Although the complaint does a terrible job of explaining a CDO, the basic premise (really basic) is this:
A collateralized debt obligation seeks to take a debt (both principal and interest) and make it attractive to investors. As a basic premise, the one thing investors like is consistency. Loan repayments, such as homes, are notorious for being inconsistent. People pay back their loans too early, or the default, etc. This means that an investor, who purchases a bond, can't depend on a steady stream of income. As such, pre creation of CDOs, mortgage loans were a poor investment.
In the 80s, Salomon Brothers (now part of Citi Group) found a way to package mortgage loans and make rain come from the sky. (for a more detailed explanation, I recommend reading, Lair's Poker). They did this by creating CDOs. CDOs are mortgage bonds. Massive groups of mortgages are pooled together and divided into groups, called "tranches." There are potentially an unlimited number of tranches, but the tranches are generally split into durations, similar to bonds. For example 3-5 years, 7-10 years, and 15-20 years.
The shorter duration CDOs receive all the early pre-payments (those who pay off their mortgage early) and the longer CDOs receive all the regular payments (those people who keep the whole mortgage to the end). Naturally, the longer someone keeps a mortgage, the more likely that person is likely to default. As such, investors with the longer durational CDO take bigger risks. Naturally, their CDOs receive higher interest rates and shorter CDOs receive lower interest rates. The CDOs are priced accordingly.
OK, now that we know what they were investing in, we can talk about how they did it. CDOs don't really bring in a lot of money on a small scale- i.e. dollar for dollar. In order to generate returns, the managers leveraged their investment. This means they borrowed the money, using the fund money as their margin requirement. The complaint suggest they leveraged up to 20 times the fund's investment money. Essentially, the managers were playing with money they didn't have. If their fund did well, then they would be rewarded handsomely. If not....bankruptcy. [it's the difference between 1x20 (fund does well) and 1x(-20)(fund not so good)].
So, as you can guess, things went bad, and eventually the fund went "el busto" and lost the funds' combined value of $1.4 billion. The indictment states that the managers made misrepresentations to investors (huge institutional investors, the type who can invest $5-$10 million, not folks who can only invest $100,000), by saying they thought the fund was looking at sunny skies, when, in fact, it was thunder and lightning was all around. In short, the Feds are charging the duo with breach of fiduciary duty to its investors.
The breach of fiduciary duty standard, essentially, states that those with the duty have to act with reasonable care towards those who they have a duty towards. They have to have act in their best interests, and must act in good faith.
The counts in the complaint are as follows:
Count 1 - Conspiracy to commit securities fraud and wire fraud
Count 2 - Securities fraud - High Grade Fund
Count 3 - Securities fraud - Enhanced Fund
Count 4 - Securities fraud - Ralph Cioffi, insider trading
Count 5-9 - Wire fraud
Looking at the indictment...I kinda think its weak. There are a lot of allegations that are based on partial comments. The basic pattern is that the indictment sets up a situation, and then throws in a partial comment, like 5-6 words, as proof. The problem is that these quotes can easily be taken out of context and manipulated. As such, it's kinda hard to accept them as weighty evidence. Maybe the actual trial will have real evidence. But from what I can see, it's kinda thin.
Secondly, there is a clear difference between making a bad business decision and acting in bad faith. There doesn't appear to be a clear plan that that was what they were up to. I think they might have made some trades, those went sour, they, like any trader, might try and trade their way out, and instead, ended up making it worse (see Long Term Capital Management- which lost $4.5 billion in 5 weeks- a pretty similar story as these two defendants, yet no criminal charges against them, see When Genius Failed). I don't think this qualifies as bad faith. It's more consistent with someone, rather than being sure of the market, is confused with the situation. It's just a bad business decision.
As for the insider trading charge against Mr. Cioffi, well, that seems a little more tenable. I could buy that before I thought there was a 10b-5 breach with the actual funds. If he did move his money without disclosing to his investors, that does cause some concern. Even if he moved his money for legitimate reasons, it still needs to be disclosed.
I do have a question about their redemption policies though. I'm not sure why the investments weren't able to be redeemed. It's possible, like in LTCM, a condition of investment was that the shares could not be redeemed for a set period of time. But that's something I'm sure the evidence will show.
There are some other problems I have with this indictment, outside of the law. First, it makes the investors out to be like they were just some innocent folks who got boondoggled by these fast talking New Yorker, Wall St. types. Absolutely ridiculous. Those who lost money in the fund were institutional investors who, likely had billions of dollars to play with. You don't get into a position of being able to trade in blocks of $57 million by happenstance. You ain't no rube. They were sophisticated investors who had the tools to make a sound analysis. They just made a bad investment. It happens. Lately, it's been happening a lot. But just because they made a poor investment, doesn't mean that someone should be held criminally liable for it.
Second, this is a terrible charade. Hundreds of billions of dollars, potentially trillions of dollars of investor value have been post in these credit crisis. I think it's silly that these two managers be the symbol of this mess. Do the Feds intend to go after Morgan Stanley, Citi, Goldman, JP Morgan, and other banks who lost out? They all contributed. They all had the same sales pitches. Feds might as well put out some more indictments. Too bad Elliot Spitzer has such a prostitute problem.
Third, I think this sends a bad message. It sends the message that these two men are responsible for the credit crisis when, instead, it was ALL of America. We, with our copious consumption, let this happen. If people hadn't hid their eyes to the realities of their mortgages, we all wouldn't be in this mess. If, instead of refinancing to buy tvs and cars, people had simply built up the equity and paid of their homes, the crush in equity might not be as great. If people hadn't simply bought homes with the intent to flip, it might not have driven prices up.
UPDATE: I just read about the 400 arrests regarding mortgage fraud on the ground level. Dubbed operation "Malicious Mortgage" (what a lame name), the FBI has investigated 144 mortgage fraud cases leading to 406 arrests over the past few months. Way to go FBI! Let's keep up the good work. I'm glad the FBI is targeting the fraud at all levels, and not just at the trading level. Spread the wealth.
True, Wall St. folks provided the tools for these people to take out these loans, but that was it. Main St. still needed to take out the loans. In short, Wall St. was merely the middle man. As everyone was involved in this collapse, we should all be held accountable, not just these hedge fund managers.
In sum, sure, I think there is the possibility of misrepresentations and insider trading, etc., but I hope the Feds have more evidence. I guess, by their nature, indictments are pretty slim. But with such a high profile case, you'd think the Feds would want to come out "guns a blazing." Here, it seems the brought a water pistol to a knife fight. Since history always seems to repeat itself on Wall St., remember that the Feds couldn't convict Frank Quattrone on the basis of emails. Pretty similar circumstances here. The Feds have a tough road ahead of them.