SEC Takes Light-Touch Approach Against Lawbreakers, Critics Say

The nation's fourth-largest bank agreed to pay an $11 million fine this week to settle federal charges that it misled investors by hiding critical facts and charging them excessive prices on portions of two billion-dollar securities during the height of the housing boom.

Or put another way: For $11 million, one of the world's biggest investment firms was able to violate basic investor protection rules, defraud its customers, not admit wrongdoing, avoid a trial and likely pocket the profit off similar deals.

The investors lost millions. The firm pocketed millions more in profit, more than offsetting the fine.

In late 2006 and early 2007, as financial firms rushed to close deals and dump inventory on investors eager to cash in while the good times lasted, Wachovia Capital Markets, a unit of the Wachovia Corporation, sold securities tied to a pair of complex financial products linked to home loans.

The products, known as collateralized debt obligations, or CDOs, contained slices of bonds backed by home mortgages. From 2004 through 2007, Wachovia, purchased by Wells Fargo in the fall of 2008, arranged 160 such deals worth more than $75 billion, according to data provider Thomson Reuters.

The two targeted CDOs -- Grand Avenue CDO II, then worth $1.5 billion, and Longshore CDO Funding 2007-3, then worth $1.3 billion -- were then diced up and sold to investors. The riskiest portions promised the highest returns. The Zuni Indian Tribe, whose reservation is in Arizona and New Mexico, and another investor bought some of Grand Avenue.

What they didn't know was that Wachovia, upon closing the deal in October 2006, struggled to find investors to buy those portions, according to a complaint by the Securities and Exchange Commission. The unit of the bank that helped underwrite the deal then marked them down on their books to 52.7 cents on the dollar, a reflection of what the firm thought the securities could fetch in the market at the time the deal closed.

Four months later, a different unit of the bank sold those same securities to the Zuni tribe and an unnamed investor at 90 and 95 cents on the dollar, the complaint shows. Though that's a slight discount than the face value of the securities, it's far above what Wachovia thought they were worth when the deal closed in late 2006. Worse, the market continued to deteriorate.

Wachovia never told their customers they had marked down those assets, or that they had paid "excessive" prices. Grand Avenue entered default in early 2008.

In the Longshore deal, Wachovia engaged in something similar, according to the complaint. The firm, in order to avoid recognizing losses on rotting securities, marked up the assets backing the CDO by $4.6 million, above what the firm's internal calculations showed, the SEC said. Investors weren't told, nor were they told that the affiliate within Wachovia that carried out the deed hadn't done so on an "arm's-length basis." Seven investors bought portions of Longshore.

"Wachovia caused significant losses to the Zuni Indians and other investors by violating basic investor protection rules -- don't charge secret excessive markups, and don't use stale prices when telling buyers that assets are priced at fair market value," Robert Khuzami, the director of the SEC's enforcement division, said in a statement.

Wachovia defrauded its customers in numerous ways, according to a cease-and-desist order prohibiting Wachovia's successor, Wells Fargo, from engaging in the same kind of conduct. The firm ripped off investors, didn't tell them about it, and its internal compliance department failed to catch any of it.

Wachovia gave up what the SEC calculated to be $6.75 million in ill-gotten profit, and a penalty of $4.45 million. Most of that money will go to the swindled investors.

But one wouldn't know the severity of the crime by looking at the penalty, market experts say.

"Once again, the SEC is giving a bank a light tap on the wrist for egregious behavior," said Janet Tavakoli, a Chicago-based derivatives expert and founder of Tavakoli Structured Finance. "Now it's Wachovia, but they've done that with many other banks as well."

During the boom, CDO underwriters took home at least 1.5 percent of the CDO's face value as fee, experts say. For the $1.5 billion Grand Avenue CDO, that's about $22.5 million. For Longshore, that's equivalent to $19.5 million. Combined, Wachovia likely made about $42 million in fees.

The penalty for Wachovia's violations is about a quarter of that.

The SEC has come under withering criticism for its apparently lax approach towards penalizing the nation's largest financial institutions for crisis-era securities violations.

Since the onset of the crisis, the SEC has found problems at Citigroup, Goldman Sachs and Bank of America, among others. Citigroup misled investors in 2007 about its exposure to more than $50 billion in securities tied to subprime mortgages. Bank of America didn't tell investors voting on its 2008 merger with ailing investment bank Merrill Lynch that it had authorized nearly $4 billion in employee bonuses at the firm, which lost nearly $28 billion that year.

And Goldman Sachs allegedly helped set up a mortgage-linked investment for a favored client that was designed to fail, yet sold it anyway to its other clients, reaping the favored client nearly $1 billion.

Citigroup settled for $75 million. Bank of America settled for $33 million. Goldman settled for $550 million.

The three firms collectively hold more than $5 trillion in assets. Wells Fargo, which assumed Wachovia's liabilities when it bought it in 2008 for about $13 billion, has nearly $1.3 trillion in assets.

"The SEC may as well just, like on the back of a parking ticket, list the fines so that firms can do a cost-benefit analysis as to whether it's worth breaking the rules," said Joshua Rosner, managing director at independent research consultancy Graham Fisher & Co. "Based on what we see out of the SEC, it appears to generally be in the interest of corporations to break those rules."

Wachovia, Tavakoli said, faces numerous lawsuits tied to its sale of complex financial products and soured mortgage loans it made to home buyers across the country.

"Wachovia has been involved in a number of dirty deals," she said. "It has this huge background of problems, and for the SEC not to use its moral authority is ridiculous."

Rosner said the allegations against Wachovia -- not disclosing the true price of securities to buyers, and misleading investors about the involvement of its affiliates -- were common throughout the industry when it came to packaging and selling CDOs.

"It seems strange that there would have only been two such deals," he said.

The SEC declined to comment beyond its statement. A Wells Fargo spokeswoman said the actions were taken by Wachovia during the early days of the credit crisis, and that it was pleased to have resolved the matter.


Shahien Nasiripour is a business reporter for The Huffington Post. You can send him an e-mail; bookmark his page; subscribe to his RSS feed; follow him on Twitter; friend him on Facebook; become a fan; and/or get e-mail alerts when he reports the latest news. He can be reached at 917-267-2335.