Grassley seeks IG review of SEC actions in a case against Bear Stearns
WASHINGTON — Senator Chuck Grassley has asked a top government watchdog tofind out why the Enforcement Division of the Securities and Exchange Commission declined tobring a case last year against Bear Stearns for improperly valuing mortgage-related investments.
In a letter sent today to the Inspector General of the Securities and ExchangeCommission, David Kotz, Grassley requested a thorough investigation into the facts andcircumstances surrounding the agency’s decision not to pursue enforcement action against BearStearns. Grassley also asked Kotz to follow up on previous audit work on the Division ofTrading and Markets at the Securities and Exchange Commission. The assessments affect largebroker-dealers such as Bear Stearns.
Last year, Grassley along with Senator Arlen Specter issued a report on the Securitiesand Exchange Commission’s failed investigation of Pequot Capital Management. The reportfound that senior agency officials showed extraordinary deference to a particular witness due tohis prominence. The August 2007 report is available at http://finance.senate.gov. Click onlegislation. Documents are posted in reverse chronological order.
The text of Grassley’s letter to the Inspector General today follows below, along with aDecember 2007 story from the Wall Street Journal.
April 2, 2008
The Honorable David Kotz
US Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549-2736
Dear Inspector General Kotz:
According to regulatory filings and a December 2007 Wall Street Journal article, the SECEnforcement Division declined to bring a case against Bear Stearns for improperly valuingmortgage-related investments. Given the later collapse and federally backed bail-out of BearStearns, Congress needs to understand more about this case and why the SEC ultimately soughtno enforcement action.
Moreover, I am particularly interested in this case in light of the SEC's failedinvestigation of Pequot Capital Management. As you know, in the final report of the Senate'sinquiry into that matter, we found that senior SEC officials showed extraordinary deference to aparticular witness because of his "prominence" as the head of Morgan Stanley.Request for Investigation
In light of my earlier investigation I need to know whether the same problems identifiedin the Pequot investigation were repeated in the Bear Stearns case. Accordingly, I request thatyou conduct a thorough investigation into the facts and circumstances surrounding the decisionto not pursue an enforcement action against Bear Stearns. Please provide a final report onwhether there was any improper action or misconduct relating to SEC investigation of BearStearns and its decision to close the investigation. The report should also describe and assess:
1. the nature, extent, and propriety of communications between Bear Stearns executives ortheir representatives and senior SEC officials;
2. the decision-making process which led to the SEC's failure to bring an enforcement
action following the drafting of a Wells notice;
3. the reasons for declining to proceed with an enforcement action; and
4. the degree to which more aggressive action by the Enforcement Division may have led toan earlier and more complete understanding of the issues that contributed to the collapseof Bear Stearns.
Request for Audit
In addition to this investigative request, I would also like your office to follow-up onprevious audit work relevant to issues surrounding Bear Stearns. The Division of Trading andMarkets (Division) is responsible for regulating the largest broker-dealers and the associatedholding companies. Offices within the Division are staffed with accountants and economists whoare responsible for reviewing the market and credit-risk exposures of the broker dealers. Theirreview includes assessing broker-dealers' quarterly financial filings, ensuring broker-dealers aremeeting net-capital requirements and that other financial ratios, such as liquidity ratios, areadequate. There is a special emphasis in reviewing the five very large broker-dealers, includingBear Stearns, known as the Consolidated Supervised Entity (CSE) Program. The Division staffexercises additional oversight of these firms and examines their risk models.
I understand that the OIG conducted a prior audit of these responsibilities in 2002.
Please provide an update of the previous findings, determine whether earlier recommendationswere implemented, and analyze the current function of these offices. The review should includea description and assessment of their missions, how the programs are run, their policies andprocedures, the adequacy of any reviews conducted regarding Bear Stearns, andrecommendations for improvements in the process.
Charles E. Grassley
December 10, 2007 - Monday
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HEADLINE: Did Authorities Miss a Chance To Ease Crunch? --- SEC, Spitzer Probed Bear CDO Pricing in '05, Before Backing Away
BYLINE: By Michael Siconolfi
Federal and state authorities may have missed an opportunity two years ago to get ahead of themortgage-securities-pricing crisis now gripping Wall Street.
In 2005, the Securities and Exchange Commission and New York state's attorney general's officelaunched separate investigations into whether Wall Street securities firm Bear Stearns Cos.harmed investors by improperly valuing complex mortgage securities. Determining the prices ofthese securities, often based on mathematical models, involves some guesswork, particularly indistressed markets.
An SEC branch office said it intended to recommend that Bear Stearns be charged forimproperly pricing about $63 million of mortgage securities it sold to a bank; the New Yorkattorney general's office, headed at the time by Eliot Spitzer, had sought information about howBear priced $16 million of mortgage securities it sold to an institutional client.
In each case, government authorities dropped the enforcement cases, according to regulatoryfilings and people familiar with the matter.
The two aborted cases have new resonance amid the credit crunch and resulting crisis engulfingthe financial world. It was Bear Stearns' disclosure of badly priced mortgage securities in two ofits internal funds that helped spark this year's mortgage-market and credit convulsions.
High-profile enforcement cases could have sent a message to Bear Stearns and other Wall Streetfirms to attempt to more accurately price mortgage securities. Such a message could have helpedblunt the impact of the current crisis, which has led to investor uncertainty over how firms pricethese mortgage-related instruments.
"The right kind of case can have an impact marketwide," says Edward Fleischman, a former SECcommissioner and now a senior counsel at law firm Linklaters.
Spokesmen for the SEC and the New York attorney general declined to comment. Bear Stearnssaid it cooperated with both investigations.
The 2005 probes cut to the heart of the issue roiling markets since this summer: determining thetrue value of securities backed by risky mortgages. Unlike stocks or bonds traded on exchanges,these securities are traded privately between dealers. Values often are based on mathematicalpricing models.
Wall Street traders long have had a motive to inflate the value of securities because their bonusesoften are tied to them. The problem is exacerbated when market trading dries up, as it has inrecent months in the mortgage area.
During the summer's credit crunch, more than 80% of investors in bonds tied to the mortgagemarket said they had trouble getting price quotes from bond dealers, according to a survey of251 institutional investors by Connecticut consulting firm Greenwich Associates.
Financial firms have disclosed write-downs totaling more than $40 billion this year involvingmortgage-related assets, partly stemming from mark-downs following cuts in the credit ratings ofcomplex securities known as collateralized debt obligations. The SEC in recent months openedbroad, new investigations into whether a number of financial firms are properly valuing suchinvestments.
In deciding which enforcement cases to bring, regulators must balance factors including theseverity of the activity, the difficulty of winning the case and limited staff. The SEC and attorneygeneral's office, for instance, have filed other major enforcement actions in recent yearsinvolving securities-firm abuses of small investors. The potential victims in the 2005 probeswere savvier institutional investors.
Still, enforcement actions can chill bad behavior. The New York attorney general and the SEChave had success brokering settlements and changing industry practices after alleging abuses instock research and initial public offerings of stock at securities firms and trading abusesinvolving mutual funds. The office of the current New York attorney general, Andrew Cuomo,recently issued subpoenas to several Wall Street firms, including Bear Stearns, seekinginformation on the packaging and selling of debt tied to high-risk mortgages.
In mid-2005, the SEC's Miami office planned to recommend that Bear Stearns be civillycharged for the way it priced and valued $62.9 million of collateralized debt obligations it sold toW Holding Co.'s Westernbank Puerto Rico bank unit. The probe involved whether Bear Stearnshad committed fraud, a person familiar with the matter says.
In a regulatory disclosure at the time, Bear Stearns said the SEC staff "intends to recommendthat the Commission bring a civil enforcement action" involving the firm's "pricing, valuation,and analysis" of the CDOs, or investments that package pools of loans. The SEC subsequentlyinformed Bear Stearns it had closed the investigation, a separate regulatory filing shows."You've got me in a situation where my hands essentially are tied," says David Nelson, directorof the SEC's Miami Regional Office, which had planned to recommend enforcement actionagainst Bear. Mr. Nelson declines to say why the SEC dropped the case, saying: "Unlesssomething is filed in a court of law, I can't comment."
At W Holding, "we took the prices for granted," said President Freddy Maldonado. He said thecompany believed poor market conditions led to declines in the CDOs it bought from BearStearns.
Mr. Maldonado says the bank ultimately took a $20 million loss after selling its $63 millionCDO portfolio. He says the SEC asked W Holding executives "different questions about pricing"of the CDOs by Bear. W Holding received a letter from the SEC saying its investigation into thebank's "investments in corporate bond and loan obligations has been completed and closed."In a separate 2005 probe, the New York attorney general's office subpoenaed Bear, seekinginformation tied to some $16 million of such CDOs, a regulatory filing shows.
In that case, Bear Stearns was valuing CDOs for an institutional client at more than 90 cents onthe dollar, say people familiar with the matter. But when the client wanted to sell the securitiesback to Bear, the firm priced the CDOs in the high-30s, the people say. A junior employee hadhandled the pricing of multiple CDOs, the people say.
Last month, Bear warned investors it will take a write-down of $1.2 billion for its 2007 fiscalfourth quarter related to mortgage securities, specifically CDOs -- creating the first quarterly lossin its 84-year history. In June, two of its internal hedge funds holding mortgage securities beganimploding, costing investors more than $1 billion.
The Bear funds initially reported a 6.75% loss for April 2007 but were forced two weeks later totell investors the loss actually was about 18%.
Amid the turmoil this year, SEC Chairman Christopher Cox said publicly the agency had openedabout a dozen investigations involving CDOs or related investments. He hasn't discussed specificprobes but said the SEC is in general looking into how investment funds value their assets.
It isn't just regulators who may have missed a chance in 2005 to get ahead of a big problem.Before the attorney general's office dropped its case, it held talks with Bear Stearns about itsCDO pricing procedures and staffing levels for valuing the securities.
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