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Fannie, Freddie watchdog in probe of alleged Wall Street front running

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[January 15, 2014]  By Aruna Viswanatha

WASHINGTON (Reuters)  A U.S. government watchdog is involved in an investigation of whether bank traders manipulated markets and engaged in front running of orders from Fannie Mae and Freddie Mac in the interest-rate swaps market, according to an FBI intelligence bulletin reviewed by Reuters.

Reuters reported on Monday that the FBI had warned regulators and security officers at financial services firms about potential abuse by traders with advance knowledge of large orders submitted by the U.S. government-owned mortgage giants.

The bulletin, which did not provide the names of the banks or traders under suspicion, warned of "unsophisticated tradecraft" such as hand signals or special ring tones that traders were using to deliver information about impending orders.

The FBI attributes some of the information to its own interviews with former and current employees at a U.S. bank and a Canadian bank, but also cites information from the inspector general's office of the Federal Housing Finance Agency.

According to a footnote to the bulletin, the source for some of the information was an employee at the U.S. bank in an interview conducted by a special agent with the FHFA, the regulator of Fannie and Freddie.

The memo does not make clear how active or advanced the FHFA involvement is. Officials at the inspector general's office were not available to comment. Representatives for FHFA, Fannie Mae and Freddie Mac declined to comment.

Fannie and Freddie, which are government-sponsored enterprises, often do large swap trades to hedge their huge holdings of home mortgages against swings in the bond market. The size of the orders makes the GSEs lucrative targets for front running and market manipulation, the FBI bulletin said.

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.

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One former high-level employee at the U.S. bank estimated that the front running had resulted in profits of $50 million to $100 million for the bank, the FBI said.

The FBI said it had "medium confidence" in the information. However, it also described the challenge of prosecuting such activity.

"The FBI assumes law enforcement will have difficulty detecting and proving illegal activity perpetrated through the use of the identified tradecraft because the resulting trades appear completely legitimate," the bulletin said.

The FHFA inspector general's office has authority to investigate crimes affecting the regulator's programs, including those that have an impact on Fannie and Freddie.

Between April and September of last year, the office's investigations led to the indictment of 75 individuals, the conviction of 55 individuals and $104 million in criminal fines and restitution orders, according to a report to Congress on its activities.

(Reporting by Aruna Viswanatha; additional reporting by Margaret Chadbourn; editing by Karey Van Hall, Martin Howell and Dan Grebler)

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