SEC Didn’t Act After Spotting Wall Street Risks, Documents Show

Mary Schapiro, of the Securities and Exchange Commission
Mary Schapiro, chairman of the U.S. Securities and Exchange Commission, speaks during the Women in Finance Symposium at the Treasury Department in Washington, in March. Photographer: Andrew Harrer/Bloomberg

The U.S. Securities and Exchange Commission, criticized by lawmakers for failing to stop practices that fueled the financial crisis, raised concerns as early as 2006 about the risks of Wall Street’s appetite for packaging mortgages into bonds.

Officials in the SEC’s division of trading and markets wrote that collateralized debt obligations tied to home loans exposed banks to writedowns if the assets weren’t immediately sold, according to documents released yesterday by a federal panel investigating the crisis.

“This risk is difficult to measure and hence to manage,” said the memo dated Feb. 1, 2006.

The Financial Crisis Inquiry Commission, which Congress formed to investigate what caused the worst economic slump since the Great Depression, released the SEC document as part of its examination into why Bear Stearns Cos. collapsed in 2008. The SEC memo noted that the amount of asset-backed securities Bear Stearns held in-house rose to a then-record $13.9 billion in December 2005 and that selling some of the bonds was “risk management’s biggest focus.”

The SEC staff agreed to follow-up on the firm’s progress when they met with executives in March 2006, the memo said.

SEC Chairman Mary Schapiro in March called the agency’s oversight of investment banks before the crisis “flawed in design and execution” because it lacked adequate staff and experience monitoring the financial health of firms. Documents released by the FCIC portray the SEC as citing concerns about Wall Street’s role in the housing market and then deciding to raise questions with company management rather than take action.


“It looks like a placebo, not a regulatory program,” FCIC Chairman Philip Angelides said at a hearing in Washington yesterday. “I didn’t see any action taken at any time by the SEC to change the business practices at Bear.”

Former SEC Chairman Christopher Cox, who led the agency from August 2005 to January 2009, told FCIC members that it never made sense to transform a regulator focused on sanctioning Wall Street into the financial industry’s supervisor.

Cox, 57, cited conversations he had with Federal Reserve officials in 2008 in which central bank employees told him a regulator could never persuade banks to hand over documents if the firms believed the information could later be used in an enforcement action.

“Supervisors tend not to be enforcers,” Cox said. “Ultimately, I think you’ve got to decide which you’re going to be.”

Slowing Demand

An SEC memo dated Aug. 2, 2006, shows Bear Stearns reported to agency officials that the amount of mortgage securities held in the firm’s “pipeline” rose almost $4 billion in June of that year, a sign that investor demand was slowing.

“The risk manager highlighted the lower turnover this month as well as a significant increase in aged inventory,” the SEC document said. “We will follow up with risk management on both the levels and aging of inventory in the securitization pipeline at the next monthly meeting.”

The situation at Bear Stearns worsened in 2007. The firm absorbed a $58 million writedown on mortgage assets in January and managers told the SEC that “these events reflect a more rapid and severe deterioration in collateral than anticipated” by risk models, according to an SEC memo dated March 1, 2007.

The SEC again said it planned to discuss the risks New York-based Bear Stearns faced the next time agency officials met with executives, the document said.

Investor Opposition

Erik Sirri, who led the SEC’s division of trading and markets until April 2009, said it would have been difficult for the agency to reduce Wall Street’s exposure to the mortgage market. Had the SEC told firms to sell holdings in October 2006, it would have faced opposition from investors, Sirri said.

“You would have to have had a view that was contradictory to the view of the entire market,” Sirri told FCIC members. “We did not have that level of confidence that we were right.”

Bear Stearns, once the fifth-biggest U.S. investment bank, spurred the crash in the market for home loans to borrowers with poor credit when two of its hedge funds collapsed in July 2007. The funds had invested in securities tied to mortgages.

The Fed and U.S. Treasury Department orchestrated a fire sale of Bear Stearns to JPMorgan Chase & Co. in March 2008.

Cox in September 2008 announced the SEC would cease monitoring capital and liquidity at investment banks after Lehman Brothers Holdings Inc. declared the biggest bankruptcy in U.S. history. The four-year-old program had about two dozen staff members and was responsible for monitoring Bear Stearns, Lehman, Goldman Sachs Group Inc., Morgan Stanley and Merrill Lynch & Co.

‘More Resources’

“You needed a lot more resources to do this,” Cox, a Republican, said yesterday. “If you’re going to get to that point where you tell people how to run their business, you’re going to need an army.”

Congress is considering forming a council of regulators to monitor U.S. banks and financial companies whose failure could threaten the economy. The council would include the SEC, the Fed, Treasury and the Commodity Futures Trading Commission.

FCIC member Peter Wallison questioned whether a council of regulators would have any more success than the SEC did during the housing boom.

“It is virtually impossible to see a problem before a problem is in front of your face, and by that time it’s too late,” Wallison said in an interview. “The regulators are the least knowledgeable people about what is actually happening in the market.”

The FCIC examined Bear Stearns and the SEC as part of its investigation into a financial crisis that has cost global banks, insurers and other companies more than $1.7 trillion. The panel is required to report its finding to Congress by the end of the year.

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