How Successful Will the SEC Investigations of CDOs and Bear Hedge Funds Be?

All the usual suspects are reporting that the SEC is planning to investigate the failed Bear Stearns hedge funds and CDOs generally. The Financial Times provides a succinct account:

The Securities and Exchange Commission on Tuesday said it had initiated a broad-based investigation into the troubled subprime mortgage market.

Christopher Cox, chairman of the SEC, told a congressional panel that the regulator was investigating a dozen subprime mortgage issues, including collaterallised debt obligations (CDOs), which are repackaged pools of debt sold to investors.

The SEC is also looking into issues surrounding the secondary market for these instruments.

Concern among investors has intensified in recent days over the fallout from troubles at two Bear Stearns hedge funds. The firm on Tuesday said it planned to extend a $1.6bn (€1.2bn, £800m) loan to one of its funds, the High-Grade Structured Credit Strategies Fund, which had suffered large losses from investments in the subprime market.

Subprime-related CDOs feature prominently in the Bear Stearns funds.

Dominic Konstam, head of interest rate strategy at Credit Suisse, said Moody’s estimates that CDO sales reached $506bn in 2006, of which more than half contained subprime exposure.

“If there is contagion, the problem certainly has sufficient scale to become a financial event,” he said.

Bear Stearns closed 0.2 per cent higher at $139.35 on Tuesday but the stock has fallen 14.4 per cent this year.

John Nestor, a spokesman at the SEC, said: “Because they are bank instruments, there is increased co-operation [between regulators] as we examine these things.”

The worries over subprime exposure on Wall Street have rattled stocks and sparked safe-option buying of short-dated government bonds. Volatility has been rising and corporate bonds have weakened in value.

David Ader, strategist at RBS Greenwich Capital, said: “The CDO worries have progressed to the regulatory level.

“Although it is unclear which firms will be directly impacted by the investigation, one thing does logically follow, this month/quarter-end will see a push toward accurate marks on these assets given the increased regulatory scrutiny.”

The Journal provided some additional details:

The Securities and Exchange Commission has opened about a dozen investigations involving complex bundled financial products, as well as the related near-collapse of two Bear Stearns Cos. hedge funds that invested in the subprime-mortgage market.

Responding to a question at a House committee hearing, SEC Chairman Christopher Cox said the agency’s enforcement division has “about 12 investigations” involving collateralized debt obligations, or CDOs, and collateralized loan obligations, or CLOs. Such bundles of debt or loans, which are sold off in smaller segments, have become very popular in recent years and are core drivers behind the surge in leveraged buyouts.

People familiar with the matter said the SEC’s enforcement division also has opened a preliminary investigation into the issues surrounding the Bear Stearns hedge funds, which invested in complex financial instruments backed by subprime mortgages…..

Earlier this year, the SEC enforcement division formed a subprime working group, which is looking at a range of topics from the securitization process to troubled subprime issuers. One area of concern involves the lack of accurate pricing in the CDO market. There isn’t an active market for CDOs, and any valuation of these vehicles involves managers making estimates, which can be overly optimistic. Prices quoted by dealers don’t always reflect the value a CDO would fetch if it were actually sold in the market.

Answering questions after the hearing, Mr. Cox said he wouldn’t discuss specific investigations but said the SEC is in general looking into how hedge funds value their assets. The Bear funds, for example, initially reported a 6.75% loss for the month of April, but they were forced two weeks later to tell investors the loss was actually about 18%.

Pricing could also prove to be an issue in the now-pulled public offering of Everquest Financial Ltd., a company backed by Bear Stearns and its two hedge funds….

In creating Everquest last fall, Bear transferred to Everquest equity in 10 CDOs, the riskiest slice offered by these vehicles. Observers have questioned Bear Stearns’s ability to value those assets, given that it was essentially both buyer and seller. About a third of Everquest’s assets are CDOs backed by subprime mortgages, according to a person familiar with the matter….

The question here is whether the SEC will be successful in getting to the bottom of the murky CDO market. The SEC has two considerable obstacles to overcome:

1. The SEC knows very little about debt instruments, and CDOs are as tough as they come

2. The SEC is chronically short staffed in its enforcement division

Issue #1 is the bigger problem. With all due respect to the SEC, it is in the business of enforcing securities regulations. That primarily means worrying about various forms of investor fraud. SEC investigations typically focus on insider trading, bucket shops (the Glengarry Glen Ross types who call old ladies and get them to buy stock in non-existent biotech firms), accounting fraud (the SEC was roundly criticized for being asleep at the switch on Enron) and providing false information about securities and their issuers. That means the vast majority of the time, their focus is on the equity markets. The bond markets are full of 800 pound gorillas who are generally assumed to be able to take care of themselves, so the SEC doesn’t go there very often.

That focus is reflected in its enforcement staff. It’s full of ambitious young lawyers. It’s not noted for math skills.

Moreover, the SEC isn’t in the business of challenging pricing methodologies, merely of making sure that pricing is consistent and dealers are not engaging in practices like front running to take advantage of customers. If investors want to pay billions of dollars for business that have no prospect of ever earning a dime, that’s their business. The SEC’s job is merely to make sure the disclosures were made.

Thus, if most players are using a consistent methodology, even if in the cold hard light of day it makes no sense (like valuing businesses on “eyeballs” as in the dot-com era, rather than on something antique like cash flow), the SEC has no basis for finding fault. Steve Waldman explains:

Since exotic securities don’t trade very often, there is no clear market price, no clear value to which funds have to “mark” their portfolios. So hedge fund managers use models to make educated guesses of what their securities are worth. Since managers earn fees by seeming to perform well, they tend to use models that, lo and behold, spit out optimistic, all-is-well valuations of their portfolios. However, a “fire sale” at Bear would put Wall Street Panglossians under pressure, as all of a sudden market prices, not very nice market prices, would be attached to securities quite similar to the ones in their own portfolios.

Let’s understand what we mean by “pressure” here. Imagine you’re a hedge fund manager sitting on a pile of leveraged rocket science that you privately think has lost much of its value. You have two choices. You can use a model that captures your intuition, and mark down the assets, forfeiting any performance fees and your seven figure job too. Or you can hold tight, keep the faith. If you make it to the end of the year, you get a big performance fee, which you get to keep even your faith turns out to have been misplaced and your investors lose money. This is a no-brainer, right? Keep da faith!

But there is a wrinkle. If you take that hefty bonus, but you really did know that the fund didn’t perform as advertised, well, there are technical terms for that. Theft. Fraud. The language of high finance can be arcane, but maybe you get my drift here. Currently hedge funds are relying on safety in numbers. If “industry best practice” is to value CDOs and XYZPDQs optimistically, then, hey, you can’t be faulted for following “industry best practice”, can you? But if anyone can make it stick that you knew, or should have known, your portfolio was trash… well, that’s bad. Plausible deniability is the whole game here. If very low asset prices from some hedge-fund yard sale get published in the Wall Street Journal, some fund manager might get nervous, and mark down his assets too, bragging about “integrity” and other unprofitable hogwash. All of a sudden, “industry best practice” is what he’s doing, and you’ve got to follow along or take a chance on Sing Sing.

Now as we have pointed out, the models commonly used to value CDOs are utter rubbish. They were devised by rating agencies for the purposes of assessing credit quality (duh, that’s what rating agencies do) but numerous sources have reported that they are being used as a pricing tool (one had to assume the investment banks peddling this stuff were more than a bit complicit in this development). What Tanta at Calculated Risk said is more colorful that our treatment, so we’ll turn to her:

News flash: There are good models, bad models, and ugly models. There are transparent and opaque models. There are stress-tested and untested models. They’re all models. And if they’re claiming to model probability of principal loss via default of the underlying collateral, that number you get at the end isn’t a dollar price. The number you get at the end could be an input into a pricing model, to be sure. But would you really want to claim that an apparent failure of your pricing model is caused solely by one credit model-generated input failing to correlate to a future market price? If so, you aren’t using a “pricing model.” I don’t doubt that there are some stupid investors out there who have been acting as if a certain credit rating–on a mortgage loan or a CDO tranche–guaranteed a certain market price. But the technical financial-accounting term for those people is “doofuses.”

Now if the SEC really wanted to get to the bottom of CDO pricing, it probably could by dint of getting some high powered academics involved, but that would be hard and controversial (even if they were correct, the industry could challenge them as being outsiders). And per above, standard practice, as long as it doesn’t constitute fraud, will stand.

But there is a simpler way to get at this: make lots of suspects do a massive e-mail dump. They will most assuredly find a smoking gun. That was the lesson of the dot-com era. It was easy to prove, for example, that analysts were pushing dubious IPOs because they’d complain about it to the investment banking side, using easy to understand words like “rubbish.” No need to master high math, just pore through enough documents and you’ll probably find pay dirt.

But that gets to problem #2, the SEC’s inadequate enforcement staff. Even when Arthur Levitt was head of the SEC, he thought the enforcement staff was way too small for its scope of responsibilities, and that was in a Democratic administration. Harvey Pitt is so libertarian that he barely believed in enforcement, and in more recent years, the Bush administration has been quietly starving the SEC by increasing its budget only to match inflation, even though filings and trading activity are growing rapidly.

And the SEC can’t use its subpoena powers unless it has a reasonable basis for action. Hence it will be easier for them to dig deeply into a few cases, but even if they do uncover problems, they may not be the problems that pose the biggest danger to the markets (unlike the Fed, the SEC is responsible for enforcing a particular set of regulations, while the Fed’s charter gives it broader powers via responsibility to assure the safety and soundness of the banking system).

But the SEC is pretty certain to get to the bottom of the Bear Stearns situation. That’s too high profile to let go by the wayside.
In theory, this investigation should not affect Bear directly (the hedge funds were independent entities). but the SEC has already uncovered the possible lack of an arm’s-length relationship between Bear and Ralph Cioffi’s hedge funds via Everqyest. a fund (apparently an actively managed CDO) whose plans to go public were scuttled. Bear was putting nuclear waste into the vehicle. From the Journal:

To form Everquest, Mr. Cioffi’s funds last October transferred equity in 10 CDOs to the company, according to its prospectus. Equity portions of CDOs are the highest-yielding, but also riskiest part of these structures.

This raises the specter that Cioffi/Bear was stuffing Everquest with paper it couldn’t sell, but would put enough higher quality securities in to offset (or obscure) the terrible assets. Stay tuned.

The other possible source of embarrassment, and perhaps lawsuits, is the revaluation of the High-Grade Structured Credit Strategies Fund, which as mentioned above, initially reported a loss of 6.75% for April but two weeks later changed it to 18%. One of two scenarios is likely: either Cioffi or someone on his team engaged in some fraudulent reporting (maybe they hoped a trade would work out to save their sorry behinds, and it didn’t, so they had to fess up) or the systems and models they used had something seriously wrong with them. The first scenario means big trouble for Cioffi; the second, since the fund was touted for its use of Bear’s systems and pricing models, would be at the very least a black eye for Bear, and in a worst case scenario, could lead to an investigation of Bear’s pricing practices.

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