(JPM) JPMorgan Chase/SEC Settle CDO Charges

JPMorgan Chase & Co.’s (JPM) U.S. broker-dealer affiliate, J.P. Morgan Securities LLC, has agreed to pay $153.6 million to settle charges with the U.S. Securities and Exchange Commission (SEC). The SEC had alleged the bank of misleading investors in a synthetic collateralized debt obligation (CDO) known as Squared CDO 2007-1 that was tied to the U.S. housing market.

The investors suffered significant losses on their investments in this product when the housing market collapsed. As part of its settlement, JPMorgan also consented to improving its reviews and approval of its mortgage securities transactions.

The Allegations

According to the SEC allegations, the CDO was structured and marketed by JPMorgan. When this product was sold to the investors, they were not informed about a hedge fund that had assisted in selecting the CDO portfolio assets.

Investors were told that the highly complex CDO investment’s mortgage assets were to be chosen by an independent manager seeking investor interests. The marketing material stated that GSCP (NJ) L.P., the investment advisory arm of GSC Capital Corp. (GSC) with expertise in analyzing CDO credit risk has selected the portfolio.

However, in reality, Magnetar Capital LLC hedge fund had substantially influenced the selection of the portfolio and had a short position over 50% of those assets. So this hedge fund obviously stood to benefit financially from the CDO default.

In March and April 2007, JPMorgan was well aware that it would incur financial losses from the Squared CDO deal as the housing market was experiencing a slowdown. It then aggressively marketed this product and sold about $150 million of those securities to over a dozen institutional investors. These investors suffered a substantial loss on their entire investment.

Charges are also brought against Edward S. Steffelin, the Team Head at GSC responsible for the Squared CDO. Steffelin has been alleged to allow Magnetar to select and short portfolio assets. The marketing materials promoting GSC’s selection of the portfolio were drafted and approved by Steffelin and no disclosures were made regarding Magnetar’s role in choosing the portfolio. It has also been alleged that at the time when Steffelin was working on this deal, he was looking for employment opportunities at Magnetar.

The Settlement

JPMorgan neither admitted nor denied the allegations but consented on settling the case by paying a charge of $153.6 million. Of this total amount, $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.

According to a statement by JPMorgan, the company had suffered around $900 million in losses on the investment. The company also reviewed certain CDOs and voluntarily paid $56 million to the investors in a transaction known as Tahoma CDO I.

Our Take

The SEC has stepped up its investigation on Wall Street companies over the sale of CDOs that were responsible for significant losses to investors and the financial crisis. Last year, Goldman Sachs Group Inc. (GS) settled a charge by paying $550 million for not disclosing to the buyers the role of a hedge fund firm in formulating the CDOs and taking a short position and betting on them to perform poorly in the open market.

While such charges will dent JPMorgan’s reputation and its financials, we believe that they are a relief for investors who have lost their hard-earned money in such investments. Therefore, such steps from regulators are welcomed by investors.

Shares of JPMorgan currently retain the Zacks #3 Rank, which translates into a short-term ‘Hold’ rating.

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