Wall Street may find itself on the hook

September 10, 2009

Sometimes legal fishing expeditions pay off.

A year ago, a Connecticut hedge fund sued UBS, contending that it knowingly sold toxic mortgage-backed securities to institutional investors but never disclosed that information.

At the time, the accusation by the fund, Pursuit Partners, seemed intriguing. But because the complaint lacked any sign that it had the beef to back up its potentially explosive claim, the litigation all but fell off the radar screen.

Now, it appears the hedge fund managers were onto something, thanks to a Connecticut state judge’s decision to allow Pursuit’s lawyers to get limited access to some of UBS’ internal emails.

In some of the emails, the investment firm’s employees describe the $35 million in collateralized debt obligations sold to Pursuit in summer 2007 as “crap” and “vomit.”

At first glance, it might be easy to chalk this up as simply another case of Wall Street bankers peddling securities they privately thought were junk.

But the big revelation unearthed by Pursuit’s lawyers is the extent to which credit rating agency Moody’s Investors Service shared information with UBS about its impending decision to lower its ratings on some of the CDOs the firm was selling.

In short, what struck a chord with Connecticut Superior Court Judge John Blawie is the evidence that Moody’s gave UBS a sneak peak into its decision-making process and that UBS used the information to its advantage. In ordering UBS to post a $35 million bond in advance of a trial, the judge said the firm’s bankers “were in possession of material nonpublic information regarding imminent ratings downgrades.”

The judge didn’t call what UBS was doing insider trading. But that’s one way to think of the critical allegation in this case.

And that’s why the Pursuit case could be bad news not only for UBS, but for other investment banks that packaged and sold exotic securities that were dependent on getting a stamp of approval from one of the major credit rating agencies.

It’s doubtful that this sharing of information between a rating agency and a Wall Street bank was an isolated event.

In one of the emails turned over by UBS and cited by Blawie, a banker is quoted as saying, “It sounds like Moody’s is trying to figure out when to start downgrading, and how much damage they’re going to cause — they’re meeting with various investment banks.”

That email should prompt some enterprising securities regulator or prosecutor to begin asking bankers at UBS and other firms who were packaging CDOs in the spring of 2007: What did you know and when did you know it?

In response to the bond order, a UBS spokeswoman said that “the decision by the Connecticut Superior Court is a preliminary procedure to require defendants to post security while a case is pending, nothing more,” adding that the bank expects to prevail in the case.

It’s less clear whether Moody’s, which also is a defendant in the Pursuit lawsuit, has any liability. There’s nothing to indicate that Moody’s had any knowledge of UBS’ plan to sell the CDOs to Pursuit.

A spokesman for the rating agency said Moody’s believes the claims against it are baseless.

The litigation sheds light on the all-too-chummy relationship that exists between the big rating firms and the investment banks.

And it’s just one more reason why the Obama administration needs to push harder for reforms that would make it easier for smaller credit rating firms to compete for work with the two big gorillas of the debt-rating world.

That’s a lot of heat coming from a lawsuit that most on Wall Street weren’t even aware of until this week.


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