Traders working on the floor of the S&P 500 pit at the Chicago Mercantile Exchange in Chicago.  

WASHINGTON: The next chapter of the subprime-lending debacle could include fraud charges for investment banks and companies that did not fully explain the risk of subprime-related securities to investors.

Within the next six months, it should be clear how regulators will proceed against those companies, said Michael Malloy, a former enforcement official of the U.S. Securities and Exchange Commission.

"Odds being what they are, somebody's going to get hooked," said Malloy, who now teaches at the McGeorge School of Law, part of the University of the Pacific. "From an investigative point of view, they'll be looking at how much of this was the result of stupidity and misfortune and how much is broader manipulation."

The broader manipulation could include failing to appropriately disclose the value or the risk of securities backed by subprime loans, which could constitute fraud, experts say.

Rising defaults in U.S. subprime loans have unleashed chaos in world financial and credit markets in recent weeks. Many subprime mortgages are packaged into mortgage-backed securities and collateralized debt obligations, bundles of securities with differing yields and credit ratings which are sold to hedge funds, banks and pension funds.

The securities commission recently told Congress that it had at least a dozen active subprime-related investigations under way but did not provide details. A commission spokesman declined to say what its subprime investigators were examining.

Carol Stacey, who recently left as chief accountant of the commission's corporate finance division, said the investor protection agency was likely to look at prices that companies gave to clients for subprime-related bonds and mortgage-backed securities.

"The SEC is going to look for whether the firm provided the client with a different valuation than they used internally," Stacey said.

Another target area, she said, is whether publicly traded companies provided timely disclosures about the risks they assumed by investing heavily in subprime assets. Stacey is now vice president of the SEC Institute, an independent organization focused on compliance issues.

SEC staff issued explicit guidance on disclosure about residential loan products as recently as November. The guidance document, which was not approved by the full commission, directs companies to "disclose changes in credit losses and interest income recognized for higher risk loans."

It also tells companies that they should disclose trends related to home loans with features that may result in higher credit risk and are likely to have a material impact on income.

For example, a case could start when the SEC enforcement staff's interest is piqued by an investment bank's revealing sizable losses from risky subprime-related securities or from an outside tip, Stacey said.

Agency staff would then look at the company's regulatory filings and see whether it had adequately disclosed risks and valuations associated with the securities.

Malloy, the former enforcement official, said there could be "first-order" or "second-order" fraud involved. Second-order fraud would occur if the company did not know how to value the infrequently traded securities but gave investors the impression the valuation was rigorous and accurate.

A more serious first-order fraud would occur if a company gave a class of subprime-related securities a much higher valuation than it knew they were worth, Malloy said.

"The first-order kind of fraud is easier to present to a jury or a judge because it makes intuitive sense," he said.

It could be difficult for the SEC or prosecutors to build a strong fraud case against a company or its officials.

Cliff Hyatt, a former SEC enforcement attorney now with Pillsbury Winthrop Shaw Pittman, said it was difficult to show that executives intentionally misrepresented valuations because subprime-related securities were thinly traded and tough to value anyway.

Malloy said the most important outcome of any SEC charges would be to help restore investor confidence.

"Clearly the SEC has to get these participants to give more credible valuations," he said.

http://www.iht.com/articles/2007/08/17/business/sec.php