The Collapse of Bear Stearns And The SEC’s Requests For Additional Authority

On Friday, the Commission formally ended the Consolidated Supervised Entities program. That program was created in the wake of the Gramm-Leach-Bliley Act, which left a regulatory gap as to investment bank holding companies. The participants in the program chose to voluntarily be supervised by the SEC, which permitted their European operations to avoid oversight by the EU. By the time the Commission made its announcement, there were no U.S. investment bank holding companies to supervise.

SEC Chairman Cox has repeatedly asked Congress to give the Commission the authority to supervise investment companies. In making this request, the Chairman has also requested authority to supervise the huge credit default swap market. Congress may have questions for the SEC before this authority is granted.

At the same time the Chairman announced the end of the CSE program, the SEC’s Office of Inspector General issued a report titled “SEC’s Oversight of Bear Stearns and Related Entities,” Report No. 446-A, September 25, 2008. That report is highly critical of the implementation of the program, and in particular, the lax supervision by the Division of Trading and Markets. The report concludes that “it is undisputable that the CSE program failed to carry out its mission in the oversight of Bear Stearns … .”

The report goes on to note that the CSE program requirements were inadequate and, in any event, red flags regarding the condition of Bear Stearns were simply missed. As the report states: “Overall, we found that there are significant questions about the adequacy of a number of CSE program requirements, as Bear Stearns was compliant with several of these requirements, but nonetheless collapsed. In addition the audit found that TM [Division of Trading and Markets] became aware of numerous potential red flags prior to Bear Stearns’ collapse, regarding its concentration of mortgage securities, high leverage, shortcomings of risk management in mortgage-backed securities and lack of compliance with the spirit of certain Basel II standards, but did not take action to limit these risk factors.”

The report goes on to raise several additional significant concerns regarding the Commission’s oversight of the CSE program including:

• Bear Stearns complied with the program’s capital and liquidity requirements, but still collapsed, raising significant questions about the adequacy of the requirements;

• Although Trading and Markets was aware that Bear Stearns had a heavy concentration of mortgage-backed securities when it joined the program and that concentration continued to increase, it took no action;

• The CSE program did not require a leverage-ratio limit for member firms;

• Trading and Markets became aware that the risk management of mortgages at Bear Stearns had “numerous shortcoming, including lack of expertise by risk managers in mortgage-backed securities at various times …” and took no action;

• Following the collapse of two Bear Stearns’ funds in June 2007, significant questions were raised about some of Bear Stearns’ senior managements’ lack of involvement in handling the crisis, but Trading and Markets failed to assess this question; and

• The Division of Corporation Finance failed to conduct the review of Bear Stearns’ most recent 10-K filing in a timely fashion. This “deprived investors of material information that they could have used to make well-informed investment decisions … the information (e.g., Bear Stearns’ exposure to subprime mortgages) could have been potentially beneficial to dispel the rumors that led to Bear Stearns’ collapse.”

The report goes on to make twenty-six recommendations regarding the oversight program.

Before the Commission is given the additional regulatory authority in this and the related areas that Chairman Cox has requested, Congress will no doubt want some assurances about how the SEC would use that authority.