelin was seeking employment with Magnetar while working on the transaction.

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.”

In March and April 2007, JPMorgan allegedly knew it faced growing financial losses from the Squared deal as the housing market was showing signs of distress.  The firm then launched a frantic global sales effort that went beyond its traditional customer base for mortgage securities.  The JPMorgan employee in charge of Squared’s global distribution said in a 3/22/07 e-mail that “we are so pregnant with this deal…Let’s schedule the cesarian (sic), please!”  Ten months later, the securities had lost most or all of their value.

JPMorgan "Mezzanine" Notes.   According to the SEC, JPMorgan sold about $150 million of so-called “mezzanine” notes of the Squared CDO’s liabilities to more than a dozen institutional investors who lost nearly their entire investment.  These investors included: 

• Thrivent Financial for Lutherans of Minneapolis.
• Security Benefit Corporation of Topeka, Kansas. 
• General Motors Asset Management of New York.
• Financial institutions in East Asia including Tokyo Star Bank, Far Glory Life Insurance Company, Taiwan Life Insurance Company, and East Asia Asset Management.

Fines and Sanctions.   JPMorgan will pay $19 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty.  About $126 million will be returned to the mezzanine investors through a Fair Fund distribution.  The settlement also requires JPMorgan to change how it reviews and approves offerings of certain mortgage securities. In addition, JPMorgan’s consent notes that it voluntarily paid $57 million to certain investors in a transaction known as Tahoma CDO I.

The SEC will seek injunctive relief, disgorgement of profits, prejudgment interest, and penalties against Steffelin.  

For further details, go to:   [SEC PR 11-131, 6/21]