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Exclusive: FBI suspects front running of Fannie, Freddie in swaps market

Fannie Mae headquarters is seen in Washington November 7, 2013. REUTERS/Gary Cameron
Fannie Mae headquarters is seen in Washington November 7, 2013. REUTERS/Gary Cameron

By Richard Leong

(Reuters) - Wall Street traders may be manipulating a key derivatives market and front running Fannie Mae and Freddie Mac, hurting the US-owned mortgage giants in the process, according to an FBI intelligence bulletin reviewed by Reuters.

Using what Federal Bureau of Investigation agents described as "unsophisticated tradecraft," such as hand signals and special telephone ring tones, some traders are conspiring to rig rates on large orders submitted by Fannie Mae and Freddie Mac, or front running them in the interest rate swaps market, the document says.

The FBI said in the bulletin that the information came from a former high-level employee at a U.S. bank and an employee at a Canadian Bank, plus interviews with other bank workers conducted in 2012 and 2013. The former high-level employee at the U.S. bank estimated the front running had resulted in profits of $50 million to $100 million for the bank, the FBI said.

The bulletin did not name any of the traders or banks suspected of the activity, or indicate whether it may extend beyond the two banks.

Front running occurs when someone with advance knowledge of another market participant's plan to make a sizable transaction puts an order in first, often profiting from a market move that can occur once the big trade has gone through.

The FBI bulletin is the latest indication that officials are concerned that traders are manipulating financial markets. U.S. and European authorities have fined 10 banks around $6 billion for allegedly manipulating the London Interbank Offered Rate, or LIBOR, and other interest rate benchmarks, and authorities are actively investigating comparable behavior in the foreign exchange market.

PHONES PROGRAMMED

Current and former employees at the U.S. bank said that swap traders at the bank programmed their phones with different ring tones to identify when certain customers were calling, alerting traders that a large order was about to be placed, the FBI said.

According to the bulletin, one employee at the U.S. bank and the Canadian bank employee reported that senior bankers at the two banks "planned and encouraged this behavior because it led to higher revenue for their respective parent banks."

Disclosure of the suspected manipulation and front running came in an FBI intelligence bulletin that was distributed last week by the bureau's field office in Charlotte, North Carolina, to security officers at financial services firms.

The FBI said it had "medium confidence" in the information, which the bulletin described as coming from "multiple corroborating sources with first-hand access." However, it said it had "low confidence" that law enforcement could prosecute suspected traders because the trades concerned seem to be completely legitimate.

"It is standard policy for the FBI to share intelligence information with our private sector partners to help protect our economy, thwart crime, and prevent threats impacting American businesses," Shelley Lynch, spokeswoman for the FBI in Charlotte, said in a statement. She would not elaborate.

Spokesmen for Fannie Mae and Freddie Mac did not immediately return calls for comment. Spokesmen for the U.S. Securities and Exchange Commission and the Commodities and Futures Trading Commission declined to comment.

Fannie Mae and Freddie Mac, which are government-sponsored enterprises (GSEs), often submit large swap orders to hedge their huge holdings of home mortgages against swings in the bond market. The size of the orders provide an incentive for front running ahead of the trades.

"GSEs frequently submit large interest-rate swap trades, making them easy targets for front running and lucrative targets for market manipulation," the FBI bulletin said.

The interest rate swap market is huge with a notional value of about $400 trillion. In addition to GSEs, pension funds and insurers use interest rate swap as a hedging tool, while municipal governments sometimes enter into these contracts to limit their interest rate risk on the debt they issued.

The FBI said its sources reported that voice brokers and senior traders at both the U.S. and Canadian banks encouraged traders to listen in on calls with the investors to gain transaction information "which could be used to facilitate front running or market manipulation."

They would then use hand signals to inform other traders of the details of the planned swaps, allowing these traders to also benefit, employees at the banks said, according to the bulletin.

(Reporting by Richard Leong; Additional reporting by Mark Hosenball, Sarah Lynch and Margaret Chadbourn in Washington; Editing by Dan Burns and Martin Howell)

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