A Reuters report says Wall Street traders may be guilty of front-running Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie / Federal Home Loan Mortgage Corp (OTCBB:FMCC) while executing the massive interest swap orders placed by the housing mortgage giants.

Fannie Mae FHFA

Reuters reviewed an FBI Intelligence Bulletin that says an employee at a US bank, and another at a Canadian bank blew the whistle on the practice – which involves placing orders on account of the bank before those of the client- to benefit from the market move that would inevitably follow once Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) or Freddie / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s orders hit.

The US bank pocketed $50M-$100M from Fannie Mae

The revelation is a new black mark on banks, already facing negative publicity for a range of dubious practices over the past few years that invited penalties running in the billions of dollars from regulators.

The US bank could have earned front-running gains ranging from $50M to $100M, estimates the employee who revealed the practice to the FBI, according to Reuters.

“Unsophisticated tradecraft”

According to the FBI’s bulletin, which was circulated last week by its Charlotte, North Carolina field office, the traders used unsophisticated tradecraft such as pre-programmed telephone ring tones that would reveal the identity of the client calling. This would forewarn traders that a large order could be in the pipeline; they would then eavesdrop on the transaction – as well as communicate its details to colleagues using hand signals.

Trillion dollar gravy train

The size of the swap transactions executed by Fannie Mae and Freddie Mac offered lucrative opportunities to the bank and its traders for front-running and market manipulation. According to this report from the Federal Housing Finance Agency Office of Inspector General, Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) had a combined notional value of over $1.6T in 2012 in the form of exchange traded and OTC (cleared and non-cleared) derivative instruments, mostly comprising clearable interest rate related swaps.

The FBI report relied on information from and interviews with bank employees through 2012 and 2013. The names of the traders and banks were not revealed by the FBI.

Front running is illegal as per SEC

In May last year the SEC charged a Dallas-based trader at an investment advisory firm with front running – the trader was alleged to have improperly profited by placing his own trades before executing large block trades for firm clients that had strong potential to increase the stock’s price. The SEC announced fraud charges and an asset freeze against the trader.

In contrast, the FBI “had ‘low confidence’ that law enforcement could prosecute suspected traders because the trades concerned seem to be completely legitimate,” says the Reuters report.