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SEC Probing Deal Between JPMorgan and Hedge Fund

The following is an analysis piece by ProPublica, an independent, non-profit newsroom that produces investigative journalism in the public interest.

The Securities and Exchange Commission is investigating whether JPMorgan Chase allowed a hedge fund to improperly select assets for a $1.1 billion deal backed by subprime mortgages, according to people familiar with the probe.

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Called "Squared" and completed in May 2007, the deal was a collateralized debt obligation, or CDO, made up of pieces of other CDOs. The hedge fund, Magnetar Capital, based in Evanston, Ill., purchased the riskiest slice of Squared as part of a strategy to bet against the mortgage market.

As we reported in April, together with Chicago Public Radio’s This American Life and NPR's Planet Money, Magnetar often purchased the riskiest portion of CDOs, enabling the banks to complete the deals. Magnetar also frequently bet against those same CDOs, using side bets. Magnetar's purchases ultimately spawned at least $40 billion worth of risky CDOs in 2006 and 2007.

While Magnetar bought the riskiest slices, the CDOs were created and marketed by investment banks. In the case of Squared, the SEC is examining whether JPMorgan adequately disclosed to the investors it marketed Squared to that Magnetar had a role in picking the securities that went into the deal while also betting against segments of the deal. The 294-page Squared prospectus, which was created by JPMorgan, has generic language warning that some investors and the CDO manager might have investments that conflict with the interests of other holders of the CDO. (Read the prospectus here.)

Magnetar has consistently maintained that its investment strategy was not based on a fundamental analysis of the housing market. The fund says it would have made money whether house prices rose or fell. And the fund has said that it didn't have final say over what assets went into its CDOs. The hedge fund did not comment on the investigation.

Having declined to comment on specific questions about Squared for our story in April, Magnetar now disputes the April ProPublica account of the Squared transaction. The fund says it invested in the transaction after it had been initiated by JPMorgan and GSC, a third-party independent manager, whose fiduciary duty was to pick the best assets for the CDO. GSC didn't respond to our requests for comment.

The investigation echoes the SEC's suit earlier this year against investment bank Goldman Sachs . In April, the SEC charged Goldman with misleading investors in the creation of a CDO called Abacus 2007-AC1. The bank did not disclose the role of a hedge fund, Paulson & Co., that helped put together the deal as part of its bet against housing. In June, Goldman paid a $550 million fine to settle the case. The agency didn't charge Paulson with any wrongdoing. In June, the Wall Street Journal reported that the agency had stepped up its probes of Magnetar's deals.

As we noted in our earlier story about Magnetar, Squared included a piece of a CDO from one of those Goldman Sachs deals, called Abacus 2006-17.

It is not clear how far the SEC's investigation has progressed. The SEC is actively looking at the entire CDO market, including multiple managers and investment banks. Since Magnetar made no legal representations to investors in any of its CDOs, it may not have violated any of the rules that govern the transactions. Another possible complication in the SEC's probe is that the biggest loser in the deal by far was JPMorgan itself.

According to a person familiar with how the deal came together, Magnetar committed to purchase $10 million worth of Squared's riskiest part, called the equity. Magnetar's purchase allowed JPMorgan to create and sell the CDO.

One participant in the deal told ProPublica that Magnetar pushed the bankers to select riskier bonds. "They really cared about it," this person said. "They wouldn't pull punches. It was always going to be crappier assets." The hedge fund requested that Squared include slices from other CDOs that Magnetar helped spawn, according to this person.

In response to questions for this story, Magnetar said that the fund "did not at any time require or expect any specific assets to be purchased into the Squared transaction." The fund said GSC, the CDO manager, "at all times exercised its own discretion and judgment regarding the characteristics and appropriateness of each of the assets selected for inclusion in Squared."

In its statement, the fund says that a number of assets were purchased for Squared "prior to Magnetar's agreeing to purchase equity in Squared."

E-mails that the SEC has obtained in the course of its investigation show Magnetar executives discussing specific assets with bankers from JPMorgan, according to the participant in the transaction. This person, who asked not to be named because of the investigation, reiterated that Magnetar requested that specific assets go into the deal.

Magnetar also said that the Squared transaction was initiated by GSC and JPMorgan "independently of Magnetar and well before Magnetar agreed to invest in the equity tranche of Squared."

The Squared deal was completed nearly a year after housing prices had peaked. Within eight months of the transaction, Squared dropped to a fraction of its initial value.

JPMorgan earned $20 million in creating Squared, according to the person involved in the deal.

JPMorgan's sales force sold parts of the CDO to 17 institutional investors, according to a person familiar with the transaction. These investors included Thrivent Financial for Lutherans, a Minnesota-based not-for-profit fraternal organization, whose $10 million investment was wiped out. Thrivent didn't respond to requests to comment. Small pieces of Squared also ended up in mutual funds run by Morgan Keegan, a regional investment bank based in Memphis, Tenn. Morgan Keegan was sued by individual investors who claimed they were misled about the risks of their investments. Among the investors was former Chicago Bulls player Horace Grant, who was awarded $1.4 million in arbitration. Morgan Keegan did not respond to requests for comment.

JPMorgan Chase, which kept the large, supposedly safe top slices of Squared on its books, without hedging itself, lost about $880 million on the deal. Banks often kept such slices since they were widely believed to be nearly risk-free.

Magnetar came out a winner. The fund earned about $290 million on its bet against Squared, according to a person familiar with the deal.

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ProPublica is an independent, non-profit newsroom that produces investigative journalism in the public interest. ProPublica is led by Paul Steiger, the former managing editor of The Wall Street Journal. ProPublica's lead is provided by the Sandler Foundation and other philanthropies.

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