The FBI Eyeballs Subprime (CFC)(GS)(MS)

April 18, 2008 by Douglas A. McIntyre

The FBI is looking into why the subprime market fell apart. As a matter of fact, it wants those who are guilty to turn themselves in so they do not have to be pursued to the ends of the Earth. According to Reuters FBI head man Bob Mueller also told a meeting of lawyers that "their corporate clients should come forward and admit any wrongdoing before the FBI or Justice Department become involved." Then there is that part about pigs flying.

The Feds believe that companies like Countrywide (NYSE:CFC) may have committed wrongful acts in their lending practices and accounting procedures. Hedge funds and banks may have been misleading, perhaps committing fraud, when they sold subprime instruments and marketed them as "safe".

The banks and brokerage firms did come up with a program to slice big pools of subprime mortgages into pieces. Using a set of formulas put together by math PhDs from Princeton and other leading educational institutions the companies modeled the likely default rates on these mortgages and put some of them into buckets which were statistically walled-off from major failures. The only trouble was that these models did not see that poor people would not be able to make the monthly note on their homes.

To a very large degree the legal case hinges on whether people read the documents which they were given. Did people taking out "to good to be true" mortgages look the future interest resets?

At banks and brokerages, both those than sold and bought the mortgage instruments, somewhere in the fine print it said that there were risks in investing in the stuff. But, it looked plenty safe. They knew the institutional salesmen marketing the paper. Some of it had "AAA" ratings.

The FBI may make a case against some of these firms which appears to include Goldman Sachs (NYSE:GS), and Morgan Stanley (NYSE:MS). But the guilt or innocence of the parties involved could swing on a single question. Somewhere in all the documents where the risks disclosed?

Douglas A. McIntyre