The squeeze appears to be getting tighter for the subprime mortgage industry and its many players. Investigators with the Federal Bureau of Investigation have opened probes into alleged accounting fraud, insider trading, and concerns over loan securitization at 14 companies.
The criminal investigation, first reported in The Wall Street Journal, marks a new stage in the ongoing probes of the industry. Subprime companies are already under scrutiny by the Securities & Exchange Commission as well as several state attorneys general. While the issues are similar to those being looked at by civil investigators at the SEC -- the two agencies are working together -- the prospect of criminal charges raises the stakes.
Who Knew What, When?
"The FBI is signaling, 'We're interested, we want a piece of the action in this case, too,'" says Jacob Frenkel, a former federal prosecutor now practicing securities law with Rockville (Md.)-based firm Shulman Rogers.
An investigator close to the probe says investigators are looking closely at the "full gamut" of participants in the securitization process, from the brokers and banks that generated the loans to the firms that packaged them together and securitized them, to the banks that have them stuffed in their portfolios.
"The question of fraud goes to the entire process -- where the loans were created, whether there was fraud in their creation, or misrepresentation as to the quality of the loans in the sales process," as they moved through the chain, says the source. "A key question is what information (loan originators or securitizers) had about the quality of the loans, and whether that was consistent with statements they made to others."
Another issue is the valuations the banks that currently hold many of the mortgage-backed securities are using to record them on their books. Investigators are examining closely whether they are being properly valued, including whether the assumptions being used in the banks' valuation models are giving realistic estimates of their current worth.
Investigators would not disclose the companies that are being probed. New Century Financial (newcq.pk.PK), the mortgage broker that filed for Chapter 11 bankruptcy in April, 2007, is one industry player that has reported in SEC filings that it faces a criminal probe. In March it announced that it was under investigation by the U.S. Attorney from the Central District of California. And in a press release on Mar. 28, 2007, Beazer Homes USA (NYSE:BZH - News) said it was cooperating with a document request by the U.S. Attorney.
Prosecutors and regulators are also looking closely at whether any executives involved in the securitization chain may have used inside information to sell shares before the extent of the problems became clear.
It's not just public company executives who may need to worry about their sales. If, for example, a hedge fund manager pulled his own money out of a fund when he became aware of valuation problems, but left customers in, that, too, could be a problem. "That's not exactly insider trading, but it could involve fraud in connection with the sale of a security," says the investigator.
While there's no way of knowing yet what the probes will turn up, or whether any actions will rise to the level at which criminal intent can be established, Frenkel points out that the involvement of the FBI is not good news for executives at firms where wrongdoing is suspected.
"As we saw in the corporate fraud cases, companies have an incentive to resolve these investigations; that may include the sacrifice of corporate personnel," he says. "People often forget in the early stages of an investigation, their interests and those of a company can diverge. Companies can settle. They don't go to jail, people do."
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