Raw report: SEC ignored red flags
Posted on Wednesday, October 8, 2008
U. S. Securities and Exchange Commission Chairman Christopher Cox’s regulators stood by as shrinking capital ratios and growing subprime holdings led to the collapse of Bear Stearns Cos., according to an unedited version of a study by the agency’s inspector general.
The report by Inspector General H. David Kotz was requested by Sen. Charles Grassley, R-Iowa, to examine the role of regulators before the firm’s collapse in March. Before its release to the public on Sept. 26, Kotz deleted 136 references — many detailing SEC memos, meetings or comments — at the request of the agency’s Trading and Markets Division that oversees investment banks.
“People can judge for themselves, but it sure looks like the SEC didn’t want the public to know about the red flags it apparently ignored in allowing Bear Stearns and other investment banks to engage in excessively risky behavior,” Grassley said in an e-mailed statement.
An unedited version of the 137-page study posted to Grassley’s Web site Sept. 26 showed that Bear Stearns traders used pricing models for mortgage securities that “rarely mentioned” default risk.
The firm lost one top modeler “precisely when the subprime crisis was beginning to hit” and write-downs were being taken, the full report said. “As a result, mortgage modeling by risk managers floundered for many months,” according to the unedited document, quoting internal SEC memos from April and December 2007. The comments were removed from the edited version publicly released by the SEC.
Kotz followed the Bear Stearns report with another requested by Grassley, this one covering the 2005 firing of Gary Aguirre, an SEC lawyer who contended that superiors impeded his inquiry into insider trading at hedge fund Pequot Capital Management. The report was released Tuesday by Grassley, the ranking Republican on the Senate Finance Committee. It said the agency should consider punishing the director of enforcement and two supervisors over the firing.
SEC spokesman John Nester didn’t immediately respond to a voice-mail message.
The Trading and Markets Division had oversight of holding companies for the five biggest U. S. investment banks, including Bear Stearns, via the Consolidated Supervised Entity Program. The division failed to follow up on “red flags” raised by the New York-based firm’s increasingly “significant concentration of market risk” from mortgage securities, according to the full document.
The SEC, which governed the firm along with the Financial Industry Regulatory Authority, “failed to carry out its mission in the oversight of Bear Stearns,” the agency said in both versions of the report. The Federal Reserve will provide $ 29 billion in financing for JPMorgan Chase & Co. ’s March 14 takeover of the investment bank after the government said it stepped in to prevent panic.
The agency censored the report because “the requests from the Division of Trading and Markets covered information contained in nonpublic memoranda and documents filed by the CSE [Consolidated Supervised Entity ] firms,” spokesman Nester said.
JPMorgan spokesman Brian Marchiony declined to comment.
A footnote in the uncensored version of the report quotes Bear Stearns Chief Executive Alan Schwartz as saying he hadn’t held “terribly current discussions” to raise capital for his firm even after the SEC asked in March, two weeks before it failed, about obtaining funds.
Schwartz didn’t return a phone call for comment. Kotz, the inspector general, as well as Cox, declined to comment.
The SEC took no action even as Bear Stearns provided more collateral to lenders as they lost trust in the 85-year-old firm, the unedited report said.
The agency removed a section of the publicly distributed report showing that the Trading and Markets Division knew Bear Stearns’ capital ratio had dropped to 11. 5 percent in March from as high as 21. 4 percent in April 2006. The ratio measures assets, adjusted for risk, relative to a firm’s equity. Ten percent is the minimum standard under international banking regulations.
Regulators from the unit “inquired whether Bear Stearns was contemplating capital infusions” even though they didn’t formally or informally pressure the firm to do so, according to the unedited version.
Under the voluntary Consolidated Supervised Entity Program, the SEC couldn’t force the firm to raise capital.
The program was shut down in September. Cox said on Sept. 26 that the program “was fundamentally flawed from the beginning because investment banks could opt in or out of supervision voluntarily.”
By censoring the Bear Stearns report, “the SEC didn’t do well by the public, and the inspector general didn’t do well by the public,” said Tom Cardamone, managing director of the Washingtonbased Global Financial Integrity Program. “The buck has to stop someplace. Joe Main Street has to rely on the professionalism of the people doing the job.”
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