Cox's SEC Censors Report on Bear Stearns Collapse

By Mark Pittman, Elliot Blair Smith and Jesse Westbrook
October 7, 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 Senator Charles Grassley to examine the role of regulators prior to the firm's collapse in March. Before it was released to the public on Sept. 26, Kotz deleted 136 references, many detailing SEC memos, meetings or comments, at the request of the agency's Division of Trading and Markets 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,” the Iowa Republican said in an e-mailed statement.

Read the report's unedited conclusion and recommendations here.

An unedited version of the total 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 writedowns 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.

Aguirre Inquiry

Kotz followed the Bear Stearns report with another requested by Grassley, this one covering the 2005 firing of Gary Aguirre, an SEC lawyer who claimed superiors impeded his inquiry into insider trading at hedge fund Pequot Capital Management. The report was released by the Senate Finance Committee member today. 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 New York Times reported the Aguirre report earlier today.

Trading and Markets 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.

“Failed” Mission

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 non-public memoranda and documents filed by the CSE 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.

No Help

While Bear had retained Lazard Ltd. as an adviser, the report quoted Schwartz saying, “The time it would take to get that done, it wouldn't help.” The CEO said rumors would cause more damage in the meantime, according to the SEC.

Schwartz didn't return a phone call for 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 Division of Trading and Markets knew Bear Stearns's 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.

“Fundamentally Flawed”

The CSE “was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily,” Cox said on Sept. 26 in announcing the program's shutdown.

“This chain of events raises very significant questions about the supervision of all types of financial institutions, not just investment banks,” said a written response to the inspector general's report from the Trading and Markets unit, headed by former agency chief economist Erik Sirri.

“With respect to Bear Stearns, the staff applied the relevant international standards for holding-company capital adequacy in a conservative manner,” the unit said.

The staff “added a holding-company liquidity requirement; and yet, they couldn't withstand a `run on the bank,’” the response said.

Kotz, the inspector general, declined to comment, as did Cox.

“Generous Marks”

Bear Stearns was able to “create capital” by inflating the value of assets including mortgages, according to the unedited study. Two days before it was rescued, the firm paid out $1.1 billion to “numerous counterparties to squelch rumors” it couldn't meet its margin calls, the full report said. The finding didn't appear in the censored version.

The firm “tended to use the traders' more generous marks for profit and loss purposes,” it said.

Trading and Markets unit members saw that Bear Stearns traders dominated less-experienced risk managers, the inspector general reported in sections that were excised from the public report.

“As trading performance remained strong for years in a row, it clearly wasn't career-enhancing to stand in the way of increasingly powerful trading units demanding more balance sheet and touting their state of the art risk-management models,” said Brad Hintz, an analyst at Sanford C. Bernstein & Co. in New York, and a former chief financial officer at Lehman Brothers Holdings Inc.

Basel Guidelines

The Basel Committee on Supervision published revised guidelines in 2004 that allowed global financial institutions to “rely on their own internal estimates of risk components” to help determine the amount of capital they needed.

By censoring the 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 Washington-based 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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