In a review of the agency's supervision of investment banks, inspector general David Kotz said that the SEC had identified "numerous, potential red flags prior to Bear Stearns' collapse . . . but did not take action to limit these risk factors." J.P. Morgan Chase bought Bear Stearns last March after initial emergency funding to keep it operating failed.
SEC Chairman Christopher Cox has said Bear Stearns was "well-capitalized and apparently fully liquid" but "experienced a crisis of confidence" that led to its collapse. Yesterday he defended his agency, saying the oversight program was voluntary and that the SEC could not force large investment banks such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns to report their capital, maintain liquidity or submit to leverage requirements.
The program "was fundamentally flawed from the beginning, because investment banks could opt in or out of supervision voluntarily," Cox said in a statement. "The fact that investment bank holding companies could withdraw from this voluntary supervision at their discretion diminished the perceived mandate."
The SEC's oversight program, known as Consolidated Supervised Entities, was created to allow global investment bank conglomerates that lack a supervisor under the law to voluntarily submit to regulation. But Cox said the SEC lacked specific legal authority to act as the regulator of investment banks.
Yesterday, Cox said the agency would end its program because the five biggest investment banks have either been swallowed by commercial banks, converted into bank-holding companies or filed for bankruptcy protection. Instead, some of the new bank-holding companies will be regulated by the Federal Reserve. The SEC said it would have stronger oversight through an agreement it struck with the Fed in July, where it would regulate the broker-dealer subsidiaries of bank-holding companies.
The inspector general said the findings of yesterday's report did not demonstrate a "direct connection" between oversight failures and the collapse of Bear Stearns. Critics said, however, that the report was another blow to the credibility of the SEC and its leadership, which have been rebuked by lawmakers.
The report pointed to Bear Stearns's large concentration of mortgage securities, its poor management of mortgage-related securities and its high leverage -- the practice of taking heavy debt compared to capital to make big investment bets. When the housing market began to collapse and mortgages went into default, the market for mortgage-related securities froze up and the banks were saddled with crippling loads of worthless assets.
"These reports are another indictment of failed leadership," ranking Senate Banking Committee member Charles E. Grassley (R-Iowa) said in a statement. "We had it at Fannie Mae and Freddie Mac, it was throughout Wall Street, and these reports document the failure of regulators at the Securities and Exchange Commission to either make its oversight program work or seek authority from Congress so that it could work."
Grassley commissioned the audit of the SEC's supervision of Bear Stearns and other large investment banking firms in April.
In congressional hearings earlier this week, Cox was sharply questioned by lawmakers for failing to stop banks from taking massive amounts of debt to invest in complex securities with little transparency. Republican presidential candidate John McCain said last week that Cox should be fired because he "betrayed the public's trust."
Jacob Frenkel, a former enforcement officer at the SEC who is now in private law practice in Rockville, said the report revealed that problems at the SEC were systemic. "Cox may be the face of the agency, but the staff and the agencies also dropped the ball because they are the ones going out and doing the inspections," he said.