Quotes of the Day

Vampire squid Goldman Sachs wasn't the only Wall Street firm allegedly sucking illegal profits out of mortgage bonds at the height of the housing credit bubble.

On Monday, the Securities and Exchange Commission (SEC) charged a former Harvard University quarterback, Thomas Priore, and his bond firm, ICP Asset Management, with defrauding the investors who bought the firm's collateralized debt obligations (CDOs), the highly structured debt securities that became popular with mortgage investors and bond managers in the late 2000s. Many of those deals have since busted, costing banks and investors hundreds of billions of dollars. Problems in the CDO market played a prominent role in the collapse of investment bank Bear Stearns and insurance giant AIG, making the financial crisis significantly worse. ICP's allegedly illegal trades cost the firm's CDO investors tens of millions of dollars. Bond insurers lost out as well. Two ICP deals were among many that had to be purchased by the Treasury Department in the government's late-2008 bailout of AIG.

For months, the SEC has been investigating what led to the extreme losses in the CDO market. In April, the SEC charged Goldman Sachs with colluding with a hedge fund to allegedly trick investors into buying a CDO backed by mortgage bonds that Goldman had set up to fail. The hedge fund, run by John Paulson, then bet against the deal. Both Goldman executives and Paulson, who has not been charged, say they did nothing improper.

The SEC case against Priore and New York City–based ICP opens a new front in the agency's investigation of the CDO market. Investment banks like Goldman package and sell CDOs as bonds. But unlike a typical mortgage-backed bond, which are set portfolios, CDOs are set up similar to mutual funds in that they have investment managers who have the ability to buy and sell assets to profit and protect investors. In practice, says Gene Phillips, a principal at PF2 Securities Evaluations, which specializes in researching CDOs, managed CDOs appear to have done worse than bond offerings that were unmanaged.

"All of these deals were private, so you can't see when and what and at what price the managers were buying," says Phillips. "You just had to assume everything was being done properly, even though as a skeptical market participant one might know that very often it wasn't."

George Canellos, director of the SEC's New York office, said his agency was examining more than 50 firms that were in the business of managing CDOs but would not comment on whether the SEC is close to bringing cases against any others besides ICP.

Priore denies the charges and says that he and his firm did nothing wrong. "At all times ICP acted in the best interests of its clients," says Priore, who is ICP's chief executive. "We intend to vigorously defend the firm against these allegations."

In the mid-2000s, dozens of bond managers entered the then hot CDO market. More than $200 million in CDOs were issued in 2006 alone, according to trade publication Asset-Backed Alert. The largest manager of CDOs that year was Société Générale, in charge of buying and selling the assets for 15 deals worth $11.5 billion. Boutique firm Cohen & Co. was the second largest manager of CDOs in 2006, with eight deals worth more than $10 billion. Cohen has disclosed that it received a subpoena in the SEC investigation of the CDO market. The third largest manager of CDOs that year was ICP, heading up $7.7 billion in deals.

In the case against ICP, the SEC alleges that the bond firm used its role as CDO manager to generate profits for the firm and its higher-paying brokerage clients at the expense of its CDOs, which generated lower fees for the firm. In one instance, according to the SEC, ICP purchased a troubled mortgage bond for one of its brokerage clients at 63.5% of the bond's original value. That same day, ICP turned around and sold the bond to one of its Triaxx CDOs at 75% of the bond's face value, booking a $2.5 million profit for its brokerage client. The SEC alleges that Priore and Triaxx executed more than a billion dollars' worth of trades for its Triaxx deals at what the firm knew were inflated prices.

Adding to Triaxx's troubles is the fact that, unlike with most other deals, ICP was both the underwriter and manager of the CDO. Because of the duel roles, ICP told investors that AIG, which insured the deal, would monitor its trades. But the SEC alleges that ICP failed to report the moves it made for its CDOs to AIG and took advantage of the fact that in general, the prices of CDOs and mortgage bonds, unlike that of stocks, are not widely known.

"The [ICP] case shows the highly troubling conflicts of interest in the structured finance market," says the SEC's Canellos. "When an asset price is not transparent, it creates the ability for managers like ICP to take advantage of that."

Priore, 41, founded ICP in 2004 as a division of Bank of New York, before buying the firm with other partners in 2006. That year the firm was sued along with other investors by Fairfax Financial Holdings, Canada's largest publicly traded insurer, for conspiring to illegally drive down the price of the company's stock. The case is still pending. In 2007, a former employee of ICP was charged with stealing computer files from the firm. During the trial it was disclosed that Priore had donated $5,000 to a charity on Long Island tied to the son of the detective who was investigating the case. All criminal charges against the former employee were eventually dismissed.

According to marketing materials from ICP dated August 2008, the firm had more than 40 employees. In the first half of that year, it was the eighth largest underwriter of mortgage-backed securities in the U.S. But the financial crisis and the SEC's investigation have put a strain on ICP. In March, Priore and one of his top lieutenants, Carlos Menedez, reportedly got into a shouting match at the firm's headquarters, according to Asset-Backed Alert. Menedez quit shortly thereafter. Others have left as well. The firm now has 13 employees.

In the normally private world of structured finance, Priore was a relatively public up and comer. In 2008, Investment Dealers Digest named Priore one of Wall Street's rising stars on its annual 40 Under 40 list. Priore regularly talked to reporters that covered his industry. Following a February 2009 speech by Treasury Secretary Timothy Geithner, which was roundly criticized for lacking in specifics, Priore told a reporter that he thought Geithner did a good job. A few months later, Priore criticized a government plan to restart the market for troubled mortgage bonds. He said banks would game the plan by setting up funds that would buy troubled deals at inflated prices with government money from their own books — a bit of self-dealing that is not too dissimilar from what the SEC is now accusing Priore of. In a 2009 article by Mergers & Acquisitions, Priore said he didn't miss the Lucite deal trophies that were just one more casualty of the financial crisis. "You know what the ultimate scorecard is? It's your profitability and the respect of your clients," Priore told the trade publication.

For Priore, those things are likely gone now too.

• Stephen Gandel