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Those Pesky Derivatives Strike Again

This article is more than 10 years old.

Morgan Stanley's office in Times Square (Photo credit: Wikipedia)

During the 2008 economic crisis, terms like CDOs, credit default swaps, and other derivatives once confined to the vernacular of the financial industry became household terms as analysts tried to explain the fading fortunes of the global economy.

Eventually, these obscure yet omnipresent products were – in large part – blamed for the credit crisis.  Derivatives stood at the center of AIG’s downfall.  JPMorgan Chase is in the process of losing billions of dollars stemming from trades involving these financial products.  And they have been the target of numerous government investigations and multimillion dollar settlements involving Citigroup, Goldman Sachs, and Wachovia (which later merged with Wells Fargo) in recent years.

Now, it’s Morgan Stanley’s turn.  Only this time, it isn’t being accused of selling dubious and enigmatic investments to naive investors.  Instead, federal regulators have claimed that the bank served as a counterparty with KeySpan (a utility) and the electricity provider's leading competitor as part of an effort to artificially prop up electricity prices in the New York metropolitan area.

In other words, derivatives have now been exposed as tools in an apparent antitrust scheme.

There is a first time for everything.  According to a court-approved consent decree entered into with the bank last week, the Department of Justice claimed that the $4.8 million settlement was the agency’s “first attempt to obtain disgorgement from a financial services firm that used derivative agreements to facilitate anticompetitive behavior.”

So just when we thought we had heard all about the threats the hazardous use of derivatives could unleash on to the economy, a leading bank apparently managed to find a new way to use them, this time to help gouge consumers of more than $150 million.

Judge William H. Pauley III, the federal district court judge based in Manhattan who approved the settlement, called the $4.8 million figure a “relatively mild sanction” compared to the apparent harm caused by the scheme.  “There is a risk,” he explained, “that a large financial services firm like Morgan Stanley could view such a modest penalty as merely a cost of doing business.”

Last year, Judge Pauley’s colleague on the bench echoed a similar sentiment in rejecting a $285 million settlement between Citigroup and the Securities and Exchange Commission.  That ruling, authored by Judge Jed S. Rakoff, added fuel to the criticism that the financial sector has largely evaded responsibility for its role in the 2008 financial meltdown.  Unfortunately for those who embraced the judge’s line of thinking, an appellate court overturned Judge Rakoff's decision.

With this in mind, Judge Pauley decided to defer to the government in this case.  He also allowed Morgan Stanley to enter into the settlement without admitting to any wrongdoing.  These types of settlements, where companies deny any liability, have come under immense criticism of late – most notably by Judge Rakoff in the same Citigroup ruling.  In response, the SEC modified its policy of allowing companies to neither admit nor deny wrongdoing when settling cases in limited circumstances earlier this year.

The criticism and the corresponding change at the SEC had little impact on this settlement, however, which was overseen by the Department of Justice’s Antitrust Division.

In fact, despite Judge Rakoff’s seminal ruling from last November, the anger directed at Wall Street for its role in the financial crisis, and the weary perception of derivatives, this settlement will likely do little to overturn the status quo in the financial sector and the outsized role derivatives will continue to play in the nation’s economy.