State investigators in Massachusetts slapped the investment company State Street Global Advisors yesterday with a $5 million fine for failing to tell investors about the role of the hedge fund Magnetar in a risky collateralized debt obligation that collapsed in the housing market crisis.

In 2006, State Street and Deutsche Bank put together a $1.56 billion CDO deal, called Carina CDO Ltd. As we reported with This American Life and NPR, Magnetar was involved in the creation of at least $40 billion of CDOs, including Carina, while simultaneously taking positions that would allow it to profit if the CDOs failed.

As we noted in our original story, sources involved in the negotiations said State Street managers were “highly skeptical” about dealing with Magnetar, raising concerns about the company’s “reputational risk.”

According to the settlement, a State Street executive also sent an email saying, “We are not comfortable with [Magnetar] shorting into the deal.”

Carina defaulted only 16 months after it was launched. Investors lost nearly $450 million. The Massachusetts settlement says Magnetar was closely involved in picking assets that went into the CDO — and “was able to reap a windfall” when it failed. (Here’s the settlement.)

Magnetar has never been charged with wrongdoing, and has always maintained that it did not have a strategy to bet against the housing market.

The settlement reached with Massachusetts faults State Street for not informing investors of Magnetar’s role in creating Carina and its bets against CDOs. “Investors were unaware of a potential conflict of interest between Magnetar and other Carina investors and thus were unable to make a fully informed investment decision,” the settlement states.

State Street will pay a $1.5 million fine and return $3.5 million to the state for fees, commissions and other revenue related to Carina.

State Street is being fined under a Massachusetts law regulating investment activity. In a statement, William Galvin, Secretary of the Commonwealth of Massachusetts, said his office “is actively investigating how banks misled buyers of securitized debt instruments backed by subprime mortgages.” The deals, he said, “allowed the mortgage crisis to continue and caused further harm to the U.S. economy.” The secretary’s office did not respond to requests for further comment on the settlement.

A spokesperson for State Street said that in accepting the settlement, the company “neither admits nor denies [Massachusetts’] findings or conclusions concerning information contained in the offering documents for the CDO.”

Massachusetts has gone after State Street before: In 2010, the company settled with Galvin’s office and the Securities and Exchange Commission for more than $300 million over charges that the firm failed to disclose to investors the extent of their exposure to subprime investments.

J.P. Morgan settled with the SEC last year for $153 million over claims that the bank misled investors about Magnetar’s role in a CDO. The SEC is also reportedly considering charges against one former manager of a Japanese bank over his involvement with Magnetar CDOs — the first public evidence of possible charges against a bank executive related to the scandal.

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