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Here's What the SEC's Citi CDO Investigation Is Really All About

The SEC is investigating Citigroup amid allegations that Citi pressured an independent manager to include particular assets in a mortgage deal, among other claims.

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Jake Bernstein and Jesse Eisinger explain in their ProPublica article:

"The deal was a collateralized debt obligation named Class V Funding III, which was completed in late February 2007. The CDO was made up of pieces of other CDOs that were themselves backed by risky slices of subprime mortgages. The deal was managed by Credit Suisse Alternative Capital, a division of the Swiss banking giant. Independent managers such as Credit Suisse were charged with picking the best assets for the CDO. Citigroup arranged and marketed the deal to investors."

It's a confusing series of transactions, but let's step through a few of the principal contentions, and try to parse the allegations.

For example, Bernstein and Eisinger write: "Among the assets purchased by Class V Funding III were portions of, or sidebets involving, at least 15 CDOs that the Illinois-based hedge fund Magnetar helped to create. Four of those CDOs were also underwritten by Citigroup."

In other words, the allegation appears to be that CDOs—or CDOs squared—were marketed by Citi as being independently managed when, in fact, Citi had a role in choosing certain assets that were included in the security, and therefore were subject to inherent conflicts of interest.

And this: "Class V Funding III was cited in another ProPublica-NPR collaboration published in August. Class V bought a piece of, or had a side bet involving, two other Citi CDOs: Octonion and 888 Tactical.

Those CDOs in turn purchased exposure to Class V. All three CDOs closed within about two weeks of each other. Such transactions could have helped investment banks to complete CDOs and earn deal-completion fees."

The substance of that allegation would seem to be that Citi improperly collected fees on the same deal more than once.

On another claim, seemingly involving conflicts of interest at Citi: "It's unclear whether Citi made other trades that would pay off in the event of a drop in Class V's value. Ultimately, the bank failed to protect itself against losses from most of the CDOs it invested in; Citigroup lost almost $34 billion on its mortgage CDO business. "

Citi appears to have lost money—but perhaps there were side bets placed against the securities that resulted in net short positions and may have generated revenue in the event of a loss.

In the broadest sense, many of the issues inherent in the CDO allegations against Citi are quite complicated, containing lots of moving parts and deal flow through a series of counterparties. That type of scenario would typically seem to make allegations more difficult to prove.

Additionally, there may be some language in the prospectus that could potentially complicate the case for The SEC: "One hurdle for any SEC action is that banks' CDO marketing materials often included warnings about generic risks involving conflict of interests. The prospectus for Class V Funding III has such language."

There's also the pending litigation: "A shareholder class-action lawsuit filed against Citigroup in federal court in Manhattan accused the company of using CDOs, including Class V Funding III, as a way to "clean out its warehouse" even as it downplayed the risk of its exposure to CDOs."

Of course, alleging something in a class action law suit doesn't suits. To wit: "Last week, District Judge Sidney Stein dismissed several of the claims but allowed the case to go forward on a number of the allegations, including that Citi misstated its exposure to CDOs."

Misstatement of risk exposure to derivates by a bank sounds like a substantively different allegation than some of the claims against Citi described in the Propublica article—namely, those claims involving conflicts of interest, undue influence, and failures to disclose material facts, all in relation to the creation and sale of certain CDOs—but time will tell as the law suit proceed through the legal process.

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