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Federal Jury Doesn't Want SEC To Take This The Wrong Way, But It Thinks This Citi CDO Case Is Bullshit

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So remember when Citi did that thing that was all the rage in 2007 where they constructed a synthetic CDO referencing mortgage-backed securities in order to facilitate their own prop bet against those MBS, but then maybe inadequately disclosed to investors that they were in fact naked short those MBS? And then they got sued by the SEC for fraud, and settled that case for $285mm, or tried to anyway*? Well the SEC also sued one Brian Stoker, the Citi VP who structured that deal, because it's important for the SEC to pursue powerful individuals responsible for financial crisis wrongdoing and who could be more powerful than the vice president of Citigroup? And unlike Citi, Brian Stoker chose to roll the dice, and today he won big but with an asterisk:

A jury on Tuesday cleared a former Citigroup executive of wrongdoing connected to the bank’s sale of risky mortgage-related investments at the peak of the housing boom, dealing a blow to the government’s effort to hold Wall Street executives accountable for their conduct during the financial crisis.

In addition to handing up its verdict, the federal jury also issued an unusual statement addressed to the Securities and Exchange Commission, the government agency that brought the civil case.

“This verdict should not deter the S.E.C. from investigating the financial industry and current regulations and modify existing regulations as necessary,” said the statement, which was read aloud in the courtroom by Judge Jed S. Rakoff, who presided over the trial.

Thanks jury! Bringing lawsuits about mortgage CDO marketing practices has been the major focus of the SEC's response to the financial crisis,** and this was the first time that approach was tested in court, and the SEC's lawyers spent building the case only to see a jury shoot them down in two days, and they have no courtroom victory or precedent to show for their work, but they won the one thing that is truly important in this vale of tears: an encouraging note from a group of anonymous strangers.

Peter Lattman sort of amazingly says this trial "served as a referendum on a questionable practice that became common in the years leading up to the financial crisis: Selling clients complex securities tied to the housing market while simultaneously betting against those same securities," and while I hate the idea of a jury trial "serving as a referendum" on anything, that does seem to be how the jury viewed it, no? Sure, they said, this Brian Stoker guy didn't do anything wrong - he wasn't even negligent - but they're pretty sure somebody did something wrong somewhere, and they'd really appreciate it if the SEC would get to the bottom of it and do something about it.

That is in microcosm the problem that the SEC deals with: everyone in America, even Eliot Spitzer, is really really convinced that there was widespread wrongdoing in the financial industry, and that that wrongdoing caused the financial crisis. The problem is that nobody really knows what it was.***

CDO fraud was a really sexy possibility. It looked fraudulent, or at least sketchy. It involved mortgages, and derivatives, and shadow-banky-type conduits, and hedge funds, all of which sound promising. Many of the buyers were European banks who are now kaput because of these deals, so there's plausible causality. And you could identify individual human beings who said things that weren't true, or at least didn't say all the things that were true, so you could go around saying: "Look. We got the guy responsible for the financial crisis. Turns out it was Brian Stoker."

But it wasn't!**** He was the best the SEC could find, and still he wasn't good enough for the jury. (And they set a low bar for themselves: they didn't charge him with a crime, or even civil fraud, just negligence.) The jury thinks that this is because the SEC needs to look harder, and maybe they're right. There is no shortage of people, or Eliot Spitzers, who think that the SEC is terrible at looking for things.

But the other possibility is that the crisis was less directly tied to deliberate fraudulence than people think, and that these jurors - who, I'll just assume, Speak For All Americans - are a little like those people (all of them) who hate Congress but re-elect their congressmen. The jury was pretty sure that the financial industry is full of crooks who conspired to throw the world into recession and evict everyone from their homes. But the one financial industry executive they got to pass judgment on, the one who sold derivatives based on misrated packages of subprime mortgage tranches to German banks that later failed because of their mortgage exposure? Obviously he didn't do anything wrong. It was those other guys who were the crooks. Good luck finding them, SEC.

Former Citigroup Manager Cleared in Mortgage Securities Case [DealBook]
Citi Employee Cleared of Negligence in CDO Case [WSJ]

* Because Judge Rakoff rejected the settlement, and then the court of appeals kind of rejected his rejection though not entirely. So many questions. Does Jed Rakoff now wish he'd approved that settlement instead of demanding a trial that now looks like a winner for Citi? Can Citi renegotiate the settlement in light of new facts?

** That and insider trading.

*** Was it really insider trading? That seems pretty lame. Libor manipulation is I guess more promising but pretty hard to take as a cause of the crisis.

**** My fuller doubts are here but in brief, the pitch book on the Citi CDO deal actually said in so many words that Citi might be naked short the deal, so it's hard to find that Stoker failed to tell clients that Citi was naked short the deal.


Appellate Court Willing to Entertain the Possibility that Citi Was Not Committing Fraud

I've had some fun these last few days proposing counterintuitive theories for why Citi might not suck as much as you probably think it does and it's nice to see others joining in the pastime, even if this sounds a little far-fetched: The district court’s logic appears to overlook the possibilities (i) that Citigroup might well not consent to settle on a basis that requires it to admit liability, (ii) that the S.E.C. might fail to win a judgment at trial, and (iii) that Citigroup perhaps did not mislead investors. That piece of rank conjecture is from the Second Circuit's opinion on an appeal* of Judge Rakoff's rejection of the settlement between the SEC and Citi over some mortgage-backed securities. Here's DealBook: