J.P. Morgan Squared CDO Case: The Sales Pitch Left Out the Bigger Bet

J.P. Morgan Securities agreed to pay $153.6 million in the J.P. Morgan Squared CDO case to settle SEC allegations that it misled investors about a hedge fund’s influence over portfolio selection while that fund bet against the assets. According to the Securities and Exchange Commission, investors heard that an experienced investment adviser had selected the portfolio. The SEC alleged that Magnetar Capital helped choose the assets and bought protection against their failure. For someone on a structured-products desk, the important comparison is between the role described in the sales materials and the position recorded in the trades.

The Securities and Exchange Commission announced the settlement on June 21, 2011. This page follows Squared’s selection process, sales pressure and settlement terms. Our broader page on structured products and CDO fraud explains the shared transaction mechanics. The agency’s Structured and New Products Unit conducted the investigation.

Squared CDO 2007-1 Referenced Other CDO Securities

Squared was a synthetic collateralized debt obligation tied to residential mortgages. According to the Securities and Exchange Commission, its investment portfolio consisted primarily of credit default swaps referencing other CDO securities whose value depended on the U.S. housing market. J.P. Morgan structured and marketed it in early 2007, as that market began showing signs of distress.

Magnetar’s Selection Role and Short Position

The Securities and Exchange Commission alleged that Squared’s marketing materials identified the investment adviser GSC as the portfolio selector. GSC had experience analyzing CDO credit risk. But the agency said the materials left out Magnetar’s significant influence over which CDOs entered the portfolio, along with its financial interest in their failure.

The Securities and Exchange Commission’s litigation release describes the protection purchases as covering a substantial portion of the assets Magnetar helped select. By the deal’s May 2007 closing, the agency alleged, Magnetar’s $600 million short position dwarfed its $8.9 million long position. The short position covered more than half of Squared’s investment portfolio.

In the Securities and Exchange Commission’s account, we see investors sold the judgment of an experienced selector while a participant betting heavily against the portfolio helped shape it. The sales pitch left out the bigger bet.

Sales Emails Told a Different Story

The Securities and Exchange Commission alleged that J.P. Morgan knew it faced growing losses from Squared as the housing market weakened. The agency said that during March and April 2007, the bank pushed a global sales effort beyond its traditional mortgage-securities customers.

The announcement quoted an internal J.P. Morgan email about Magnetar’s appetite for more transactions. The message connects deal volume to an expectation that the market would deteriorate:

The employee directing Squared’s global distribution pressed colleagues to finish the deal in another email quoted by the agency. For a sales or structuring employee, the internal reason for moving a deal can be as revealing as the final presentation used to move it:

Mezzanine Investors Took the Losses

According to the Securities and Exchange Commission, J.P. Morgan sold approximately $150 million of Squared’s mezzanine notes to approximately 15 institutional investors. These were the deal’s riskiest notes after the equity. The agency said those investors lost virtually all of their principal.

The buyers included an insurance and retirement-products company in Topeka, a faith-based membership organization in Minneapolis, an asset manager for General Motors pension plans, and financial institutions in East Asia. Those institutions were buying exposure to mortgage performance through the Squared notes. On the other side of the selection story, the agency alleged that Magnetar stood to benefit from defaults in assets it helped choose.

In Squared, the mezzanine sales identify who put money at risk, the portfolio identifies the reference securities, and the protection trades identify the contrary economic interest. An analyst who knows how those records fit together can explain more than the final collateral list alone shows.

The Deal File Connects Selection, Sales and Short Positions

The Securities and Exchange Commission’s account makes the term sheet and pitch book central to the disclosure problem. In its separate allegations against GSC’s portfolio-selection team leader, the agency said that employee permitted Magnetar to select and short collateral and reviewed and edited those investor-facing documents before distribution. The agency also alleged that the team leader was seeking employment with Magnetar while working on the transaction, without investors knowing.

For a structured-products analyst, the evidence behind the offering is the connection between those records. Selection correspondence can explain who proposed an asset and whose preferences shaped the final portfolio. Marketing drafts show how that participation was described to investors. The hedge records show whether the participant buying protection was exposed to the same assets it helped select.

We look at those relationships with the person who understands the work. A sales employee may know which presentation reached a buyer. An analyst may understand why the collateral changed. Someone working with the trades may know the position behind the stated role. The useful account connects the representation, the decision and the economic interest within the same transaction.

The Settlement Allocated Money and Required New Reviews

J.P. Morgan’s agreement included a $133 million civil penalty, alongside $18.6 million in profits to be returned and $2 million in interest. The Securities and Exchange Commission also required changes to how the bank reviewed and approved offerings of certain mortgage securities.

The announced allocation directed $125,869,721 to the mezzanine investors and $27,730,279 to the U.S. Treasury. The announcement described a full return of the harmed investors’ losses under the settlement.

The review requirement reaches the same part of the business as the alleged omission. For someone who worked on an approval, what reviewers understood about selection and short positions is part of the story.

Goldman Sachs Also Acknowledged Incomplete CDO Marketing

In its July 2010 settlement announcement concerning Goldman Sachs, the Securities and Exchange Commission reported that the firm acknowledged incomplete CDO marketing materials that should have revealed another participant’s role. Goldman agreed to pay $550 million and reform its business practices to settle charges of misleading investors in a subprime mortgage product. The parallel is the missing participant in the presentation: an insider’s knowledge of who helped create the investment can change the account the buyer was given.

What a Structured-Products Insider Can Add

A study of occupational fraud found that whistleblowing became a more likely detection method as more people participated in a fraud. The Significance of Whistleblowing as an Anti-Fraud Measure, published in the Journal of Forensic & Investigative Accounting in 2018, reports that relationship across its sample. For a complex offering, we look for the person who can explain how a decision visible in their work disappeared from the description investors received.

If you are considering reporting securities fraud to the SEC, the Squared allegations show why your account of the deal matters. The comparison starts with the portfolio-selection promise and reaches the trades that gave another participant an interest in default. Speak to one of our Whistleblower Experts about what you saw on the deal.

Eligible SEC whistleblowers can receive 10% to 30% of qualifying sanctions collected in actions exceeding $1 million. A whistleblower case under the False Claims Act can pay 15% to 30% of what the government recovers. The False Claims Act concerns fraud against government. Squared was an SEC securities-enforcement action.

You Know What the Sales Pitch Left Out

If you saw a participant shape the collateral while its trades told a different story, talk with our whistleblower experts about the deal. We shape the selection work, disclosures and economic interests into your strongest case, and bring in securities fraud whistleblower lawyers who understand structured products. We stay beside you as you turn what you know into a case the SEC can investigate.