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SEC charges hedge fund manager with hiding losses from RMBS investments

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The Securities and Exchange Commission has charged a hedge fund manager in Baton Rouge with defrauding investors by hiding millions of dollars in losses suffered during the financial crisis from investments tied to residential mortgage-backed securities (RMBS).

The SEC alleges that Walter As Morales and his firm Commonwealth Advisors caused the hedge funds they managed to buy the lowest and riskiest tranches of a collateralised debt obligation (CDO) called Collybus.

They sold mortgage-backed securities into the CDO at prices they had obtained four months earlier while knowing that the RMBS market had declined precipitously in the meantime. As the CDO investments continued to perform poorly, Morales instructed Commonwealth employees to conduct a series of manipulative trades between the hedge funds they advised (called cross-trades) in order to conceal a USD32m loss experienced by one of the funds in its Collybus investment.

Morales and Commonwealth lied to investors about the amount and value of mortgage-backed assets held in the hedge funds, and they created phoney internal documents to justify their false valuations.

“Morales and Commonwealth Advisors concealed significant hedge fund losses from investors, including pension fund investors, instead of owning up to them and facing the consequences,” says Robert Khuzami, director of the SEC’s division of enforcement. “Investors put their fundamental trust in the hands of their investment adviser, and they deserve better than being manipulated and lied to through deceptive trades and phony documents.”

According to the SEC’s complaint filed in US District Court for the Middle District of Louisiana, Commonwealth’s hedge fund clients included pension funds and individual investors. Morales and Commonwealth invested a significant portion of hedge fund assets in RMBS. When the mortgage markets began to decline dramatically in 2007, bond rating agencies began to aggressively downgrade subprime RMBS. Therefore, Commonwealth clients were sustaining heavy investment losses and Morales knew those losses would probably continue.

The SEC alleges that rather than come clean with investors, Morales directed Commonwealth to execute more than 150 deceptive cross-trades from two hedge funds they advised to another one of their hedge funds in June 2008 at prices below Commonwealth’s own valuation for those securities. After the trades, Morales directed a Commonwealth employee to mark the securities at fair market value, which created a fraudulent USD19m gain for the acquiring hedge fund at the expense of the funds that sold. Morales ordered the cross-trades even though Commonwealth had represented in forms filed with the SEC that it would not execute such trades between these hedge fund clients. Moreover, when the trades raised concern from the prime broker, Morales falsely represented that the transactions were for a legitimate business purpose and at prevailing market prices.

The SEC further alleges that Morales deceived Commonwealth’s largest investor about its exposure to the CDO. Morales agreed to limit the investor’s exposure to Collybus through its investment in a particular Commonwealth hedge fund to 10 per cent of that hedge fund’s equity. Morales, however, abided by this agreement only temporarily, and the investor’s exposure to Collybus more than doubled by mid-2008. After the large investor learned that Commonwealth was not following its stated valuation procedures, the investor requested valuation committee meeting minutes to review. Morales prepared false minutes that were delivered to the investor purporting to describe meetings that never occurred.

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