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?

Former hedge fund managers Matthew Tannin and Ralph Cioffi have been arrested by the Federal Bureau of Investigation, charged with securities fraud and conspiracy in connection with their management of two Bear Stearns hedge funds which collapsed last summer, a bellwether event in the subprime and credit crisis.

The two are the highest level executives charged in the subprime mess to date.

As we told you in an exclusive, the FBI and the Department of Justice are zeroing in on the role of hedge funds, now at the top of their hit list, with potentially more indictments against hedge fund managers in coming days (”Hedge Funds in the Crosshairs”).

Separately, the FBI and Department of Justice have announced this afternoon the arrests of nearly 300 low to mid-level mortgage fraudsters, in an action dubbed “Operation Malicious Mortgage,” reports Fox DC correspondent Ian McCaleb.

Close to 42 FBI field offices have been engaged in these operations since March 1st and are part of the crackdown on mortgage frauds that have contributed to the country’s housing mess, McCaleb reports, who adds that 406 have been charged.

It’s a story we told you about first at Fox Business (”Why an Underfunded FBI Could Hurt You”).

Arrests took place in Chicago, Dallas, Houston, Miami, New York City, Atlanta, Portland, Detroit, Phoenix, Seattle and Honolulu.

Back to the Bear Stearns indictments. Hedge funds can pay their managers up to 20% annually out of the gains in their funds, giving them an incentive to inflate underlying assets or mislead investors about the health of their funds, law enforcement officials say.

The former hedge fund managers’ lawyers have denied their clients committed any wrongdoing.

I will let the charges speak for themselves, straight from the indictment:

Cioffi, Tannin and others told investors that the High Grade fund invested in low-risk, “high grade” debt securities, primarily AAA and AA rated tranches of CDOs, enhancing its ability to generate returns through leverage.

The defendants and others led investors to believe that the High Grade fund was only slightly riskier than a money market fund.

By 2006, however, the fund’s performance had begun to decline…as a consequence of threatened investor withdrawals of money from the High Grade fund, Cioffi, Tannin and others opened the Enhanced fund in August 2006.

The Enhanced fund invested primarily in CDOs [collateralized debt obligations], using substantially more leverage than the High Grade funad.

Cioffi, Tannin and others told investors that the Enhanced fund would generate greater profits than the High Grade fund, but that the Enhanced fund would carry only limited additional risk.

Cioffi and Tannin told…investors that they had invested their own money in the funds…critically important to investors because it expressed the managers’ faith in the fund.

As of July 31, 2006, investors had invested a total of approximately $1.527 billion in the High Grade fund. When the Enhanced fund opened, many High Grade fund investors switched their investment to the Enhanced Fund.

They did this, in significant part, because Cioffi and Tannin told, and caused others to tell, investors that they were moving their own personal funds from the High Grade fund to the Enhanced fund.

Starting at least by March 2007, Cioffi, Tannin and others believed that the funds were in grave condition and at risk of collapse.

Rather than disclosing the true state of the funds to investors and lenders, thus allowing an orderly wind-down of the funds, Cioffi and Tannin agreed to make misrepresentations in the ultimately futile hope that the funds’ bleak prospects would change and that their incomes and reputations would remain intact.

In February 2007, the Enhanced fund reported a return of approximately -.08%, which was the first time that either of the funds had a negative monthly return. The High Grade fund reported a return of approximately 1.5%.

On March 2, 2007, Cioffi hosted an informal meeting attended by Tannin and two other members of the funds’ portfolio management team.

Cioffi talked about the extremely difficult month the funds had experienced in February, and stated that the funds had averted disaster and led a vodka toast to celebrate surviving the month.

Cioffi directed those present not to talk about the funds’ difficulties with others, including other members of the fund’s team.

Throughout March 2007, Cioffi consistently acknowledged to Tannin and others he was deeply concerned about the state of the funds, particularly because of the exposure to the subprime mortgage market.

On March 1, Cioffi allegedly told a team economist at Bear Stearns: “Don’t talk about [the February results] to anyone or I’ll shoot you…I can’t believe anything has been this bad.”

On March 3, Cioffi told Tannin that at least “[w]e have our health and families [we] are not a 19-year-old Marine in Iraq…” Later that day, Cioffi told Tannin “the worry for me is that subprime losses will be far worse than anything people have modeled.”

As early as March 11, 2007, Cioffi had already concluded that “[w]e will be hard pressed to be up in [the High Grade fund] or [the Enhanced fund] in March.”

Four days later, Cioffi wrote an email to a colleague stating that “I’m fearful of the..markets. Matt [Tannin] said it’s either a meltdown or the greatest buying opportunity ever, I’m leaning towards the former. As we discussed it may not be a meltdown for the general economy but in our world it will be.”

Toward the end of March, the performance of the funds had deteriorated to the point where Cioffi expressed to a funds team member that, “I’m sick to my stomach over our performance in [M]arch.”

In a March 30, 2007 email Tannin wrote to one investor: “You have chosen the absolute silliest time to redeem.”

Cioffi was also concerned about the fund’s liquidity position, especially that of the High Grade fund. Internal [Bear Stearns] reports showed throughout March 2007 that the High Grade fund was in an extremely precarious liquidity position.

Cioffi was particularly concerned that he needed to sell the funds’ assets at unfavorable prices to meet margin calls from repo lenders. On March 14, Cioffi acknowledged to a team member that, “[wle do need to take positions down in [the High Grade fund]. We are getting loads of margin calls.”

Cioffi, Tannin and others on the portfolio management team were so concerned about the High Grade fund that they discussed the possibility of merging it with the Enhanced fund.

Cioffi and Tannin…continued to tout the funds throughout March 2007 in an effort to improve the funds’ liquidity positions by enticing more capital into the funds and by staving off any potential redemptions.

Cioffi and Tannin told..investors throughout March 2007 that the market presented a buying opportunity.

On March 7, Cioffi told a Bear Stearns broker who had more than 40 of his clients invested in the funds that Cioffi believed the market was such that, “we have an awesome opportunity.”

On the same day, Tannin told the same broker, “I think [Cioffi] and I are in agreement that we are looking at some great possibilities for the coming months. I don’t know where you are putting your money now but I would suggest we speak about adding more to the fund. That’s what I’m thinking.”

Similarly, Tannin told investors that he believed that the market presented tremendous “buying opportunities” and that Tannin himself was so confident in the funds prospects that he was going to add money to his investments.

For example, on March 15, Tannin told an investor, that “[w]e are seeing opportunities now and are excited about what is possible. I am adding capital to the fund. If you guys are in a position to do the same I think think [sic] this is a good opportunity.”

In an email message to another member of the portfolio management team at the end of March 2007, Tannin expressed satisfaction at his success in convincing investors to add more capital to the Funds: “If believe it or not - I’ve been able to convince people to add more money. . . . ”

In contrast with Cioffi and Tannin’s representations to investors that the funds had tremendous opportunities to buy undervalued assets, Cioffi told Tannin and another team member on March 15 that the funds “have to be very light on the investment side and continue to raise cash in [the High Grade fund] and maintain cash in [the Enhanced fund],” primarily to meet margin calls.

Despite his repeated representations to investors that he was going to add to his own investment in the Funds, Tannin never did so.

On March 23, 2007, Cioffi started the process of transferring $2 million of his approximately $6 million investment in the Enhanced fund to another Bear Stearns hedge fund, Structured Risk Partners (”SRP”), for which Cioffi had supervisory oversight, effective April 1, 2007.

SRP, as Cioffi knew, had recently experienced returns far superior to those of the funds. In fact, on March 22, 2007, in relating to [Bear Stearns]‘ president the returns of the funds and SRP, Cioffi stated, “at least [SRP] keeps getting better.”

Despite receiving repeated questions from investors about his personal investments in the funds, a material factor in investors’ investment decisions, Cioffi never told them that he had transferred $2 million out of the Enhanced fund and into SRP.

Moreover, Cioffi falsely informed [Bear Stearns] that he made the switch so that one of the SRP managers would have a personal investment in SRP .

Both funds experienced losses for March 2007. The High Grade fund reported a return of -3.71% and the Enhanced fund returned -5.41%.

One of the three largest investors in the funds (”Major Investor #I) told Cioffi on April 18 that it was considering a redemption of its approximately $57 million investment.

Among other things, Cioffi falsely informed Major Investor #1 that he and the other portfolio managers had $8 million invested in the Funds and that this represented one-third of their liquid net worth.

Cioffi failed to inform Major Investor #I, however, that he had recently withdrawn $2 million of his approximately $6 million investment from the Enhanced fund.

On April 19, 2007, a member of the funds’ portfolio management team produced a CDO report (the “CDO Report”) that showed that CDOs held by the funds were worth significantly less than had previously been determined.

In mid April Cioffi told a broker that there was no “buy interest on anything anywhere in this world or universe. I think we need to go into outer space to find new buyers of cdos.”

On April 22, Tannin recommended to Cioffi that they either shut the funds down or significantly change the funds’ investment strategies.

In an e-mail message, Tannin advised Cioffi and another manager of the funds that, “over the last few months” he had believed that the funds should either be closed or “get very very aggressive.”

In support of closing the funds, Tannin stated that the “subprime market looks pretty damn ugly . . .. If we believe the [CDOs report is] ANYWHERE CLOSE to accurate I think we should close the funds now. The reason for this is that if [the CDO report] is correct then the entire subprime market is toast. . . . If AAA bonds are systematically downgraded then there is simply no way for us to make money - ever.”

Tannin concluded that, “caution would lead us to conclude the [CDO Report] is right - and we’re in bad bad shape.” Tannin noted the hurdles that they would meet if they adopted a “very aggressive” investment strategy, including whether investors would remain with the funds.

Tannin then asked, “Who do we talk to about this? [Bear Stearns' president]? [Bear Stearns' co-president]? Outside counsel? (And here we have to be careful because our outside counsel is Bear Stearns’ counsel NOT our counsel - this is another very big issue we at least need to think about.”

Tannin circumvented Bear Stearns’ email system by sending this email from his personal account to the personal email accounts of Cioffi’s wife and the other funds manager.

Tannin cautioned Cioffi the next day against disclosing anything to other fund employees that could signal the extent of the funds’ troubles by stating, “I think we should be conscious of statements like ‘if we sold all the assets at the mark’ while we are on the desk. We have a lot to do - and we’ll do it - but I think it is important to keep everyone else as focused as possible.”

Tannin and Cioffi never disclosed the gravity of the funds’ problems to investors or more senior [Bear Stearns] personnel. Instead, at a meeting on April 24, 2007, Cioffi, Tannin and others told senior [Bear Stearns] personnel that they were confident that the funds were in good shape and would continue to be successful.

On April 25, 2007, Cioffi and Tannin hosted a conference call for funds investors during which they made misleading statements and omitted material facts.

Tannin, in stark contrast to the grim views expressed in his email to Cioffi of just three days before, told investors: “So, from a structural point of view, from an asset point of view, from a surveillance point of view, we’re very comfortable with exactly where we are. . .. the structure of the fund has performed exactly the way it was designed to perform,” and “it is really a matter of whether one believes that careful credit analysis makes a difference, or whether you think that this is just one big disaster. And there’s no basis for thinking this is one big disaster.”

Cioffi [later falsely claimed] that, “[tlhe next big redemption date would be June 30th, and as of now, I believe we only have a couple million of redemptions for the June 30 date. . . . I believe we have about 45 million in subscription, and 25 [sic] of that is from Bear Stearns and those will be for, I believe those are all for May 1st.”

Cioffi failed to disclose the approximately $57 million redemption submitted by Major Investor #I, with whom Cioffi had met on April 18, 2007.

Cioffi also omitted any reference to $67 million in redemptions scheduled for April 30 and May 31, 2007. As for the “June 30″ redemptions, while Cioffi stated that there were only “a couple million,” in fact, there were a total of approximately $47 million, which included a portion of Major Investor #ll’s $57 million redemption.

Cioffi failed to mention that he had pulled $2 million from the Enhanced fund only 24 days earlier. Tannin failed to mention, despite contrary representations to multiple investors, that he had not added additional money to his investment in the funds. 

During May 2007, Cioffi asked [Bear Stearns] Pricing Committee, a group of professionals who were charged with overseeing the ultimate calculation of the funds’ NAV, to use higher values for some assets held by the funds in calculating the funds’ April 2007 NAV than the values that were set according to the Pricing Committee’s rules.

The values advocated by Cioffi would have yielded an April 2007 return of approximately -6.5% for the Enhanced fund. When challenged by the Pricing Committee as to the basis for using the higher values of the funds, Cioffi was unable to produce any evidence supporting his alternative pricing method. Ultimately, the Pricing Committee rejected Cioffi method, resulting in an April 2007 return in the Enhanced fund of approximately -18.97%.

On May 31, 2007, even after it became apparent that the final return for the Enhanced fund would be significantly worse than the estimated return, Tannin asked Cioffi, “do we give [Major Investor #2], whose identity is known to the grand jury] the -6.5 April or the larger down April?”

Cioffi and Tannin also continued to misrepresent the funds’ financial status and redemption picture in an effort to stem the tide that ultimately resulted in the collapse of the funds. On May 3, 2007, Tannin informed a Repo lender that the funds anticipated no large redemptions.

In fact, between March 1 and May 3, thirteen investors, including two of the largest investors in the funds and Cioffi himself, had requested redemptions.

As late as May 30, 2007, Cioffi told an investor that “so far we have talked any June redemptions of note (other than about $5M) to pull their redemptions.” Many investors, whose cumulative redemption requests far exceeded $5 million, had not withdrawn their June redemption requests.

On at least one occasion in May 2007, Cioffi falsely stated that he still had $5.5 million invested in the Enhanced fund, omitting that he had taken $2 million of that investment and put it into another hedge fund. 

On June 7, 2007, investors were told that they could no longer redeem their investments in the Enhanced fund, regardless of whether or not they had already submitted redemption requests. On June 17, 2007, investors were provided the final April 2007 return of -5.09% for the High Grade fund and -18.97% for the Enhanced fund.

On June 9, 2007, when the funds’ collapse was imminent, Cioffi stated that, “[ilf I can't [turn the Funds around] I’ve effectively washed a 30-year career down the drain.”

On June 26, 2007, investors were told that they could no longer redeem their investments in the High Grade fund, regardless of whether or not they had already submitted redemption requests.

Eventually, investors were told that the funds had both lost 100% of their respective values, resulting in a total investor loss of approximately $1.4 billion. 

The United States Securities and Exchange Commission and others began investigating the funds’ collapse in the summer of 2007.

As part of its investigation, the SEC requested that Bear Stearns produce documents and materials relating to the funds. While gathering the documents and materials, Bear Stearns learned that Tannin’s tablet computer, which he had used to take notes during 2007, and one of Cioffi’s notebooks, in which he had taken handwritten notes for the period January 1, 2007 to June 17, 2007, were both missing.

 

With record losses from the subprime and credit crisis veering towards the $400 bn mark, here come the market police.

In the crosshairs: Hedge funds, including the indictments of the two Bear Stearns hedge fund managers.

A senior law enforcement official said in an interview that hedge funds now sit at the top of the hit list of federal investigations into the subprime crisis, including at the Department of Justice and the Federal Bureau of Investigation. Expect more announcements of hedge fund indictments in coming days, sources say.

Federal authorities say Ralph Cioffi and Matthew Tannin, ex-managers of two now defunct hedge funds at Bear Stearns that at one point were worth a total of $20 bn, have surrendered in New York City. The hedge funds ran aground in June of last year, costing investors an estimated $1.6 bn and kicking off the credit crisis. The two are alleged to have misled investors about the health of the hedge funds, which invested in risky subprime and credit securities. Bear Stearns lent one of the funds about $1.6 bn, and the loan was never fully paid back. The investment firm never recovered, and was eventually subject to a Federal Reserve-orchestrated shotgun marriage with JPMorgan Chase.

Because of the record losses from the subprime and credit crisis, “regulators are under terrific pressure to look into hedge funds,” says Michael R. Young, a top securities lawyer at Willkie Farr & Gallagher, a white shoe law firm in New York City.

The two Bear Stearns hedge fund managers would be the highest level Wall Street executives to be charged in connection with the subprime and credit crisis to date. Details of the indictment are expected later today. A New York City grand jury is expected to return sealed indictments. The U.S. Attorney’s office in Brooklyn declined comment.  The FBI did not return a call for comment.

Federal and state regulators have stepped up a nationwide probe into companies that allegedly committed wrongdoing in the subprime collapse, which includes investigations into hedge funds. The investigations are being run by the Department of Justice, the FBI and the Internal Revenue Service, sources say. The investigators are looking into disclosure issues, including whether market players intentionally misled and deceived investors about the value of subprime securitizations, among other things, sources say.

Hedge funds made hundreds of billions of dollars in trades of hard-to-value subprime and credit assets that do not always carry market prices. Because hedge funds annually pay their managers as much as 20% of investment gains each year, the fear is that they helped overestimate the values of these securities to line their own pockets at the expense of investors.

Despite managing assets that range into the trillions of dollars, hedge funds operate under a self-regulatory structure and fall outside of the regulatory purview of the Securities and Exchange Commission. They are not required to file quarterly or annual financial reports, for example.

With the subprime and credit crisis, a growing number of Congressional, federal and Wall Street officials are debating that they should make such filings, as such disclosures would provide much needed transparency into their portfolios, leverage ratios and potentially their trades, sources say.

In a January 2008 report, federal auditors at the Government Accountability Office called for stepped up vigilance over hedge fund activities, citing the fact that because the funds use multiple prime brokers as service providers, no single broker has enough independent information about a fund’s total leverage.

After the collapse of Bear Stearns, the SEC began probing a dramatic rise in trading on option contracts which would benefit buyers if the company’s stock declined quickly and dramatically.

Earlier, the SEC had launched a subprime working group in the spring of 2007, which now has about three dozen open investigations covering a broad range of potential wrongdoing, including at hedge funds, ranging from the origination process, to the securitization and retail sales of mortgage-backed securities, as well as insider trading, sources say.

The SEC is also looking at fraud and breaches of fiduciary duty in the creation of collateralized debt obligations, including valuation problems, sources say.  The FBI is also conducting probes of hedge funds, as well as companies involved in the housing mess such as subprime lenders, numbering as many as 19, sources say.  

And the SEC has been probing how hedge funds account for illiquid assets, sources say. For example, when hedge fund managers are unable to value assets, they have the option of moving them to “side pockets,” where they are not included in calculations of a fund’s net asset value.

Hedge funds can park bad assets in these “side pockets” in order to hide losses from investors. In turn, hedge fund managers don’t disclose to investors the percentage of the fund’s portfolio in a side pocket or what standards they used to determine which assets would be stuck there, according to a report from Wolters Kluwer Financial Services.

Private equity companies, pension funds, and portfolio managers are also hiring forensic accountants in an attempt to try and claw back their losses on subprime securities and structured products by proving hedge funds and other players knowingly committed fraud in their valuations of these securities, sources say. To do that, they need to prove that these individuals knew these securities had a higher chance of flopping than what they were telling clients.

Similarly, federal prosecutors may have a hard time proving their case against the Bear Stearns hedge fund managers.

At the crux of these cases sits a legal principle called “scienter,” (a Latin word meaning knowledge), whereby prosecutors would have to prove the hedge fund managers, including Cioffi and Tannin, deliberately or knowingly knew their actions were illegal in order to prove they were legally responsible at the time of the alleged crime. Scienter is notoriously difficult to prove, prosecutors literally having to be sitting in an alleged criminal’s lap to prove a crime, which is why they tend to rely on emails to prove their case, as in the Bear Stearns matter.

“High profile meltdowns almost always create pressure for regulatory probes,” Young says. “Sometimes they’re justified, sometimes not.”

Separately, the relatively new Financial Industry Regulatory Authority, launched in July 2007 through the merger of the National Association of Securities Dealers and certain functions of the New York Stock Exchange, is also conducting probes. The probe reportedly includes hedge funds.

FINRA can fine, suspend or expel from the industry companies which violate FINRA rules, federal securities laws, or rules enacted by the Municipal Securities Rulemaking Board.

FINRA, which tends to focus on abuses of senior investors, has sent letters to as many as two dozen companies that sell collateralized mortgage obligations requesting detailed information about sales, marketing, review processes, and consumer complaints. These widely marketed products are often targeted at seniors and are difficult to understand.

Some major hedge fund players are being swept up in the dragnet.

The SEC has been investigating the $5 bn hedge fund DB Zwirn, which ran a high-yield bond portfolio. The commission is requesting information about how the hedge fund valued its assets, sources say. DB Zwirn is winding down its fund after colossal redemptions. The fund had specialized in purchasing corporate loans and other illiquid credits.

The fund had raised the valuation issue itself in a letter to investors last year that said a fund manager who left in 2005 had failed to “follow a systematic pricing methodology” for a portfolio of high-yield bonds, according to reports.

However, DB Zwirn said its lawyers and auditors uncovered “no conclusive evidence that the portfolio was overvalued” but found that by using one pricing methodology, “the portfolio may have been marginally overvalued,” reports indicate, and returned to investors a sum equal to the management fees on the discrepancy, $818,398.

A growing number of Congressmen are demanding that votes be delayed on the new $300 billion housing relief legislation until hearings are held into a controversial mortgage loan program at Countrywide Financial involving alleged preferential treatment given to elected officials.

Countrywide (CFC) officials allegedly gave preferential treatment in mortgage loans, including float-down interest rates and shaving of points, to a select group of VIPs that included both Sens. Kent Conrad [D-N.D.] and Chris Dodd [D-Conn.], both of whom have denied any wrongdoing. Countrywide’s controversial deals were given under the “Friends of Angelo” program, nicknamed after Countrywide chief executive Angelo Mozilo. Portfolio Magazine reported the allegations last week.

James Johnson, a former chief executive of Fannie Mae, resigned recently as an adviser to the presidential campaign of Sen. Barack Obama after the Wall Street Journal reported that Johnson received sweetheart loans from Countrywide. Johnson’s lawyer has said those loans were made on normal terms.

House and Senate rules bar members from knowingly receiving gifts worth $100 or more annually from companies that use registered lobbyists. Countrywide’s ethics code restricts executives, employees and board directors from improperly trying to influence government employees with money, gifts, loans, rewards, favors or anything of value.

The disclosures about the Countrywide program have sent members of Congress scrambling to defend themselves and assure voters that they did not receive preferential treatment in getting mortgages from Countrywide. Bank of America (BAC) is forging ahead to buy Countrywide in a deal now estimated to cost $3.3 bn. A special shareholder vote on its Countrywide purchase is scheduled for June 25.

Sen. Jim DeMint, [R-S.C.], has signaled he might try to block the housing measure due to the allegations.

“The housing bill has a multibillion-dollar taxpayer bailout for a company that reportedly gave preferential loans to members of Congress,” a spokesman quotes the Senator as saying. “This is exactly the type of thing Americans are sick of.”

Rep. Darrell Issa (R-) and Rep. Mark Souder also sent Rep. Henry Waxman (D-Calif.) a letter demanding hearings “on allegations that mortgage lenders may have made special deals with members of Congress,” noting that “prominent people,” including Senators Dodd and Conrad as well as “Fannie Mae CEOs Jim Johnson and Franklin Raines” allegedly received loans with preferential terms.

The two Congressmen are also asking that Rep. Waxman use his influence to “stop any legislation bailing out mortgage lenders until all tainted individuals have recused themselves, and the legislation has been examined and declared free of any undue influence.”

In an exclusive interview on Fox Business, Rep. Issa demanded that the new $300 billion housing bill, which aims to help distressed homeowners and provide some relief to lenders, “be scrubbed” to ensure no conflicts of interest exist.

Rep. Issa was notably vocal earlier this year at a Congressional hearing looking into lucrative compensation given to bank executives at a time when taxpayers are losing their homes during the housing crisis. Testifying at the hearing were former Merrill Lynch top executive Stanley O’Neal, former Citigroup head Charles Prince, and Countrywide’s chairman and chief executive Mozilo.

In a pointed exchange, Issa had said at the time that “this is a hearing in search of bad guys. Are there bad guys in front of me? I’m not seeing it,” adding that the executives suffered alongside shareholders as the value of their stock in their companies plunged as well, despite the fact that these executives have been criticized for mismanaging their companies.

Rep. Issa and Rep. Souder addressed this issue in their letter, which noted that the loans, if true, “seem more egregious than the large compensation packages” the companies paid their CEOs and “deserve to be investigated with the same zeal as was the link of executive pay to the mortgage crisis.”

Similarly, Rep. Jeb Hensarling (R-Texas) has called for hearings to determine whether members received “preferential treatment” with their mortgages “while millions of hardworking Americans struggle to repay their mortgage debts and cope with $4 [per] gallon gasoline and soaring foods prices,” he noted in an open letter to Congressional colleagues.

Hensarling said he would request the hearings in a follow-up letter to House Speaker Nancy Pelosi (D-Calif.).

Newly released financial disclosure reports show at least a dozen House members also hold loans issued by Countrywide, according to the Washington, D.C. newspaper Roll Call. However, Roll Call is finding that most of the loans were given to these elected officials prior to their winning their elections to Congress.

Bank of America (BAC) has advertised itself as “the bank of opportunity.”

Countrywide Financial (CFC) and politicians who got inside sweetheart loan deals would have to agree.

The question for shareholders in Bank of America is this: Does the bank fully comprehend the extent of the problems it will soon inherit when it buys Countrywide?

Bank of America is forging ahead to buy Countrywide in a deal now estimated to cost $3.3 bn. Bank of America had earlier invested $2 bn in Countrywide prior to the announcement of the deal offer last January, which analysts understood Bank of America made to protect its initial stake.

A vote on its Countrywide purchase is scheduled for June 25. Bank of America is set to report second quarter 2008 financial results on Monday, July 21. A disastrous period of record write-offs soured Bank of America’s first quarter profits. 

The fallout continues to escalate over Countrywide’s “Friends of Angelo” program, where the nation’s biggest lender (by loan volume) gave sweetheart loans to politicians who were allegedly were either acquainted with or were friends of Countrywide chief executive Angelo Mozilo, including Sen. Kent Conrad (D-N.D.) and Sen. Christopher Dodd (D-Conn.). New foreclosure data on Countrywide also shows just how unhealthy the country’s biggest lender is.

In addition, Countrywide faces regulatory probes over its questionable lending practices. Shareholder lawsuits have also poured in against Countrywide, and its CEO Mozilo still faces controversy over his stock sales in Countrywide, made at a time when Mozilo was making positive statements about the lender when the housing crisis was hurting results (Mozilo has ascribed his stock sales to a pre-existing executive plan).

Bank of America has $40 bn in cash and cash equivalents on its balance sheet, so it may be getting Countrywide’s real estate footprint on the cheap. The question is whether that sum is enough to withstand Countrywide’s regulatory probes, shareholder suits and negative publicity over Mozilo.

With a vote on the deal about a week away, here are Bank of America’s trouble spots:

The “Friends of Angelo” Program: James Johnson, a former chief executive of Fannie Mae, resigned last week as an adviser to the presidential campaign of Sen. Barack Obama after the Wall Street Journal reported that Johnson received sweetheart loans from Countrywide. Johnson’s lawyer has said those loans were made on normal terms. Now two senators also are caught up in the fallout from this program.

Senate rules bar members from knowingly receiving gifts worth $100 or more annually from companies that use registered lobbyists. Countrywide’s ethics code restricts executives, employees and board directors from improperly trying to influence government employees with money, gifts, loans, rewards, favors or anything of value.

According to the Washington, D.C. newspaper Roll Call, Sen. Conrad reportedly said the Senate Ethics Committee will look into mortgages he received from Countrywide.

Sen. Conrad said a review of a $1.2 mn loan he got in 2002 to purchase a vacation home in Bethany Beach, Del., showed he received a one percentage point discount on fees. Sen. Dodd in similar fashion got fractions off of points on his mortgages, as well as reduced interest rates on two mortgages by the time the loans closed, says Portfolio Magazine.

Roll Call reports that the senator has said he didn’t ask for or know about the discount. Sen. Conrad also said he has since discovered that Countrywide made a departure from normal lending practices in 2004 when it gave him a $96,000 mortgage loan backed by an eight-unit apartment building he owns in Bismarck, N.D. Portfolio Magazine reports that Mozilo sent an email to employees to “make an exception due to the fact that the borrower is a senator,” referring to Sen. Conrad.

Sen. Conrad says Countrywide typically made loans only on properties with four or fewer units, Roll Call reports. Sen. Conrad has said he will seek refinancing on the property from another lender. He also has said he believes he may have overpaid for the Bismarck loan, that he welcomes a Senate ethics inquiry, and to lessen the negative publicity about the point shave on his 2002 loan, plans to donate $10,500 to Habitat for Humanity, a nonprofit group that builds homes for poor people.

Sen. Dodd, chairman of the Senate Banking, Housing and Urban Affairs Committee, (Countrywide has had business before this committee), also has confirmed he received mortgages from Countrywide and that he will cooperate with any probes from the ethics committee, denying he sought special treatment from the lender.

“The rates that we received were not some cut-rate deals at all but rather standard rates that you negotiate out there, well within the range that people were being offered,” Sen. Dodd has said. Later came these statements from Sen. Dodd at a press conference. “There was no red flag to me [that] we were getting special treatment,” Sen. Dodd has said. “We don’t believe we did anything wrong. We negotiated a mortgage.”

The senator reportedly said Countrywide told him and his wife that they were being placed in a special program but that he assumed that was because they were longtime customers. Sen. Dodd said he has known since 2003 that his Countrywide mortgage was designated a “VIP” account, but that he never inquired about what the VIP status meant.

*Footnote: According to the D.C. newspaper The Hill, Sen. Conrad has sought to clarify a subsequent report that he spoke to Mozilo by phone about his mortgage. The reports quote Conrad as saying he didn’t call the lending executive or realize that talking to him could result in any special treatment. “I didn’t call him. I called my friend who happened to be with him at the time,” he said, referring to Johnson, the former chairman of Fannie Mae, whom Conrad says he called to ask for advice on getting a new mortgage.

The Hill says that by pure coincidence, according to Conrad, Mozilo was sitting next to Johnson, who suggested the senator speak to him directly. Conrad doesn’t recall whether Mozilo referred him to a Countrywide loan officer, or whether the company contacted him.

Meanwhile, Sen. Jim DeMint, (R-S.C.), has signaled he might try to block the housing measure, saying through a spokesman: “The housing bill has a multibillion-dollar taxpayer bailout for a company that reportedly gave preferential loans to members of Congress. This is exactly the type of thing Americans are sick of.”

Analysts and Investors Oppose the Acquisition: Analysts say Bank of America’s purchase of Countrywide Financial could endanger its  shareholders, who have already warned that the bank can’t absorb all of Countrywide’s problems.  “It’s a lot to ask Bank of America shareholders to stomach,” says Mike Larson, a real estate analyst at Weiss Research in Jupiter, Fla. Bank of America shareholder David Dreman, chairman of Dreman Value Management, opposes the deal. In the last three quarters, Countrywide has lost $2.5 bn, according to financial filings. Total nonperforming assets hit $6 bn in the first quarter of 2008, almost five times that of the same period last year. It had $95 bn in loans held for investments on its books, and it’s got high exposure to falling home prices in California and Florida. Countrywide also has $15.6 bn in mortgage-backed and other securities that it wants to unload, with $10.4 bn of these so-called Level 2 assets, thus difficult to value because the market for them is in a blackout mode. Another $5.1 bn are valued on the bank’s own models, not market prices, because the market for them are frozen solid.

Costly Foreclosures at Countrywide Continue to Rise: The number of homes that Countrywide has had to foreclose on continues to rise, with asking prices now worth a total of $2.6 bn. It now has to contend with more than 3,500 homes in California and 1,600 foreclosed homes in Florida. Prices continue to drop dramatically. To track its foreclosures, use this blog: http://countrywide-foreclosures.blogspot.com. 

Paper Gains Powered More than Half of B of A’s First Quarter Profits: Bank of America’s first quarter results were helped by a one-time gain of $776 mn from Visa’s (V) IPO. Second quarter profits may not look so great in comparison. Bank of America’s first-quarter net income dropped 77% to $1.21 bn, or $0.23 per share, down dramatically from the year ago results of $5.26 bn, or $1.16 per share. Bank of America set aside $3.29 bn for future credit losses and wrote of $2.72 bn. Nonperforming assets - which represent delinquent loans payments — ballooned to $7.83 bn. 

Bank of America’s Rich Dividend: The bank’s dividend currently yields 8.6%, or $2.56 a share. Watch to see whether it slashes its dividend to save some cash, as did Citigroup (C) and Wachovia (WB). To keep its dividend, the bank will have to pay out virtually everything it earns in 2008, as the 2008 consensus analyst estimate for the bank’s earnings is $2.66 per share.