With the recent indictment of two senior hedge fund managers at Bear Stearns on federal conspiracy, securities fraud and wire fraud charges, a federal court in the Eastern District of New York revealed the most recent impact of the government's growing scrutiny of the participants in the subprime meltdown. The indictment of the hedge fund managers is a stark reminder that as the effects of the lending crisis continue to spread across the U.S. economy, federal and state law-enforcement and regulatory bodies are sharpening their focus on potential targets of their investigations — a list that includes virtually every player in the subprime-mortgage marketplace.
In many ongoing investigations across the country, Department of Justice officials are working closely with federal and state regulatory investigators and prosecutors. Examples of this cooperation include recent actions filed by the Illinois and California attorneys general, who after intensive investigations into the business practices of Countrywide Financial Corp., filed suits against the company and its chief executive. Both suits claim that Countrywide misled borrowers about the values of adjustable-rate mortgages.
And even before the rescue and acquisition of Bear Stearns by JPMorgan Chase, federal prosecutors in the Eastern District of New York had begun investigating last summer's collapse of the two Bear Stearns hedge funds, both of which experienced massive losses tied to mortgage-backed securities. Similarly, federal prosecutors from across the country, aided by the Federal Bureau of Investigation and other law-enforcement agencies, have launched their own criminal investigations into dozens of companies associated with the subprime crisis.
On the civil enforcement front, the Securities and Exchange Commission has tapped the services of more than 100 attorneys to assist with its subprime investigations. The SEC recently confirmed that its Subprime Task Force has opened dozens of investigations involving a number of major companies.
In the process, investigators are amassing a huge arsenal of public documents, such as regulatory filings and investor reports, as well as internal e-mails, taped telephone conversations and text messages from targeted individuals and companies. In fact, e-mails may be pivotal in the prosecution of the Bear Stearns case: messages authored by the fund managers, the government alleges, reveal that the managers were concerned about the possible demise of the hedge funds long before their respective collapses, yet continued to market the funds and failed to disclose their growing concerns to investors.
Given the current atmosphere and the wide-net effort to identify potential fraudulent activity by individuals and institutions involved in the subprime-lending crisis, who should be concerned? The simple answer is, everyone. Likely targets include:
Mortgage lenders. In addition to the Illinois and California charges, New York Attorney General Andrew Cuomo recently revealed that his office is investigating the possibility that inflated property appraisals may have been made in collusion with bank lenders. Cuomo's office has issued hundreds of subpoenas in an effort to learn more about how Wall Street sold subprime mortgage investments.
Credit-rating agencies. The DOJ and SEC are investigating whether credit-rating agencies improperly assigned inflated ratings to mortgage-backed securities, collateralized-debt obligations and other structured-finance products without conducting appropriate due diligence or with less than full impartiality. The SEC is also looking into tightened reporting requirements for credit-rating agencies; a final report and recommendations are expected within the next few months.
Bond insurers. Various federal and state prosecutors and investigators are looking into securitizations, valuations, accounting processes, and disclosures to state insurance regulators, as well as making inquiries into potential fraud.
Major banks. The DOJ and SEC are examining whether inflated valuations, capital adequacy and delayed announcements of losses on mortgage investments were simple errors or negligence or, instead, reflected a willful pattern of misdirection by the banks designed to improve short-term financial results and to deceive the investing public.
Investment funds. In addition to probes of activities described above, federal investigators are examining investment funds for potential insider trading and accounting "tricks" that may have been used to move underperforming assets from their books.
Brokerage firms. Federal and state investigators are also exploring allegations that brokers inflated the worth of subprime-loan packages, hid losses, or used one set of modeling scenarios to price securities on their own books while using a different valuation scheme for their clients' books.
Executives. The actions of individual corporate executives are being scrutinized closely in the above-mentioned investigations. At the same time, the Oversight and Government Reform Committee of the U.S. House of Representatives recently called executives from Citigroup, Merrill Lynch and Countrywide Financial Group to testify at public hearings exploring the multimillion-dollar compensation awards they received while their companies were writing down billions of dollars of subprime mortgages.
When and how these investigations will end is an open question. However, given the scope and complexity of the subprime-mortgage lending and investment worlds — and the vast amounts of data that investigators are gathering in order to identify potential criminal conduct — it is likely that the current state of affairs will last for the foreseeable future.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
