Bear Stearns Collapse: Why It May Also Be the End for the SEC

The Securities and Exchange Commission (SEC) was set up as a reaction to the stock market crash of 1929 to provide oversight of brokerage firms and protect investors. Last month, Morgan Stanley and Goldman Sachs Group, Inc., filed to become bank holding companies. Now with the sale of Bear Stearns, the bankruptcy of Lehman Brothers Holdings, Inc., and the sale of Merrill Lynch & Co. to Bank of America Corp., the SEC now has no large firms left to oversee.

A recent report by Inspector General David Kotz has concluded that the SEC missed numerous warning signs leading up to the shotgun sale of Bear Stearns Cos. Bear Stearns, one of the most aggressive investment banks, agreed to be sold to J.P. Morgan Chase & Co. According to the report, the SEC failed to require the investment bank to rein in its risk taking. It failed to carry out its mission in its oversight of Bear Stearns. Despite the SEC staff having identified in 2006 precisely the types of risks that evolved into the subprime crisis, the SEC did not exert influence over Bear Stearns to use this experience to add a meltdown of the subprime market to its risk scenarios. There are many who blame the present crisis on years of looser regulations that allowed Wall Street firms to take on greater risks without adequate oversight.

The report details how the SEC made no efforts to require Bear Stearns to reduce its debt or raise money, failed to take steps after identifying numerous shortcomings in Bear Stearns’ risk management of mortgages, and also missed opportunities to push Bear management to address the problems. The report criticized the SEC for allowing internal auditors at Bear Stearns, not external auditors who would presumably be more objective, to perform critical work in reviewing the firm’s risk management. The SEC also did not review Bears Stearns’ strategy for informing investors about its funding plans following the failure of two of its hedge funds in July 2007. The SEC took too long to review Bear Stearns’ 2006 annual report and seek more information from the firm, which would have resulted in Bear disclosing more information about its mortgage portfolio to investors.

The SEC maintains that the failure is a result of the SEC not having enough authority to effectively oversee the banks and that the SEC has already expressed its concerns to Congress. The SEC staff completed its review of Bear Stearns’ 2006 annual report after its collapse.

Another report found that the SEC conducted in-depth reviews for only six of the 146 brokerage firms registered with the agency. The failure to carry out the purpose and goals of the Broker-Dealer Risk Assessment program hinders the SEC’s ability to foresee or respond to weaknesses in the financial markets.

As lawmakers take a second look at financial oversight, these reports could be nails in the coffin for the SEC. The power of the SEC could be dispersed to other agencies, such as the Federal Reserve. These reports document the failure of the SEC to either make its oversight program work or seek authority from Congress so that it could work.

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