Could The Subprime Lending Crunch Have Been Averted?
Kurt Brouwer December 10th, 2007
It should not be surprising that there were signs of an impending crisis in subprime lending as far back as 2005. No doubt fingers will be pointed — in this case — at the Feds as well as at Elliot Spitzer who was then New York’s Attorney General and is now its Governor. This Wall Street Journal article points out what happened [emphasis added below]:
Did Authorities Miss a Chance To Ease Crunch? (Wall Street Journal, December 10, 2007, Michael Siconolfi)
‘Federal and state authorities may have missed an opportunity two years ago to get ahead of the mortgage-securities-pricing crisis now gripping Wall Street.
In 2005, the Securities and Exchange Commission and New York state’s attorney general’s office launched separate investigations into whether Wall Street securities firm Bear Stearns Cos. harmed investors by improperly valuing complex mortgage securities. Determining the prices of these securities, often based on mathematical models, involves some guesswork, particularly in distressed markets.
An SEC branch office said it intended to recommend that Bear Stearns be charged for improperly pricing about $63 million of mortgage securities it sold to a bank; the New York attorney general’s office, headed at the time by Eliot Spitzer, had sought information about how Bear priced $16 million of mortgage securities it sold to an institutional client.
In each case, government authorities dropped the enforcement cases, according to regulatory filings and people familiar with the matter.
The two aborted cases have new resonance amid the credit crunch and resulting crisis engulfing the financial world. It was Bear Stearns’s disclosure of badly priced mortgage securities in two of its internal funds that helped spark this year’s mortgage-market and credit convulsions…
…The 2005 probes cut to the heart of the issue roiling markets since this summer: determining the true 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 mathematical pricing models….
…In deciding which enforcement cases to bring, regulators must balance factors including the severity of the activity, the difficulty of winning the case and limited staff. The SEC and attorney general’s office, for instance, have filed other major enforcement actions in recent years involving securities-firm abuses of small investors. The potential victims in the 2005 probes were savvier institutional investors.
Still, enforcement actions can chill bad behavior. The New York attorney general and the SEC have had success brokering settlements and changing industry practices after alleging abuses in stock research and initial public offerings of stock at securities firms and trading abuses involving mutual funds. The office of the current New York attorney general, Andrew Cuomo, recently issued subpoenas to several Wall Street firms, including Bear Stearns, seeking information 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 civilly charged for the way it priced and valued $62.9 million of collateralized debt obligations it sold to W Holding Co.’s Westernbank Puerto Rico bank unit. The probe involved whether Bear Stearns had committed fraud, a person familiar with the matter says.
In a regulatory disclosure at the time, Bear Stearns said the SEC staff “intends to recommend that 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 subsequently informed 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, director of the SEC’s Miami Regional Office, which had planned to recommend enforcement action against Bear. Mr. Nelson declines to say why the SEC dropped the case, saying: “Unless something is filed in a court of law, I can’t comment.”…
…In a separate 2005 probe, the New York attorney general’s office subpoenaed Bear, seeking information tied to some $16 million of such CDOs, a regulatory filing shows…’
Back in my days at Merrill Lynch, we saw how a new form of investment — zero coupon bonds — could be difficult for investors to evaluate and price. A few years later there was the mortgage-backed bond fiasco so ably chronicled in Michael Lewis’ book, Liar’s Poker (W.W. Norton 1989). No doubt the warning signs were there in those cases too. However, it took a while for investors to approach zero coupon bonds and mortgage-backed bonds them with a proper state of caution.
By comparison, each of those vehicles were simple compared to subprime loans, collateralized mortgage obligations (CDOs), structured investment vehicles (SIVs) and so on. It is no wonder that the regulators did not see this mess coming. Most denizens of Wall Street did not either.
For more background on the subprime lending mess and why it affects other financial markets see Subprime and Stocks — What Happened and Gaining From The Subprime Meltdown.
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