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

In Monday's charge, the SEC alleges Litvak lied to counterparties about the pricing of securities he was selling to investors, and even about whether there were actual firms on the other side of the trade. Much of Litvak's alleged fraudulent trading appears to have exploited taxpayers.

For instance, in a trade with AllianceBernstein (AB) -- an asset manager picked by the Treasury to purchase mortgage bonds on taxpayers' behalf -- Litvak is alleged to have told a representative for the asset manager that he had bought two mortgage securities at 58 cents and roughly 58.25 cents on the dollar and would sell them for a spread of 5/32 of a dollar.

The SEC alleges that Litvak actually bought the securities, worth a total of $60 million, at 56.50 and 57.50 cents on the dollar and pocketed a spread of 61/32.

Those lies, the SEC alleges, helped Jefferies to pocket an additional $600,000 on the trades. In total, the SEC's complaint alleges that in 25 illegal trades, Litvak earned $2.7 million in illicit gains.

The charge may be disturbing for Wall Street trading desks because the profitability of over-the-counter fixed-income products such as mortgage securities and swaps often hinge on the opacity of trading prices.

While the SEC's complaint points out that Litvak's alleged lies are a violation of federal securities laws, it might be the case that other trading desks on Wall Street routinely come close to misleading clients when it comes to pricing trades.

Might Wall Street's opacity in giving counterparties fair pricing on complex financial products be the other side of the coin to Goldman's account of its structuring of the Abacus CDO?

The defense of Litvak's trading rings eerily similar to that of Goldman and other investment banks in their culpability for underwriting securities that would later fail.

"Every Jefferies counter-party in each transaction in this indictment got the exact bond bargained for at a price each wanted to pay," Patrick J. Smith, an attorney at DLA Piper, said in a statement on Litvak's behalf. "These were principal transactions between sophisticated market participants."

The SEC's complaint appears to zero in on Litvak's alleged lies, which may have violated antifraud provisions in federal securities laws.

"Brokers must always tell their customers the truth, particularly in complex securities transactions in which it is difficult for investors to determine market prices on their own," said George Canellos, deputy director of the SEC's Division of Enforcement, in a statement Monday. "Litvak repeatedly lied to his customers and invented facts to bring additional profits into his firm and ultimately his own pocket at their expense."

It's possible that when all sides have been heard, Litvak may have crossed a line in misstating the pricing of securities. "If you can prove the intent of the misrepresentation, then that would be enough," says Hazen of the University of North Carolina School of Law.

The real question for Wall Street is how to do business fairly -- and legally -- in opaque markets, where profits can be negotiated by way of fat spreads charged to counterparties. Tchir, the former credit trader, points to the allegation that Litvak fraudulently misrepresented Jefferies' bond inventory for a client order as a detail of the complaint that may trouble Wall Street traders.

"There is no gray area here," said Thomas G. Rohback, a partner at Axinn Veltrop & Harkrider, of the U.S. attorney and SEC's misrepresentation claims, if details of their allegations are accurate. "If this is indicative of the way everybody in this industry behaved, it should have big ramifications."

Litvak's lawyer maintains the trader's innocence. "Jesse Litvak did not cheat anyone out of a dime. In fact, most of these trades turned out to be hugely profitable. ... The allegation that Jesse defrauded any counter-party -- PPIP or private -- is simply untrue," Smith said in a statement Monday.

The SEC claims Litvak made nearly $12 million in discretionary bonuses during the trader's alleged fraud -- money the commission may attempt to recover.

Under PPIP, a vehicle that was part of the government's larger $700 billion Troubled Asset Relief Program, the government invested $22.1 billion in public-private investment funds to revive the mortgage market. Recently, asset managers BlackRock and AllianceBernstein liquidated their PPIP funds, netting the Treasury annualized gains of between 18% and 24% and a profit of about $900 million.

-- Written by Antoine Gara in New York

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