State Street versus Main Street?

The financial press is reporting today that the State Street Corporation, which manages an astounding $2 trillion for pension funds and other institutions, has set aside over $600 million to cover legal claims stemming from clients whose investments lost money because of exposure to the securitized mortgage arena. It is certainly interesting that even a self-described conservative financial house like State Street drank the mortgage back security cool aid. While $600 million may sound like a lot of money, it's likely only the tip of the iceberg. Indeed, the rest of Wall Street should follow State Street's lead instead of stonewalling.

The cash reserves could amount to a multi-billion exposure to lawsuits brought by pension funds, municipalities, hedge funds and high net worth individuals. Given the interest of the financial regulatory community – it was reported FINRA has finally joined the action and has sent requests to more than a dozen brokerages for marketing and client account information used to steer clients toward mortgage related securities – a settlement along the likes of the $1.4 billion research/investment banking conflicts could also be in the future.

State Street Corp. is indeed where Main Street and Wall Street collide. Pension funds and mutual funds are comprised of the weekly contributions from mom-and-pop investors' paychecks. State Street allegedly took client funds that were suppose to be invested in treasuries and corporate bonds and instead invested them into the mortgage security market. After the client lost $80 million, the response from State Street will go down in annals of Wall Street's stupidest client responses ever (and that's saying something). Allegedly a State Street executive told his client that the firm "forgot there was a lot more risk in the strategy."

Clients are suing State Street under the Employee Retirement Income Security Act (ERISA), which is a relatively new legal strategy. Prior to the last year's Supreme Court decision known as "Tellabs," the standard to prove fraud was easier to meet. Unfortunately the business-friendly Supreme Court decided that a plaintiff must show a "strong inference" of fraud but didn't exactly define what that meant. Because of that risk, ERISA is being used to recoup for investor losses in this case and we will likely see its use increase.

In addition to the billions of dollars tied to litigation, Wall Street will lose billions more due to the collateral damage to brokerage reputations. Confidence in Wall Street's ability to invest honestly is shattered and no amount of rainy day funds can save that.