Ex-Jefferies Arrest Shows Market Lacking Transparency: Mortgages

January 31, 2013

By Zeke Faux and Chris Dolmetsch

Jesse Litvak, a former Jefferies & Co. mortgage-bond trader, is accused of cheating customers by using unscrupulous sales tactics that the U.S. Securities and Exchange Commission's deputy director of enforcement called "unfit for a used car lot." Such practices are widespread in a market lacking transparency, investors and regulators say.

Litvak was arrested Jan. 28 and charged by the U.S. Attorney's Office in Connecticut with defrauding firms, including BlackRock Inc., AllianceBernstein Holding LP and Magnetar Capital LLC, out of more than $2 million by allegedly lying about the origins and prices of securities. Some of the trades involved a federally subsidized program to revive the mortgage-bond market after it froze in 2008. Litvak, 38, pleaded not guilty.

The case shows how even Wall Street's most sophisticated mortgage investors remain largely at the mercy of middlemen a decade after regulators forced brokers of other types of bonds to publish data electronically on a system called Trace. Managers who depend on dealers to find securities and quote prices over the phone are often misled, said Marilyn Cohen, founder of Envision Capital Management Inc. in Los Angeles.

"I suspect they all do it," said Cohen, who oversees $325 million. "If the mortgage-backed securities market ever required prices to post on Trace, as do the corporate and muni markets, this wouldn't happen."

Denies Cheating

Litvak's lawyer at DLA Piper LLP, Patrick Smith, said in a statement that his customers agreed to the prices and that Litvak didn't "cheat anyone out of a dime." He declined to say more.

The tactics Litvak allegedly used are probably "fairly commonplace, fairly widespread," Reid Muoio, deputy head of the SEC's structured and new products unit, said during a Jan. 29 panel discussion at the American Securitization Forum's annual conference in Las Vegas. "I've been told that today by actually a number of different industry participants," Muoio said.

According to the indictment, Litvak would misrepresent a seller's asking price for a mortgage-backed security to a buyer, or vice versa, and keep the difference for New York-based Jefferies. Or he would invent a third-party seller for bonds in the firm's inventory, allowing him to charge an extra commission, prosecutors said.

16 Counts

Litvak is charged with 16 counts, including securities fraud, which carries a maximum 20-year prison sentence, and defrauding the Troubled Asset Relief Program. He pleaded not guilty Jan. 28 in federal court in Bridgeport, Connecticut, and was released on $1 million bond, according to U.S. Attorney David Fein. He is due to appear in court in New Haven May 6.

The SEC sued Litvak in Connecticut federal court, accusing him of "misrepresentations and misleading conduct."

"The kind of false claims made by Mr. Litvak repeatedly were unfit for a used car lot, let alone the marketplace for mortgage-backed securities," George Canellos, deputy director of the SEC's enforcement division, said on a Jan. 28 conference call.

Six of the funds Litvak allegedly defrauded were part of the program to use TARP to help buoy the market for home-loan bonds after it froze during the global credit crisis. More than 100 firms applied to manage one of the nine funds established under the program, and each received $1.4 billion to $3.7 billion of bailout money to invest along with private capital, according to Fein.

Government Connection

The connection to the government program probably influenced the decision to bring charges, according to Thomas Gorman, a former SEC attorney.

"Based on those facts, it seems like a fairly egregious situation," said Gorman, now a partner at Dorsey & Whitney LLP. "You have someone not only ripping off the government but ripping off the government while it's trying to help the very market the man's working in."

Regulators started investigating Litvak after Jefferies paid $2.2 million to settle a dispute with a customer in March, Litvak said in an October Delaware Chancery court filing in a lawsuit he lodged against the bank to cover his legal fees after he was fired. Jefferies says the matter should be resolved through arbitration, according to Litvak's filing.

The client that complained was AllianceBernstein, according to a person familiar with the matter who asked not to be identified in discussing a private dispute.

Tick Commissions

In June 2011, Litvak told an AllianceBernstein trader that he had bought some bonds for "67-21," meaning 67 cents and 21 ticks, or 21/32 of a cent, according to the SEC's civil complaint. He agreed to sell the bonds to AllianceBernstein for a 4-tick commission, Litvak sent a message to a person at another firm about the trade.

"im def gonna be working for something. . . . f this 4- 8/32s sht."

Litvak had actually bought the bonds for 67-15 and earned an extra $10,000 in undisclosed commission, the SEC said.

Jonathan Freedman, a spokesman for AllianceBernstein, declined to comment on the allegations.

In the corporate bond market, trades are generally posted on Trace, making deception more difficult, according to Lawrence Post, chief executive officer of Beverly Hills, California-based money manager Post Advisory Group LLC.

"When it Traces you can see the price and when it doesn't Trace you have to be very careful," Post said. "You have to do your homework and check around and see what the market is."

Trace Origins

Trace, started in 2002 by the Financial Industry Regulatory Authority, now provides pricing data on corporate bond trading to anyone with Internet access. While the group is starting to provide trade data on government-backed mortgage bonds, it's still analyzing how to roll out the system in the $1 trillion market for so-called private label debt, according to Steve Joachim, Finra's executive vice president of transparency services.

"We want to be sure we understand the full impact of transparency," Joachim said in a phone interview. "This is a much more complex marketplace."

The importance of bringing disclosure to that market was heightened in 2008 as soaring defaults on mortgage debt such as subprime bonds triggered the global credit crisis. Those securities rebounded last year as the U.S. housing recovery strengthened, drawing investors including hedge funds, retail funds and pension managers.

"In every other market we've seen since they've started bringing transparency, it has improved trading," said Joseph Fichera, chief executive officer of New York-based financial advisory firm Saber Partners LLC, who's advocated expanding Trace since 2007. "It has increased investor confidence and broadened the market."

Defraud Government

Litvak is the first person charged under a 2009 law that makes it illegal to defraud the government in relation to TARP, Christy Romero, the program's special inspector general, said in a conference call with reporters Jan. 28

"He's the first but he won't be the last," said Barry Boss, a partner with Cozen O'Connor in Washington and a former assistant federal public defender. "We'll be seeing a lot of law enforcement focus on the bailout funds and on TARP," Boss said in a phone interview.

The size of Litvak's alleged fraud is dwarfed by the returns of some of the TARP funds. The U.S. Treasury invested $528 million in the BlackRock fund, for example, and received that money back as well as $389 million in profit, the company said in December.

Certain Misdirection

Money managers expect a certain amount of misdirection from the salespeople they work with in all markets, according to Turney Duff, a former trader at Galleon Group LLC and other hedge funds. Traders cut off salesmen who take advantage of their trust, said Duff, whose memoir, "The Buy Side," is scheduled to be published in June by Crown Business.

"My feeling is there are plenty of guys out there looking to rip me off, but it's part of my job to develop and cultivate relationships I can trust," Duff said.

The criminal case is U.S. v. Litvak, U.S. District Court, District of Connecticut (New Haven). The civil case is SEC v. Litvak, 13-132, U.S. District Court, District of Connecticut (New Haven).

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