On June 21, 2011, the Securities and Exchange Commission (“SEC”) announced that J.P. Morgan will pay $153.6 million to settle charges that it misled investors in a complex mortgage securities transaction. Investors who lost money as a result of J.P. Morgan’s misconduct will receive their money back. J.P. Morgan sold approximately $150 million of the securities to more than a dozen institutional investors who lost nearly their entire investment.

The SEC alleged that J.P. Morgan 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 that the hedge fund had a short position in more than half of those assets. The performance of the CDO was tied to the performance of residential mortgages. Because the hedge fund had a short position, it stood to benefit if the assets it selected for the CDO portfolio lost value. This gave the hedge fund the motive to select poor-quality assets that were likely to lose value. But investors in the CDO were not told that J.P. Morgan had allowed the hedge fund to hand pick poor-quality assets. To the contrary, J.P. Morgan’s marketing materials represented that the assets would be selected by an independent manager looking out for investor interests. This appears to have been a gross misrepresentation to investors.

The SEC’s complaint states that the CDO known as Squared CDO 2007-1 was structured primarily with credit default swaps tied to 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 the investment advisory arm of GSC Capital Corp. (GSC). J.P. Morgan failed to disclose to investors that the Magnetar Capital LLC hedge fund played a significant role in selecting CDOs for the portfolio and that Magnetar stood to benefit if the CDOs lost value. In an internal e-mail discovered by the SEC, a J.P. Morgan employee stated, “We all know [Magnetar] wants to print as many deals as possible before everything completely falls apart.”

J.P. Morgan consented to a final judgment for violations of Federal securities laws and payment of $18.6 million in disgorgement, $2 million in prejudgment interest and a $133 million penalty. Of the amount paid, $125.87 million will be returned to investors and $27.73 million will be paid to the U.S. Treasury.

This case is similar to one filed last year against Goldman Sachs involving the ABACUS CDO. Goldman Sachs similarly permitted a hedge fund to choose the assets for a synthetic CDO when that hedge fund held a short position against the assets, without disclosing the hedge fund’s involvement to investors.

In each case, J.P. Morgan and Goldman Sachs allowed hedge funds clients who wanted to bet against subprime mortgages to design securities that likely would decline in value as home loans defaulted. The banks then sold the securities without disclosing that the assets in the securities were hand-picked based on their poor quality and likelihood of default. Such conflicts undermine investor confidence in the integrity of financial institutions and in the securities markets as a whole.

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