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Criminal Charge Against Jefferies Trader Should Have Wall Street Quaking (Update2)

(Updates to add comment from a law partner in the fourth-to-last paragraph.)

NEW YORK (TheStreet) -- Imagine a scenario in which the government attempts to aid the free-falling housing market by way of a $22 billion investment, and Wall Street traders see an opportunity to boost their million-dollar bonuses using deceptive trading tactics at a cost to their clients.

That's the charge brought by the Securities and Exchange Commission and the U.S. attorney on Monday against former Jefferies (JEF) Managing Director Jesse Litvak, who is alleged to have committed fraud by misleading clients about the trading prices of complex mortgage securities during a taxpayer-supported program aimed at reviving the ailing housing market.

It also may not be that different from business as usual in one of Wall Street's most profitable trading markets -- and that should have the nation's top investment banks worried.

On Monday, the SEC and U.S. attorney charged Litvak, a senior trader in Jefferies' mortgage-trading unit, with 16 criminal counts including one TARP fraud charge, four counts of making false statements and 11 counts of securities fraud.

Litvak's offense, according to the SEC's complaint, was that the trader lied to his counterparties about the price and demand of mortgage-backed securities traded between 2009 and 2011, when the government was trying to revive a key engine of the housing market through the U.S. Department of Treasury's taxpayer-supported Public-Private Investment Program ("PPIP").

The sucker on the other side of Litvak's trade was often the U.S. taxpayer, according to the SEC's complaint

Litvak plead not guilty to the charges on Monday and was released from jail on a $1 million bond. Jefferies repaid $2.2 million to a client related to the trades, according to March settlement.

While the complaint may reveal to the casual Wall Street observer the extent of greed and manipulation that drives profits on trading desks -- akin to the scalping that occurred in gas stations in New York and New Jersey after Hurricane Sandy -- it also sheds light on what could be deemed illegal on Wall Street and eventually become a focus of regulators like the SEC.

The charge against the ex-Jefferies trader may expose another side of Wall Street trading profits the SEC is willing to go after, three years after the agency brought fraud charges against Goldman Sachs (GS) for structuring a complex mortgage security called the ABACUS 2007-AC1 collateralized debt obligation.

While the SEC has gone after banks for poor disclosure of what was contained in complex mortgage trades such as Abacus, the agency hasn't done as much legwork in investigating how products are traded in opaque debt markets known as over-the-counter trading.

That is, until Monday's charge against the former Jefferies trader.

The SEC's April 2010 complaint against Goldman Sachs alleged that the bank misled investors on the risks in the Abacus security it underwrote and failed to disclose that an investor shorting the trade had picked out much of the mortgage muck contained in the CDO.

When Goldman was hauled in front of Congress, lawmakers were appalled to find out the bank had shorted the security -- betting on a decline in its price -- and questioned how a Wall Street firm could sell something to clients that some of its traders predicted would blow up.

Notably, Goldman's chief executive, Lloyd Blankfein, argued the bank didn't owe its clients, sophisticated investors who had the capacity to understand the risks of the Abacus security, a fiduciary duty.

[Goldman later settled with the SEC for $550 million without admitting guilt, and a Goldman trader, Fabrice Tourre, will go on trial July 15. Top Wall Street players including Citigroup (C), JPMorgan (JPM), Bank of America Merrill Lynch (BAC) and Morgan Stanley (MS) have settled similar complaints.]

After investigating disclosure in over-the-counter mortgage security offerings, the SEC may now look at trading maneuvers in those markets.

"I think the Street is going to have to get some clarity on what they can and can't tell customers," says Peter Tchir, head of TF Market Advisors and a former credit trader at Deutsche Bank, UBS and Royal Bank of Scotland.

The charges against Litvak may drive the standardization and electronic trading of more over-the-counter debt securities, or put more products onto TRACE (Trade Reporting and Compliance Engine), a reporting system for trading in investment grade, high yield and convertible debt, he said.

SEC action against price misrepresentation in over-the-counter market making is nothing new, said Thomas Lee Hazen, a professor at the University of North Carolina School of Law. Still, he concedes it may be a rare instance where charges have been brought against a trader dealing in over-the-counter markets at a major Wall Street bank.

Hazen sees an analogy to a late-1990s price-fixing scandal on the Nasdaq, which led to a $1 billion-plus settlement between Wall Street's largest banks and the U.S. Department of Justice and SEC.

Currently, global regulators, including the SEC, are in the midst of investigating a bank bid-rigging scandal involving the setting of short-term interest rates such as Libor, the London Interbank Offered Rate. So far, the inquiry has led to large settlements at Barclays (BCS) and UBS (UBS), in addition to some trader arrests. Bank of America, Citigroup and JPMorgan have been subpoenaed, according to corporate filings and media reports.

The SEC and U.S. attorney have also had success in prosecuting fraud violations related to auction rate securities.

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