The underbelly of securitized banking is emerging

The underbelly of securitized banking is showing, as investors and traders fight over the scraps left after the financial crisis of 2007-2008.

One battle that has gotten media attention is a class action against JP Morgan Chase, where pension funds that were clients of JP Morgan are claiming that officials of the giant bank, up to and including CEO Jaime Dimon, used a devious repo maneuver to enrich themselves at the expense of the pension funds.

“JP Morgan accused of breaking its duty to clients,” said The New York Times April 10.  “Hollywood vs. Wall Street,” said Deadline/Hollywood April 11, referring to the fact that the lead plaintiff is the American Federation of Television and Radio Artists pension plan. The media coverage never mentions repurchase agreements, but the lawsuit sure does.

Securitized banking, where institutions use repurchase agreements, or repos, to finance much of the business of securitizing loans and holding securities, was the key market that collapsed in 2008, causing the credit crisis and the taxpayer bailout of the giant banks.

In the unraveling, firms are finding a lot to sue each other over, and those lawsuits are giving the public a look inside the normally hidden transactions of securitized banking.

High on the list of discontents are claims that repo lenders greedily took advantage of weakened repo borrowers by unreasonably demanding more collateral, refusing to renew their repo loans and unnecessarily forcing borrowers into bankruptcy.

Repo lenders don’t care if they drive a borrower into bankruptcy, critics argue, because they can get repaid immediately by selling their collateral, unlike most creditors who have to wait until a bankruptcy judge approves repayment.

In the case against JP Morgan, the pension funds claim JP Morgan enriched itself at their expense by having them invest in Sigma Finance Inc. securities that JP Morgan knew were doomed to fail, while slyly getting control of Sigma’s best securities for itself by making repo loans to Sigma and taking the best securities as collateral. When Sigma failed, JP Morgan seized the collateral and left little of value for the pension funds, they claim.

The plaintiffs claim  JP Morgan’s top officers including CEO Dimon knew when they began making repo loans to Sigma that the SIV was in serious trouble, and they should have advised their pension fund clients to withdraw their Sigma investments.

JP Morgan denies the allegation, saying it made repo loans to Sigma to help it survive, not to benefit from its demise. It says the side of the bank that gives investment advice is separated from the side that does the repo lending, and bank regulators prohibit the two from sharing information, to prevent potential conflicts of interest.

Here’s the outline of the dispute, which is an inside look at how money was, and still is, made and lost in securitized banking:

In the first step, JP Morgan advised the pension plans to lend some of the stocks they owned to firms that wanted to borrow the shares for a brief period, for trading purposes, in exchange for cash. Later, the borrowers would return the securities, and the pension plans would return the cash, minus a fee.

When the pension plans agreed to lend some of their stock holdings, they were participating in what Wall Street calls securities lending, a common way for institutional investors that hold a lot of securities, like pension funds and insurance companies, to make a little extra cash.

JP Morgan put that temporary cash into a pool that it managed for many investors, with JP Morgan receiving a percent of the returns for its trouble.

In June 2007 that pool bought two-year notes issued by Sigma Finance, including $500 million for the pension plans, according to the lawsuit.

Sigma Finance was one of the off-the-books businesses that banks and others created as a cheap way to securitize loans, especially mortgages. In mid-2007, with $56.2 billion in assets, Sigma was the first, oldest and world’s largest of its type, which was a structured investment vehicle or SIV, according to JP Morgan.

But just as JP Morgan was investing the pension plans’ temporary cash in Sigma securities, investors were beginning to lose confidence in all mortgage-backed securities.

Sigma and other SIVs started having trouble selling their securities and began turning to repo lenders for more of their financing.  Between June 2007 and September 2008, Sigma repo borrowing grew from $1.4 billion to $18 billion, according to JP Morgan.

Although some JP Morgan officials had doubts that Sigma could survive , according to e-mails and reports filed as exhibits in the pension lawsuit, JP Morgan began making repo loans to Sigma in February 2008. To protect itself, it demanded almost $1 billion more in collateral than it lent to Sigma, and collected $230 million in repo fees, according to plaintiffs.

At least one JP Morgan official saw the repo lending to troubled Sigma as a “very big money making opportunity as market deteriorates,” according to an e-mail filed in the case.

After a run on Lehman Brothers by repo lenders caused Lehman to fail on September 15, 2008 – and after JP Morgan’s own money market funds sold the Sigma securities they held, according to the suit – JP Morgan on September 30 declared Sigma in default and refused to renew its repo loans. Other large banks soon followed. Sigma failed October 1, 2008.

Overall JP Morgan made $8.4 billion in repo loans to Sigma, according to JP Morgan, and it received $9.3 billion in Sigma’s “best assets” as collateral, according to plaintiffs.

When Sigma’s repo lenders fled, and took their collateral with them, they left behind $1.9 billion in assets to cover $6.2 billion in outstanding senior secured debt, including the securities owned by the three pension plans, plaintiffs claim.

The value of some of the repo collateral that JP Morgan held was depressed by the financial crisis but later recovered, and JP Morgan ultimately enjoyed nearly $1.7 billion in profits on the Sigma collateral, while the Sigma securities that JP morgan bought for the pension plans are worth less than 6 cents on the dollar, the plaintiffs claim.

In clear breach of its fiduciary obligations, JP Morgan poached Sigma’s best assets for itself at favorable prices despite knowledge that its conduct would materially impair the financial interests of the Class (plaintiffs) when Sigma eventually collapsed. JP Morgan made no disclosure to the Class that would allow them to protect their interests. Nothing about its status as a multi-faceted financial institution allows JP Morgan to so blighely disregard the highest duties known to law.

JP Morgan replies:

It would have been irrational for JPMC to give more than $8 billion of its own cash to an entity that it expected to fail, particularly in the treacherous market conditions of 2008 when there could be no assurance that Sigma’s assets could be sold for their intrinsic value. Indeed, when Sigma collapsed in September 2008, JPMC’s own position was approximately $383 million underwater, even after fees earned on the repo transactions.  Although JPMC conducted an auction for Sigma’s assets – as required under the repo agreements – in many cases there were no bidders. JPMC continued to hold a losing position on those assets at least through the first and second quarters of 2009. If, as plaintiffs contend, JPMC had presciently predicted market movements, believe that Sigma would fail before the repo transactions expired and wanted to obtain Sigma’s assets, it would simply have waited until the collapse and then bought the assets. That would have been far more rational (than) putting $8 billion at risk months in advance.

Documents filed in the case, including private e-mails, give insights into the thinking of top JP Morgan officials about securitized banking during the difficult months between June 2007 and September 2008. The case itself includes a review of the vissisitudes of SIVs in 2007 and 2008.

When the press excludes repurchase agreements from their accounts of this lawsuit and instead writes, for example, that “JPMorgan lent the vehicle billions of dollars and received valuable assets in the form of a security deposit,” RepoWatch believes this denies readers the understanding that this dispute is a mirror into the wheeling-and-dealing market among giant financial institutions that was responsible for the financial crisis of 2007-2008.

It denies readers the insight that the repo market is insular and incestuous and vulnerable to manipulation and runs.

It denies Americans – who ultimately bore the losses in the last crisis, and who will bear them again in the next – a chance to weigh in on what RepoWatch considers to be the most important, and most ignored, issue of the financial crisis: How should securitized banking be reformed?

The case is 09-cv-00686, Board of Trustees of the AFTRA Retirement  Fund v. JP Morgan Chase Bank, filed Jan. 23, 2009, in U.S. District Court, Southern District of New York. Other pension funds that have joined the suit are the Imperial County Empoyees’ Retirement System and the Committee of the Manhattan and Bronx Service Transit Operating Authority Pension Plan.


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