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.

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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