Did the SEC Miss Warning Signs at Bear Stearns?

Did the Securities and Exchange Commission miss warning signs back in 2005 that could have helped it stop the meltdown at Bear Stearns?  

It's a question that arises from an SEC probe into Bear Stearns in 2005 alleging that the Wall Street firm may have fraudulently valued mortgage-related securities, the very same products that led to Bear Stearns' collapse, forcing a rescue orchestrated by the Federal Reserve that involved getting JPMorgan Chase (JPM) to park its ambulance outside its doors.

The SEC subsequently dropped the 2005 case, prompting an inquiry from Senator Charles Grassley (R-IO), a ranking member of the Senate Finance Committee. But the senator's inquiry went nowhere. 

Allegations about the fraudulent valuations and disclosures of these securities also led last week to the arrests of two former hedge fund managers who ran two Bear Stearns hedge funds that collapsed and cost investors $1.6 bn last summer, triggering the downfall of Bear Stearns. JPMorgan Chase eventually bought Bear for $10 a share. At the time, Bear had $389 bn in assets and $387 bn in liabilities against just $11.9 bn in shareholders equity. JPMorgan is now digesting this outsized balance sheet.

The funds at issue were the High-Grade Structured Credit Strategies Fund and its highly-geared cousin, the High-Grade Structured Credit Strategies Enhanced Leverage Fund.

The 2005 case involving Bear Stearns raises serious concerns for investors when it comes to the strength of the market police and its oversight of credit derivatives concocted during the housing bubble.

The case is a little known and little understood matter brought in 2005, one that critics say could have saved the SEC a lot of headaches now, if it had chosen to use its regulatory muscle at the time.

Award-winning journalist Michael Siconolfi at The Wall Street Journal broke this story in December 2007, "Did Authorities Miss a Chance to Ease Crunch? SEC, Spitzer Probed Bear CDO Pricing in 2005, Before Backing Away."

The SEC has come under fire lately for not taking a tougher oversight role on Wall Street. The agency's trading and markets division is supposed to regulate the biggest broker-dealers, which means it's charged with keeping tabs on whether investment banks have enough capital on their balance sheets as well as the strength of their risk management systems.

The Federal Bureau of Investigation is now probing 19 large companies, including investment banks, credit rating agencies, accounting firms and hedge funds to determine their potential criminality in the subprime and credit mess.

The FBI, which is looking at large-scale, corporate insiders, has not disclosed which companies are the subject of these probes. Accounting fraud, insider trading and criminal failure to disclose appropriate valuations of securitized loans and derivatives are under investigation. The SEC has also opened numerous investigations.

At issue are collateralized debt obligations (CDOs), ultra-high risk credit derivatives that the investment banks sold to complacent institutional funds, including pension funds, endowments and insurance portfolios.

Back in July of 2005, Bear Stearns buried in a footnote a terse, cursory disclosure about a regulatory probe in a quarterly filing, after disclosures about things like fights with the Utah state retirement board and the state of West Virginia.

It noted it faced a possible civil enforcement action related to pricing, analysis, and valuation of $62.9 mn in CDOs, a series of high-yielding bonds supported by revenue streams from commercial, residential and mobile-home mortgages.

Bear Stearns reported too that then-New York Attorney General Eliot Spitzer had subpoenaed the firm about $16 mn in CDOs it had sold to an undisclosed client. The firm also disclosed it had set aside $100 mn in legal reserves to handle the investigation and possible litigation.

Bear Stearns didn't provide any details or identify the customer that bought the CDOs.

Later, it came to light that the SEC's Miami office allegedly planned to recommend that Bear Stearns be civilly charged for fraudulently pricing and valuing $62.9 mn of CDOs it sold to W Holding Co.'s Westernbank Puerto Rico bank unit, CDOs which reportedly later cost the bank $20 mn.

Bear Stearns was reportedly valuing these CDOs at more than 90 cents on the dollar, but when the client wanted to sell the securities back to Bear, the firm priced the CDOs in the high-30s. Hudson United Bank also had reportedly complained to Spitzer after trying to unload the CDOs and allegedly discovering they were worth far less than Bear Stearns claimed.

By that time, CDO sales were already posing trouble for the highly leveraged Bear Stearns. The firm's leverage ratio rose from 26.0 in 2005, meaning that total assets were 26 times the value of its shareholders' equity to 32.8 in 2007.

Bear Stearns went belly up largely due to a run on the bank, which exposed that it had little capital to support its ocean liner of debt, partly because of problems it had with CDOs backed by mortgages issued in 2005 and 2006 during the peak of the US housing bubble.

Recently, Sen. Grassley wrote SEC Inspector General David Kotz to look into the 2005 Bear Stearns matter.

"Given the later collapse and federally backed bail-out of Bear Stearns, Congress needs to understand more about this case and why the SEC ultimately sought no enforcement action," he wrote, asking that the inspector general look into "the degree to which more aggressive action by the Enforcement Division may have led to an earlier and more complete understanding of the issues that contributed to the collapse of Bear Stearns."

Grassley had cited a congressional probe which found that SEC investigators purportedly treated Morgan Stanley chief executive John Mack with "undue deference" in its inquiry into Pequot Capital Management, because of his "Wall Street prominence and ability to hire prestigious counsel," implying the agency backed off from investigating Bear Stearns for similar reasons.

The SEC declined an enforcement action against Pequot Capital Management in connection with an insider-trading investigation in 2006.

Back then, Gary Aguirre, a former SEC attorney, told a congressional panel that he suspected John Mack, now the chief executive of Morgan Stanley , was a possible source of tips to Pequot.
Aguirre claims he was fired from the agency when his investigation got too close to Mack, a major fundraiser for President Bush. But the SEC denied giving Mack special treatment.
"I am particularly interested in this [the Bear Stearns] case in light of the SEC's failed investigation of Pequot Capital Management," Grassley wrote.  "I need to know whether the same problems identified in the Pequot investigation were repeated in the Bear Stearns case."

But citing confidentiality, SEC Chairman Christopher Cox rejected Grassley's request for information in an April 16 letter, stating: "The Commission does not disclose the existence or nonexistence of an investigation or information generated in any investigation unless made a matter of public record in proceedings brought before the Commission or the courts."

The alleged weakness in market oversight is chilling at a time when it's clear even Wall Street doesn't understand the Frankenstein products it has created, securities backed by loans given to borrowers with no compunction about mailing back the keys to their homes, dead loans walking.

Aggregate global CDO issuance exploded in dollar size along with the inflation of the housing bubble. CDO issuance totalled $157 bn in 2004, $249 bn in 2005, and $489 bn in 2006, says the Securities Industry and Financial Markets Association.

Many CDOs are cut and paste jobs. For example, they often are constructed on the backs of credit default swaps, which are bets about the direction of mortgage-backed securities, which are built on landfill, meaning, mortgages given to borrowers who got these loans even though they had no income and no assets and no credit history. 

There is virtually no independent pricing information about these CDOs, as there is a limited secondary market for trading these specialized bonds. Many of these securities are not liquid or tradable as a share in, say, IBM or a barrel of oil is. Instead, investors must depend on the Wall Street firms that create and sell them to get an inkling of what they are worth, valuations the firms can cook up on their own, according to accounting rules

Check out this interview in the August 2005 edition of Wall Street & Technology with Ralph Cioffi, one of the former Bear Stearns hedge fund managers now under arrest. In it Cioffi reveals how rickety the whole process of creating credit derivatives really is:

The interview notes that Cioffi explained that in the dealer-to-customer market [for credit default swaps], traders mostly construct contracts over the phone and via Bloomberg e-mails. Transaction and settlement records are created through a good deal of cutting and pasting of documents, and confirmations sometimes do not arrive for as long as 90 days, he noted.

Question: Did Cioffi, or anyone else on Wall Street for that matter, vet the underlying collateral backing these securities, the mortgage debt taken out by shaky borrowers?

"When we execute via Bloomberg," Cioffi continued, "we have to notify our back office through an e-mail, we calculate the settlement amount, the dealer sends us the amount and then we notify the buyer or seller of protection, so there are a number of steps."

Really? Did any of those steps include checking in on homeowners who got loans with no money down and no assets?