SEC’s Oversight of Bear Stearns 

and Related Entities: 

The Consolidated Supervised 

Entity Program 

Sections of this report have been redacted to 

delete information that SEC believes is nonpublic and confidential 

September 25, 2008 

Report No. 446-A 
UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

OFFICE OF

INSPECTOR GENERAL

September 25, 2008

To:

From:

Subject:

Chairman Christopher Cox

Erik Sirri, Director, Division of Trading and Markets

Lori Richards, Director, Office of Compliance Inspections and

Examinations

John White, Director, Division of Corporation Finance

Jonathan Sokobin, Director, Office of Risk Assessment

H. David Kotz, Inspector Gene*K'

Audit of SEC's Oversight ofBear Steams and Related Entities: The

Consolidated Supervised Entity Program, Report No. 446-A

This memorandum transmits the Securities and Exchange Commission, Office of

Inspector General's (OIG) final report detailing the results of our audit on the

SEC's Oversight of Bear Stearns and Related Entities: The Consolidated

Supervised Entity Program. This audit was conducted pursuant to a

Congressional request from Ranking Member Charles E. Grassley of the United

States Senate Committee on Finance.

The final report consists of 26 recommendations that are addressed primarily to

the Division of Trading and Markets (TM). Recommendations 18 and 25 are also

addressed to the Office of Compliance Inspections and Examinations (OCIE)

and Recommendation 19 is also addressed to the Office of Risk Assessment

(ORA). Recommendations 20 and 21 are addressed to the Division of

Corporation Finance (CF), Recommendation 17 is addressed to CF and TM, and

Recommendation 22 is addressed to Chairman Cox.

In response to the draft report, responsible management officials agreed with 21

out of 26 recommendations. TM concurred with 20 of 23 recommendations

addressed to them and disagreed with Recommendations 13, 15, and 16. OGlE

concurred with both recommendations addressed to them. CF concurred with

Recommendation 17, but disagreed with Recommendations 20 and 21.

Your written responses to the draft report, dated September 18, 2008, are

included in their entirety in Appendices VI and VII. In addition, DIG's response

to Chairman Cox's and Management's comments are included in Appendix VIII.
Should you have any questions regarding this report, please do not hesitate to

contact me. During this audit we appreciate the courtesy and cooperation that

you and your staff extended to our auditors.

Attachment

cc: Peter Uhlmann, Chief of Staff, Chairman's Office

Diego Ruiz, Executive Director, Office of the Executive Director

Brian Cartwright, General Counsel, Office of General Counsel

Andrew Donohue, Director, Division of Investment Management

John Nester, Director Office of Public Affairs

William Schulz, Office of Legislative and Intergovernmental Affairs

Bob Colby, Deputy Director, TM

Daniel Gallagher, Deputy Director, TM

Shelley Parratt, Deputy Director, CF

Michael Macchiaroli, Associate Director, TM

Mary Ann Gadziala, Associate Director, OCIE

Matthew Eichner, Assistant Director, TM

John Walsh, ChiefCounsel, OCIE

Thomas K. McGowan, Assistant Director, TM

Herb Brooks, Assistant Director, TM

William Lenox, Ethics Counsel, Office of General Counsel

Denise Landers, Legal Counsel, TM

Juanita Bishop Hamlett, Branch Chief, OCIE

Darlene L. Pryor, Management Analyst, Office of the Executive Director

Rick Hillman, Managing Director of Financial Markets and Community

Investment, GAO

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

111

September 25, 2008
The CSE Program (Including Reviews Performed

on Bear Stearns)

Executive Summary

Background: During the week of March 10, 2008, rumors spread about liquidity

problems at The Bear Steams Companies, Inc. (Bear Steams).! As the rumors

spread, Bear Steams was unable to obtain-secured financing from

counterparties. This caused severe liquidity problems. As a result, on Friday

March 14, 2008, JP Morgan Chase &Co. (JP Morgan) provided Bear Steams

with emergency funding from the Federal Reserve Bank of New York (FRBNY).2

According to Congressional testimony,S after the markets closed on March 14,

2008, it became apparent that the FRBNY's funding could not stop Bear Steams'

downward spiral. As a result, Bear Steams concluded that it would need to file

for bankruptcy protection on March 17, 2008, unless another firm purchased it.

On Sunday March 16, 2008, (before the Asian markets opened), Bear Steams'

sale to JP Morgan was announced with financing support from the FRBNY. In

May 2008, the sale was completed.

Because Bear Steams had collapseQ, at the time of our fieldwork, there were six

holding companies in the Securities and Exchange Commission's (Commission)

Consolidated Supervised Entity (CSE) program. hi addition to Bear Steams,

these six holding companies include or included Goldman Sachs Group, Inc.

(Goldman Sachs), Morgan Stanley, Merrill Lynch & Co. (Merrill Lynch), Lehman

Brothers Holdings Inc. (Lehman Brothers), Citigroup Inc. and JP Morgan. On

September 15, 2008, Lehman Brothers announced that it would file for

bankruptcy protection and Bank of America announced that itagreed to acquire

Merrill Lynch.4 Both firms had experienced serious financial difficulties. Finally,

on September-21, 2008, the Board of Governors of the Federal Reserve System

(Federal Reserve) approved, pending a statutory five-day antitrust waiting period,

applications from Goldman Sachs and Morgan Stanley to become bank holding

companies with the Federal Reserve as their new principal regulator. As a

result, the future of the CSE program is uncertain.

1 See Acronyms used in Appendix I.

2 The funding was from the Federal Reserve Bank of New York (FRBNY) through JP Morgan Chase & Co.

(JP Morgan) to The Bear Steams Companies, Inc. (Bear Steams) because JP Morgan. unlike Bear

Steams, could borrow money from the FRBNY.

3 Timothy Geithner (President and Chief Executive Officer, FRBNY) and Alan Schwartz (President and

Chief Executive Officer ofBear Steams) before U.S. Senate Committee on Banking, Housing and Urban

Affairs on Turmoil in U.S. Credit Markets: Examining the Recent Actions of Federal Financial Regulators

dated April 3, 2008. -

4 The audit fieldwork was completed prior to these events on September 15, 2008.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25. 2008

Report No. 446-A

IV
Of the seven original CSE firms, the Commission exercised direct oversight ov~r

only five firms (Bear Steams, Goldman Sachs, Morgan Stanley, Merrill lynch,

and Lehman Brothers), which did not have a principal regUlator. The

Commission does not directly oversee Citigroup Inc. and JP Morgan because

these firms have a principal regulator, the Federal Reserve.

. -

The CSE program is a voluntary program that was created in 2004 by the

Commission pursuant to rule amendments under the Securities Exchange Act of

1934.5 This program allows the Commission to supervise these broker-dealer

holding companies on a consolidated basis. In this capacity, Commission

.supervision extends beyond the registered broker-dealer to the unregulated

affiliates of the broker-dealer to the holding company itself. The CSE program

was designed to allow the·Commission to monitor for financial or operational

weakness in a CSE holding company or its unregulated affiliates that might place

United States regulated broker-dealers and other regulated entities at risk.

A broker-dealer becomes a CSE by applying to the Commissioll for an

exemption from computing capital using the Commission's standard net capital

rule, and the broker-dealer's ultimate hQlding company consenting to group-wide

Commission supervision (if it does not already have a principal regulator). By

obtaining an exemption from the standard net capital rule, the CSE firms' brokerdealers are p~rmitted to compute netcapital using an alternative method. The

Commission designed the CSE program to be broadly consistent with the

Federal Reserve's oversight of bank holding companies.

Bear Steams' main activities were investment banking, securities and derivatives

sales and trading, clearance, brokerage and asset management. Bear Steams

was highly leveraged with a large exposure (i.e., concentration of assets) in

mortgage-backed securities. Bear Steams had less capital and was less

diversified than several of the other CSE firms.

The Commission stated that Bear Steams' unprecedented collapse was due to a

liquidity crisis caused by a lack of confidence. Chairman Christopher Cox

described Bear Steams as a well-capitalized and apparently fully liquid major

investment bank that experienced a crisis of confidence, denying it not only

unsecured financing, but short-term secured financing, even when the collateral

consisted of agency securities with a market value in excess of the funds to be

borrowed.6 .

5 Source: Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of

Consolidated Supervised Entities (69 Fed Reg. 34.428). Securities and Exchange Commission

(Commission). 21 June 2004.

<http://www.sec.gov/rulesflinal/34-49830.htm>.

6 Source: Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before United states (U.S.) Senate Committee on Banking, Housing and Urban Affairs, 110lh Congo (April

3,2008) (statement of Christopher Cox, Chairman, Commission).

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

v
Congressional Request. On April 2, 2008, the Office of Inspector General

(OIG) received a letter from Ranking Member Charles E. Grassley ofthe United

States Senate Committee on Finance, requesting that the o.lG analyze the

Commission's oversight of CSE firms and broker-dealerS subject to the

Commission's Risk Assessment Program.7 This letter noted that the

Commission's Division of Trading and Marke~s (TM) was responsible for

regulating the largest broker-dealers, and their associated holding companies.

The letter requested a review of TM's oversight of the five CSE firms it directly

oversees, with a special emphasis on Bear Steams. The letter requested that

the OIG analyze.how the CSE program is run, the adequacy of the

Commission's monitoring of Bear Steams, and make recommendations to

improve the Commission's CSE program.

The United States Senate Committee on Finance letter also requested that the

OIG provide an update of findings made in its previous audit report on the

Commission's Broker-Dealer Risk Assessment Program (Broker-Dealer Risk

Assessment Program, Report no. 354, issued on August 13,2002).8

Audit Objectives. In response to the April 2, 2008 Congressional Request, the

OIG conducted two separate audits with regard to the Commission's oversight of

Bear Steams and related entities. This audifs objectives were to evaluate the

Commission's CSE program, emphasizing the Commission's oversight of Bear

Steams and to determine whether improvements are needed in the

Commission's monitoring of CSE firms and its administration of the CSE

program.

The OIG performed a second audit on the Commission's Broker-Dealer Risk

Assessment Program to follow up on the current status of recommendations

made in the GIG's prior audit report of the Risk Assessment Program (BrokerDealer Risk Assessment Program, Report no. 354, issued on August 13, 2002)

and to examine the Broker-Dealer Risk Assessment program to determine

whether improvements are needed. The Commission's Risk-Assessment

program tracks the filing status of 146 broker-dealers that are part of a holding

company structure arid have at least $20 million in capital. The Risk

Assessment Program report found that TM is not fulfilling its obligations in

accordance with the underlying purpose of the Broker-Dealer Risk Assessment

program in several respects. TM has failed to update and finalize the rules

goveming the program, TM has not enforced the filing requirement incumbent on

broker-dealers, resulting in the failure of nearly one-third of the required firms to

file 17(h) documents, TM has not yet determined whether the two remaining

Bear Steams' broker-dealers are obligated to file Form 17-H, and TM only

7 A copy of this request letter Is attached to this report in full in Appendix II.

8 The U.S. Senate Committee on Finance letter also requested that the Office of Inspector General (OIG)

conduct an investigation into the facts and circumstances surrounding the Commi~sion's decision not to

pursue. an Enforcement Action against Bear Steams. This issue will be addressed in an OIG

investigative report to be issued on September 30. 2008.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25,2008 .

Report No. 446-A

vi
conducts an in-depth review of the filings for six of the 146 filing firms that TM

determined are most significant, based on their free credit balances and .

customer accounts. Audit report number 446-B examining the Commission's

Risk Assessment program contains 10 recommendations and was issued on

September 25, 2008.

Retention of an Expert~ Given the complexity of the subject matter, the' OIG

retained an expert, Albert S. (Pete) Kyle to provide assistance with this audit.

Professor Kyle joined the University of Maryland faculty as the Charles E. Smith

Chair Professor gf Finance at the Robert H. Smith School of Business in August

2006. He earned a Bachelor of Science degree.in Mathematics from Davidson

College in 1974, studied Philosophy and Economics at Oxford University as·a

Rhodes Scholar and completed his Ph.D. in Economics at the University of

Chicago in 1981. He was a professor at Princeton University's Woodrow Wilson

School from 1981-1987, at the University of California's Haas Business School in

Berkeley from 1987-1992, and at Duke University from 1992-2006.

.Professor Kyle is a renowned expert on many aspects of capital markets, with a

particular focus on market microstructure. He has conducted significant

research on such topics ·as informed speculative trading, market manipulation,

price volatility, and the information content of market prices, market liquidity,· and

contagion. His paper "Continuous Auctions and Insider Trading" (Econometrica,

2005) is one of the mostly highly cited papers in theoretical asset pricing.

Professor Kyle,was elected a Fellow of the Econometric Society in 2002. He

was also a board member of the American Finance Association from 2004-

2006. He selVed as a staff member of the Presidential Task Force on Market

Mechanisms (Brady Commission), after the stock market crash of 1987. During

his career, he has worked as a consultant on finance topics for several

government agencies, in addition to the Commission, -including the Department

of Justice, the Internal Revenue Service, the Federal Re~elVe and the

Commodity Futures Trading Commission.

Professor Kyle's Curriculum Vitae appears in Appendix'" of this report.

In this audit, Professor Kyle analyzed TM's oversight of the CSE firms, with

particular focus on Bear Steams, Professor Kyle reviewed TM's internal

memoranda on the CSE firms, which documented TM's assessment of the CSE

firms' operations and reviewed data in the CSE firms' monthly and quarterly CSE

program filings.

From this information, Professor Kyle analyzed the firms' financial data, holdings,

risk management strategies, tolerance for risk and assessed the adequacy of the

firms' filings. In particular, Professor Kyle analyzed Bear Steams' capital,

liquidity, arid leverage ratios, access to secured and unsecured financing, and its

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

Report No. 446-A

vii

September 25, 2008
compliance with industry and worldwide standards such as the Basel Standards.9

Professor Kyle analyzed how TM supervised or oversaw Bear Steams'

mortgage-backed securities portfolio, its use of models to measure risk, the

adequacy of its models, its model review process, the relationship between its

traders and risk management department, and its risk-management scenarios.

Professor Kyle also examined how TM supervised Bear Stearns' internal

operations, including its funding of two prominent hedge funds that collapsed iri

the summer of 2007.

Audit Conclusions and Results. The CSE program's mission (goal) provides

in pertinent part as follows:

The regime is intended to allow the Commission to monitor for, and

act quickly in response to, financial or operational weakness in a

CSE holding company or its unregulated affiliates that might place

regulated entities, including US and foreign-registered banks and

.. broker-dealers, or the broader financial system atrisk. 10 ~mphasis

added]

Thus, it is undisputable that the CSE program failed to carry out its mission in its

oversight of Bear Steams because under the Commission and the CSE

program's watch, Bear Steams suffered significant financial weaknesses and the

FRBNY needed to intervene dt:Jring the week of March 10, 2008, to prevent

significant harm to the broader financial system.11 .

This audit was not intended to be a complete assessment of the multitude of

events that led to Bear Steams' collapse, and accordingly, does not purport to

demonstrate any specific or direct connection between the failure of the CSE

Program's oversight of Bear Steams and Bear Steams' collapse. However, we

have identified serious deficiencies in the CSE program that warrant

improvements. Overall, we found that there are significant questions ~bout the

.adequacy of a number of CSE program requirements, as Bear Steams was

9 "The Basel Committee on Banking Supervision (Basel Committee) seeks to improve the quality of

banking supervision worldwide, in part by developing broad supervisory standards. The Basel Committee

consists of central bank and regulatory officials from 13 member countries: Belgium, Canada, France,

Germany, Italy, Japan, Luxembourg. the Nethertands, Spain, Sweden. Switzerland, United Kingdom. and

United States. The Basel Committee's supervisory standards are also often adopted by nonmember

countries.w Source: Government Accountability Office. Bank Regulators Need to Improve Transparency

and Overcome Impediments to Finalizing the Proposed Basel II Framework. Report No. 07-253, February

15,2007.

10 Source: SEC [Commission] Consolidated Supervision ofBroker-Dealer Holding Companies Program

Overview and Assessment Criteria. Commission. 16 Mar 2007.

<http://www.sec.gov/divisionslmarketreg/cseoverview.htm>.

11 The Commission established criteria (the link is provided belOW) for measuring the success of the

Consolidated Supervised Entity (CSE) program. While the CSE program may have been successful in .

achieving its established criteria, none of the criteria standards directly related to the failure of a CSE firm

and its effect on the broader financial system (as stated in the CSE program's goal statement).

Source: SEC [Commission] Consolidated Suoervision of Broker-Dealer Holding Companies Program

Overview and Assessment Criteria. Commission. 16 Mar 2007.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446~A

viii
compliant with several of these requirements, .but nonetheless collapsed. In

addition, the audit found that TM became aware of numerous potential red flags

prior to Bear Stearns' collapse, regarding its concentration of mortgage

securities, high leverage, shortcomings of risk management in mortgage-backed

securities and lack of compliance with the spirit of certain Basel II standards, but

did not take actions to limit these risk factors.

In addition, the audit found that procedures and processes were not strictly

adhered to, as for example, the Commission issued an order approving Bear

Stearns to become a CSE prior to the completion of the inspection process.

Further, the Division of Corporation Finance (CF) did not conduct Bear Stearns'

most recent 1O-K filing review in a timely manner.

The audit also identified numerous specific concerns with the Commission's

oversight of the CSE program, some of which are summarized as follows: 12

(a) Bear Stearns was com~liant with the CSE program's capital and

liquidity requirements; 1 however, its collapse raises questions

about the adequacy of these requirements;

(b) Although TM was aware, prior to Bear Stearns becoming a CSE

firm, that Bear Stearns' concentration of mortgage securities was

increasing for several years and was beyond its internal limits, and

that a portion of Bear Stearns' mortgage securities (e.g., adjustable

rate mortgages) represented a significant concentration of market

risk, TM did not make any efforts to limit Bear Stearns' mortgage

securities concentration;

(c) Prior to the adoption of the rule amendments which created the

CSE program, the broker-dealers affiliated with the CSE firms were

required to either maintain:

• A debt to-net capital ratio of less than 15 to 1 (after their first

year of operation); or

• Have net capital not less than the greater of $250,000 or two

percent of aggregate debit items computed in accordance

with the Formula for Determination of Reserve Requirements

for Broker-Dealers.

However, the CSE program did not require a leverage ratio limit for

the CSE firms. Furthermore, despite TM being aware that Bear

Stearns' leverage was high, TM made no efforts to require Bear

12 We have no specific evidence indicating whether any of these issues directly contributed to Bear Stearns'

collapse since our audit scope did not include a determination of the cause of Bear Stearns' collapse

(see Appendix IV).

13 As discussed in the Scope and Methodology section (see Appendix IV), we did not independently verify

(i.e., recalculate and determine the accuracy) Bear Stearns' capital or liquidity amounts.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

IX
Stearns to reduce its leverage, despite some authoritative sources

describing a linkage between leverage and liquidity risk;

(d)· TM became aware that risk management of mortgages at Bear

Steams had numerous shortcomings, including lack of expertise by

risk managers in mortgage-backed securities at various times; lack

of timely formal review of mortgage models: persistent -

understaffing; a proximity of risk managers to traders suggesting a

lack of independence; turnover of key personnel during times of

crisis; and the inability or unwillingness to update models to reflect

changing circumstances. Notwithstanding this knowledge, TM

missed opportunities to push Bear Steams aggressively to address

these identified concerns;

(e) There was no documentation of discussions between TM and Bear

Steams of scenarios involving a meltdown of mortgage market

liquidity, accompanied by a fundamental deterioration of the

mortgages themselves. TM appeared to identify the types of risks

associated with these mortgages that evolved into the subprime

mortgage crisis yet did not require Bear Steams to reduce its

exposure to subprime loans;

(f) Bear Steams was not cOmpliant with the spirit of certain Basel II

standards and we did not find sufficient evidence that TM required

Bear Steams to comply with these standards;

(g) TM took no actions to assess Bear Steams' Board of Directors' and

senior officials' (e.g., the Chief Executive Officer) tolerance for risk

although we found that this is a prudent and necessary oversight.

procedure;

(h) TM authorized (without an appropriate delegation of authority) the

CSE firms' internal audit staff to perform critical audit work involving

the risk management systems instead of the firms' external

.auditors as required by the rule that created the CSE program;

(i) In June 2007, two of Bear Steams' managed hedge funds

collapsed. Subsequent to this collapse, significant questions were

raised about some of Bear Steams' senior managements' lack of

involvement in handling the crisis. However, TM did not reassess

the communication strategy component of Bear Steams'

Contingency Funding Plan (CFP) after the collapse of the hedge

funds, and very significant questions were once again raised about

some of Bear Steams' managements' handling of the crisis during

the week of March 10, 2008;

0> The Commission issued four of the five Orders approving firms to

use the alternative capital method, and thus become CSEs

(including Bear Steams) before the inspection process was

completed; and

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
(k) CF did not conduct Bear Steams' most recent 1O-K filing review in

a timely manner. The effect of this untimely review was that CF

deprived investors of material information that they could have

used to make well-informed investment decisions (i.e., whether to

buy/sell Bear Steams' securities). In addition, the information (e.g.,

Bear Steams' exposure to subprime mortgages) could have been

potentially beneficial to dispel the rumors that led to Bear Stearns'

collapse.

Recommendations. We identified 26 recommendations (see Appendix V) that

should significantly improve the Commission's oversight of CSE firms. Chairman

Cox's and Management's comments are attached in Appendix VI and VII,

respectively. Our recommendations include:

(a)

(b)

(c)

(d)

(e)

(f)

(g)

(h)

A reassessment of guidelines and rules regarding the CSE firms'

capital and liquidity levels;

Taking appropriate measures to ensure that TM adequately·

. incorporates a firm's concentration of securities into the CSE

program's assessment of a firm's risk management systems and

more aggressively prompts CSE firms to take appropriate actions

to mitigate such risks;

A reassessment of the CSE program's policy regarding leverage

ratio limits;

. Ensuring that: (1) the CSE firms have specific criteria for reViewing

and approving models used for pricing and risk management, (2)

the review. and approval process conducted by the CSE firms is

performed in an independent manner by the CSEs' risk

management staff, (3) each CSE firm's model review and approval

process takes place in a thorough and timely manner, and (4) limits

are imposed. on risk taking by firms in areas where TM determines

that risk management is not adequate;

Being more skeptical of CSE firms' risk models and working with

regulated firms to help them develop additional stress scenarios

that have not already been contemplated as part of the prudential

regulation process;

Greater involvement on the part of TM in formulating action plans

for a variety of stress or disaster scenarios, even if the plans are

informal;

Taking steps to ensure that mark disputes do not provide an

occasion for CSE firms to inflate the combined capital of two firms

by using inconsistent marks; .

Encouraging the CSE firms to present Value at Risk and other risk

management data in a useful manner, which is consistent with how

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
the CSE firms use the information internally and allows risk factors

to be applied consistently to individual desks;

(i) Ensuring (in accordance with Basel II) that the Consolidated

Supervised Entities take appropriate capital deductions for illiquid

assets and appropriate capital deductions for stressed repos,

especially stressed repos where illiquid securities are posted as

collateral;

G) Greater discussion of risk tolerance with the CSE firms' Boards of

Directors and senior management to better understand whether the

actions of CSE firms' staff are consistent with the desires of the

Boards of Directors and senior management;

(k) Requiring compliance with the existing rule that reqUires. external

auditors to review the CSE firms' risk management control systems

or seek Commission approval in accordance with the

Administrative Procedures Act for this deviation from the current

rule's requirement;

(I) Ensuring that reviews of a firm's CFP includes an assessment of a

CSE firm's intemal and external communication strategies;

(m) Developing a formal automated process to track material issues

identified by the monitoring staff to ensure they are adequately

resolved;

(n) Ensuring that they complete all phases of a firm's inspection

process before recommending that the Commission allow any

additional CSE firms the authority to use the alternative capital

method; .

(0) Improving collaboration efforts among TM, eF, the Office of

Compliance Inspections and Examination (OCIE), and the Office of

Risk Assessment (ORA);

(p) The development by CF of internal guidelines for reviewing filings

timely and tracking and monitoring compliance with its internal

guidelines; and

(q) The creation of a Task..Force led by ORA with staff from TM, the

Division of Investment Management, and OGlE to perform an

analysis of large firms with customer accounts that hold significant

amounts of customer funds and have unregulated entities, to

determine the costs and benefits of supervising these firms on a

consolidated basis.

The final report consists of 26 recommendations that are addressed primarily to

the Division of Trading and Markets (TM). Recommendations 18 and 25 are also

addressed to the Office of Compliance Inspections and Examinations (OGlE)

and Recommendation 19 is also addressed to the Office of Risk Assessment

(ORA). Recommendations 20 and 21 are addressed to the Division of

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
Corporation Finance (CF), Recommendation 17 is addressed to CF and TM, and

Recommendation 22 is addressed to Chairman Cox.

In response to the draft report, responsible management officials agreed with 21

out of 26 recommendations. TM concurred with 20 of 23 recommendations

addressed to them and disagreed with Recommendations 13, 15, and-16. OCIE

concurred with both recommendations addressed to them. CF concurred with

Recommendation 17, but disagreed with Recommendations 20 and 21.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

Report No. 446-A

xiii

September 25, 2008
TABLE OF CONTENTS

Executive Summary iv

Table of Contents xiv

Background and Objectives ................................................................•.........................1

Findings and Recommendations 10

Finding 1:- Bear Stearns Was Compliant With The CSE

Program's Capital Ratio And Liquidity Requirements, But The

Collapse Of Bear Stearns Raises Questions About The

Adequacy Of These Requirements 10

Capital 10

Adequacy of Capital Levels 10

Increased Access to Secured Financing 11

Recommendation 1 13

Liquidity 14

Recommendation 2 17

Finding 2: TM Did Not Adequately Address Several Significant

Risks That Impact The Overall Effectiveness Of The CSE

Program 17

Concentration of Assets 17

Recommendation 3 18

Leverage 19

Recommendation 4 20

Bear Stearns Model Review Process and Risk

Management Staffing Were Inadequate In The Area Of

Mortgage Backed Securities 20

Recommendation 5 24

Risk Scenarios 24

Recommendation 6 27

Recommendation 7 27

Non-compliance With Basel 11 27

Mark Disputes 27

Recommendation 8 29

Inconsistent VaR Numbers 29

Recommendation 9 29

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September 25, 2008
Bear Stearns' Capital Requirements for Illiquid

Assets and Stressed Repos Require Careful

Oversight 29

Recommendation 1D 33

Tolerance for Risk ; 33

Recommendation 11 - 33

Finding 3: TM, Without Explicit Authority, Allowed The CSE

Firms' Internal Auditors To Perform Critical Work 34

Recommendation 12 35

Finding 4: TM Did Not Review The Communication Strategy

Component Of Bear Stearns' Contingency Funding Plan After

The Collapse Of Two Of Its Managed Hedge Funds 35

Recommendation 13 36

Finding 5: TM's Monitoring Staff Do Not Adequately Track

Material Issues 37

Develop a Formal Automated Tracking Process 37

Recommendation 14 38

Follow-up on Prior OCIE Findings 38

Recommendation 15 4D

Finding 6: The Commission's Orders Allowing Firms (Including

Bear Stearns) To Use The Alternative Capital Method Were

Generally Approved Before The Inspection Process Was

Completed 4D

Recommendation 16 41

Finding 7: Collaboration Between TM and Other Commission

Divisions/Offices Should Be Significantly Improved 41

Collaboration with CF 41

Recommendation 17 42

Collaboration with OCIE 42

Recommendation 18 43

Collaboration with ORA 43

Recommendation 19 43

Finding 8: CF's Filing Review Of Bear Stearns' 2DD6 1D-K

Was Not Timely 44

Review of Bear Stearns' 1D-K Filing .44

Recommendation 2D 45

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September 25, 2008
Bear Stearns' Response to CF's Comment Letter. .45

Recommendation 21 46

Finding 9: Certain Firms May Pose A Systemic Risk

Because They Are Not Supervised On A Consolidated Basis .46

Recommendation 22 47

Finding 10: TM Should Address Organizational Issues

Involving The Future Of The CSE Program .48

Changes to the CSE Program .48

Recommendation 23 49

Program Staffing 49

Recommendation 24 50

Ethics Manual 50

Recommendation 25 50

Coordination with Other Regulators 50

Recommendation 26 51

Appendices

Appendix I: Acronyms 52

Appendix II: Congressional Audit Request 54

Appendix III: Curriculum Vitae (OIG expert: Albert "Pete" Kyle) 56

Appendix IV: Scope and Methodology 70

Appendix V: List of Recommendations 76

Appendix VI: Chairman Cox's Comments 81

Appendix VII: Management Comments 83

Appendix VIII: OIG Response to Chairman Cox & Management

Comments 116

Appendix IX: Gross Leverage Ratios 120

Appendix X: Criteria 121

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

XVI

September 25, 2008
Background and Objectives

Background

General Background Information. The Division of Trading and Markets (TM)14

is responsible for regulating broker-dealers, which includes administering the

Consolidated Supervised Entity (CSE) and Broker-Dealer Risk Assessment

programs. The Office of Compliance Inspections and Examinations (OCIE) has

responsibility within the Securities and Exchange Commission (Commission) for

conducting the inspections15 of broker-dealers, including broker-dealers that are

affiliated with CSE firms16 (i.e., investment banks).17 The following TM offices

are directly involved in these programs:

• Office of Financial Responsibility: This office is responsible for

administering the financial responsibility regulations (e.g., net capital rule18

14 See Acronyms used ir;J Appendix I.

15 The Division of Trading and Markets (TM) uses the term "inspections", however, the Office of Compliance

Inspections and Examinations (OCIE) uses the term "examinations". For purposes of this audit report, we

use the term "inspections" to refer to both. In addition, for purposes of this audit report, OCIE also

includes the Inspection staff in the Commission's regional offices.

16 During our audit fieldwork, there were four Consolidated Supervised Entity (CSE) firms whose principal

regulator (as discussed below) was the Commission: Goldman Sachs Group, Inc., Lehman Brothers

Holdings Inc. (Lehman Brothers), Merrill Lynch & Co., Inc., and Morgan Stanley. On September 15,

2008, Lehman Brothers announced that it would file for bankruptcy protection and Bank of America

announced that it agreed to acquire Merrill Lynch & Co., Inc. On September 21, 2008, the Federal

Reserve approved, pending a statutory five-day antitrust waiting period, applications from Goldman

Sachs and Morgan Stanley to become bank holding companies. The Bear Stearns Companies, Inc.

(Bear Stearns) was also a CSE firm (approved in November 2005) until its collapse. In addition, JP

Morgan Chase & Co. (JP Morgan) and Citigroup Inc. have been approved to use the alternative method

for their broker-dealer capital requirements, but the Board of Governors of the Federal Reserve System

(Federal Reserve) is their principal regulator (i.e., is responsible for the consolidated entity) but the

Commission is responsible for the oversight of their broker-dealers. As a result, the Securities and

Exchange Commission (Commission) defers oversight (of the consolidated entity) of JP Morgan and

Citigroup to the Federal Reserve to avoid duplicative or inconsistent regulation.

17 In 2007, in response to a Government Accountability Office (GAO) report Financial Market Regulation:

Agencies Engaged in Consolidated Supervision Can Strengthen Performance Measurement and

Collaboration. Report 07-154, March 15,2007 (as discussed in the Prior Audit Coverage section of the

Scope and Methodology - see Appendix III); the Chairman (in consultation with the other Commissioners)

decided to transfer the responsibility for conducting inspections of the consolidated entities from OCIE to

TM. The timing of the actual transfer is discussed in more detail later in this report. OCIE retained

(within the Commission) responsibility for conducting inspections of the CSEs' broker-de-alers. The Self

Regulatory Organizations (SRO) have the primary inspection responsibility for the registered brokerdealers. OCIE has oversight responsibility of these broker-dealers and conducts periodic inspections.

The Financial Industry Regulatory Authority (FINRA) is the primary regulator of approximately 5,000

broker-dealers registered in the United States (U.S.).

18 "The net capital rule focuses on liquidity and is designed to protect securities customers, counterparties,

and creditors by requiring that broker-dealers have sufficient liquid resources on hand at all times to

satisfy claims promptly". Source: GAO Report Risk~Based Capital Regulatorv and Industry Approaches

to Capital and Risk, Report No. GGD-98-153, July 20,1998.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

1
and customer protection19). These regulations are intended to protect

customers and financial institutions. This office also oversees the

Securities Investor Protection Corporation and has approximately nine

staff.20

• Office of Prudential Supervision and Risk Analysis: The staff (referred to

as "monitors") in this office work in teams of three to review each CSE

firm. They perform their work mainly through periodic meetings and

informal discussions with CSE staff. The staff also review CSE required

financial filings. The staff have backgrounds in economics, accounting,

and finance and expertise in credit, market, or liquidity risk. Approximately

13 individuals comprise the staff.

• Office of CSE Inspections: this office is responsible for conducting the

inspections on the CSE firms. They have seven staff who are located in

both Washington D.C. and New York.

CSE Program. In 2004, the Commission adopted rule amendments under the

Se'curities and Exchange Act of 1934,21 which created the voluntary CSE

program. This program allows the Commission to supervise certain brokerdealer holding companies on a consolidated basis. In this capacity, Commission,

supervision extends beyond the registered broker-dealer to the unregulated

affiliates of the broker-dealer and the holding company itself. The CSE program

was designed to allow the Commission to monitor for financial or operational

weakness in a CSE holding company or its unregulated affiliates that might place

United States (U.S.) regUlated broker-dealers and other regulated entities at risk.

A broker-dealer becomes a CSE by applying to the Commission for an

exemption from the Commission's standard net capital rule,22 and the brokergealer's ultimate holding company consenting to group-wide Commission'

supervision, if it does not already have a principal regUlator. By obtaining an

exemption from the standard net capital rule, the CSE firms' broker-dealers are

permitted to compute net capitai using an alternative method.23 ,

19 The customer protection rule "is designed to ensure that customer property (securities and funds) in the

custody of broker-dealers is adequately safeguarded:

Source: GAO Report Risk-Based Capital Regulatory and Industry Approaches to Capital and Risk,

Report No. GGD-98-153, July 20,1998.

20 The Securities Investor Protection Act of 1970. 15 U.S.C. § 78aaa et. seq., as amended, was enacted to

protect customers from losses resulting from a broker-dealers' failure, thereby promoting investor .

. confidence in the securities markets. The Securities Investor Protection Corporation was created by the

Act to pay investor claims. (See 15 U.S.C. § 78ccc).

21 Source: Final Rule: A1temative Net Capital Requirements for Broker-Dealers That Are Part of

Consolidated Supervjsed Entities (69 Fed Reg. 34.428). Commission. 21 June 2004,

<http://www.sec.gov/ruleslfinal/34-49830.htm>.

22 See 17 C.F.R. § 24015c3-1.

23 The altemative capital method is based on mathematical models and scenario testing, while brokerdealers operating under the' standard net capital rule must meet certain ratios and maintain minimum net

capital levels based on the type of securities activities they conduct. (See 17 C.F.R. 240.15c3-1(a)(7».

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25. 2008

Report No. 446-A

2
The Commission designed the CSE program to be broadly consistent with the

Board of Governors of the Federal Reserve System's (Federal Reserve)

oversight of bank holding companies. However, the CSE program "reflects the

reliance of securities firms on mark-to-market -accounting as a critical risk and

governance control. Second, the design olthe CSE regime reflects the critical

importance of maintaining adequate liquidity in all market environments for

holding companies that do not have access to an external liquidity provider.n24

The CSE application process includes TM reviewing a firm's application25 (for an

exemption from the net capital rule) and makes a recommendation to the

Commission. Approval of.the firm's application is contingent on the firm agreeing

to group-wide Commission supervision of the consolidated entity (including

.unregulated affiliates), if the firm does not already have a principal regulator. In

addition, CSE firms must agree to:

• "Maintain and document an internal risk management control system for

the affiliategroup;n26 . -

• "Calculate a group-wide capital adequacy measure consistent with the

international standards adopted by the Basel Committee on Banking

Supervision [27] ('Basel Standards,).,,28 The CSEs are required to maintain

an overall Basel capital ratio29 of not less than the Federal Reserve's 10

percent "well-capitalized" standard for bank holding companies. The CSE

must notify the Commission (e.g., file an EarlyWaming Notice) if the 10

percent capital ratio is or is likely to be violated,3o or if tentative net capital

of the broker-dealer falls below $5 billion;31

24 Source: Examining Regulation and SupelVision ofIndustrial Loan Companies Before us Senate .

Committee on Banking, Housing and Urban ~ffairs, 110lh Cong. (October 4,2007) (statement of Erik

Slm, Director ofTM, Commission).

25 The application process includes inspections whose purPose is to verify the information the firms

provides during the application process and to "assess the adequacy of the implementation ofthe firm's

internal risk management policies and procedures."

Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divislonslmarl<etreg1hcsupervision.htm>..

26 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisionslmarl<etreg/hcsupervision.htm>. .

27 "The Basel Committee on Banking Supervision (Basel Committee) seeks to Improve the quality of

banking supervision worldwide, in part by developing broad supervisory Standards. The Basel Committee

consists of central bank and regulatory officials from 13 member countries: Belgium, Canada, France,

Germany, Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, United Kingdom, and

United States. The Basel Committee's supervisory standards are also often adopted by nonmember .

countries." Source: GAO. Bank Regulators Need to Improve Transparencv and Overcome Impediments

to Finalizing the Proposed Basel II Framework. Report No. 07-253, February 15, 2007.

28 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisionslmarl<etreg/hcsupervisioh.htm>. [footnote added]

29 The Basel capital ratio is capital divided by risk weighted assets.

30 We are aware of one instance where this occurred. In our opinion, TM acted reasonably..

31 Sources for the infonnation include: .

• Risk Management and its Implications for Systemic Risk Before U.S. Senate Committee on

Banking, Housing and Urban Affairs, 110th Congo (June 19, 2008) (statement of Erik Sim, Director

ofTM, Commission); and .

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

3
• Maintain "sufficient stand-alone liquidity and sufficient financial resources

to meet its expected cash outflows in a stressed liquidity environment

where access to unsecured funding is not available for a period of at least

one year. Another premise of this liquidity planning is that any assets held

in a regulated entity are unavailable for use outside of the entity to deal

with weakness elsewhere in the holding company structure, based on the

assumption that during the stress event, including a tightening of market

liquidity, regulators in the U.S. and relevant foreign jurisdictions would not

permit a withdrawal of capital;,,32 .

• "Consent to Commission examination [inspection] of the books and

records of the ultimate holding company [i.e., the consolidated enti~l and

its affiliates, where those affiliates do not have principal regulators;"

• "Regularly report qn the financial and operational condition of the holding

company, and make available tc) the Commission information about the

ultimate holding company or any of its material affiliates that is necessary

to evaluate financial and operations risks within the ultimate holding

company and its material affiliates;,,34 and

• "Make available [examination] inspection reports of principal regulators for

those affiliates that are not subject to Commission [examination]

inspection.,,35

The firms agreed to consolidated supervision because of the preferential capital

·treatment under the alternative method and international reqUirements. The

European.Union's (EU) Conglomerates Directive reqUired that affiliates of U.S.

registered broker-dealers demonstrate that they were subject to consolidated

supervision by a U.S. regulator orface significant restrictions on their European

. operations.36 .

• Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated

Supervised Entities (69 Fed Reg. 34-428). Commission. 21 June 2004.

<http://www.sec.gov/ruleslfinal/34-49830.htm>.

32 Source: Risk Management and its Implications for Systemic Risk Before u.s. Senate Committee on

Banking, Housing and Urban Atfuirs, 110lh Congo (June 19, 2008) (statement of Erik Sim, Director ofTM,

Commission),

33 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisionslmarketreg/hcsupervision.htm>. .

34 Source: SEC [CommisSion] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisionslmarketreg/hcsupervision.htm>.

35 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreg/hcsupervision.htm>.

36 According to the CSE final rule, "EU [European Union] 'consolidated supervision' consists-of a series of

quantitative and qualitative rules, imposed at the level ofthe ultimate holding company, regarding firms'

internal controls, capital adequacy, intra-group transactions, and risk concentration. Without a

demonstration of 'equiValent' supervision, U.S. securities firms have expressed concems that an affiliate

institution located in the EU either may be subject to additional capital charges or be required to form a

sub-holding company in the EU: See 'Directive 2002l87/EC of the European Parliament and of the

Council of 16 December 2002." Source: Final Rule: Alternative Net Capital Requirements for BrokerDealers That Are Part of Consolidated Supervised Entities (69 Fed Reg. 34.428). Commission. 21 June

2004. <http://www.sec.gov/rules/final/34-49830.htmP42 10820>.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

4
Mortgage Loans. Beginning around late 2004, lenders offered mortgages to

individuals who did not meet the normal qualifications (e.g., income or credit

history). Many of these loans had teaser rates and/or were interest only. These·

more risky loans are referred to as "subprime mortgages." The theory behind

approving these risky loans was that the homeowner would be able to -refinance

the loan in a few years because of the increased growth in home values and the

individual's improved credit rating. Banks converted these loans into securities

and sold the securities to other firms (known as the securitization process).

Once home values began to decrease, mortgage loan defaults started to

increase, causing the market value of the mortgage securities to decrease. In

the ensuing months, the financial services industry wrote-down billions of dollars

in the value of all types of mortgage securities.37

Bear Stearns' Collapse.38 The Bear Steams Companies, Inc. (Bear Steams)

was a holding company that had two registered broker-dealers.-Its main

activities were investment banking, securities and derivatives sales and trading,

clearance, brokerage and asset management.39 Bear Steams was highly

leveraged40 with a large exposure (i.e., concentration ofassets) in mortgagebacked securities.41 Bear Steams also had less capital and was less diversified

than several of the CSE firms.

In June 2007, two of Bear Steams' managed hedge funds collapsed because of

subprime mortgage losses.42 Nearly a year later, dUring the week of March 10,

2008, rumors spread about liqUidity problems at Bear Steams. Due to Bear

Steams' lenders not rolling over secured financing, Bear Steams faced severe

liqUidity problems on March 14,2008.43 As a result, on March 14,2008, JP

Morgan Chase & Co. (JP Morgan) provided Bear Steams with emergency

87 In accordance with Generally Accepted Accounting Principles, the securities must be valued at fair

market value (i.e., mark to market accounting).

38 Sources for this Information include:

• Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before U.S. Senate Committee on Banking, Housing and Urban Affairs, 11Oth Congress (April 3,

2oo8) (statement ofTimothy Geithner, President and Chief Executive Officer, Federal Reserve

Bank of New York (FRBNY); . .

• Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before U;S. Senate Committee on Banking, Housing and Urban Affairs, 110th Congress (April 3,

2008) (statement of Jamie Dimon (Chairman and Chief Executive Officer, JP Morgan); and

• Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators .

Before U.S. Senate Committee on Banking, Housing and UrI;lan Affairs, 11Oth Congress (April 3,

2008) (statement of Alan Schwartz (President and Chief Executive Officer, Bear Steams).

89 Source: 2006 Bear Steams' Annual Report (page 32).

40 There are many definitions of leverage. A simple definition of leverage is assets divided by capital. Bear

Steams' gross leverage ratio was about 33-1 .. See Appendix IX.

41 Depending on the definition used to classify a mortgage as "subprimeu

, Bear Steams' exposure to

5ubprime mortgages varied.' However, it clearly had a large exposure to mortgage securities overall.

42 Bear Steams' direct exposure to these hedge funds was minimal.

43 A pledge of collateral supports secured financing.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

5
funding.44 According to Congressional testimony,45 after the markets closed on

March 14, 2008, it became apparent that FRBNY's funding could not stop Bear'

Steams' downward spiral. As a result, Bear Stearns concluded that it would

need to file for bankruptcy protection on March 17, 2008, unless another firm

purchased it.46 On March 16, 2008, Bear Stearns' sale to JP Morgan was

announced with financing support from the FRBNY. In May 2008, the-sale was

completed.

In testimony given before the Senate Committee on Banking, Housing, and

Urban Affairs on-April 3, 2008, Chairman Christopher Cox stated that Bear

Steams' collapse was due to a liquidity crisis caused by a lack of confidence.47

Chairman Cox described Bear Steams' collapse as a "run on the bank'.48 which

occurred exceptionally fast and in an already distressed market environment

(i.e., the credit crisis). Specifically, Chairman .Cox testified as follows:

What happened to Bear Steams during the week of March 10th

was likewise unprecedented. For the first time, a major iRvestment

bank that was well-capitalized and apparently fully liquid

experienced a crisis of confidence that denied it not only unsecured

financing, but short-term secured financing, even when the

collateral consisted of agency securities with a market value in

excess of the funds to be borrowed. Counterparties would not

provide securities lending services and clearing services. Prime

brokerage clients moved their cash balances elsewhere. These

decisions ~y counterparties, clients, and lenders to no longer

transact with Bear Steams in tum influenced other counterparties,

clients, and lenders to also reduce their exposure to Bear

Steams.49 .

44 The funding was from FRBNYthrough JP Morgan to Bear Steams because JP Morgan could borrow

money from FRBNY.

45 SoUrce: Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before U.S. Senate Committee on Banking, Housing and Urban Affairs, 110th Congress (April 3, 2008)

(statements ofTimothy Geithner, President and Chief Executive Officer, FRBNY) arid Alan Schwartz,

President and Chief Executive Officer, Bear Steams).

46 Source: Turmoil in the U.S. Credit Markets: Examining the RegUlation ofInvestment Banks by the

Securities'and Exchange Commission Before the U.S. Senate on Securities, Insurance, and Investment

110111 Cong. (May 7,2008) (statement of Erik Sirri, Director ofTM, Commission). _

47 Source: Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before US Senate Committee on Banking, Housing and Urban Affairs, 110lh Congo (April 3, 2008)

(statement of Christopher Cox, Chairman, Commission). .

48 Source: Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederal Financial Regulators

Before US•. Senate Committee on Banking, Housing and Urban Affairs, 110th Cong. (April 3, 2008)

(statement of Christopher Cox, Chairman, Commission).

49 Source: Turmoil in U.S. Credit Markets: Examining the Recent Actions ofFederafFinancial Regulators

Before U.S. Senate Committee on Banking, Housing and Urban Affairs. 110th Congo (April 3, 2008)

.(statement of Christopher Cox, Chairman, Commission).

SEC's Over'Sight of Bear Steams and Related Entities: The CSE Program September 25. 2008

Report No. 446-A

6
According to a Commission press release,50 TM monitored Bear Stearns' capital

and liquidity daily since Bear Stearns' hedge funds collapsed. According to data

(provided to TM by Bear Stearns), there was adequate capital at the holding

company level and at Bear Stearns' two registered broker-dealers prior to and

dUring the week of March 10,2008. hi addition, the Commission stated that

Bear Steams was compliant with the $5 billion liquidity requirement,51-

Furthermore, according to data we reviewed, Bear Steams had significantly

increased its liquidity levels since May 2007.52 .

The Commission stated that neither the CSE program nor any regulatory model

(i.e., the Basel Standards)53 used by commercial or investment banks considered

the possibility that secured financing, even when backed by high-quality .

collateral could become completely unavailable. Instead, the CSE program only

considered that a deterioration of secured financing could occur (e.g., that

financing terms could become less favorable) and that unsecured funding could

be unavailable for atleast one year.

The Commission's Response to Bear Steams' Collapse. In the aftermath of

Bear Steams' collapse, the Commission has:

• Supported the work of the Basel Committee on Banking Supervision

regarding their planned updated guidance (i.e., strengthening the

standards applicable to liqUidity risks) on liquidity management;54

• Supported legislation to make the CSE program mandatory.55 At a recent

Congressional hearing before the Committee on Financial Services,

House of Representatives, July 24, 2008, Chairman Christopher Cox

stated:

60 Source: Statement of SEC Division ofTradinq and Mar1<ets Regarding The Bear Steams Companies.

Commission. 14 March 2008. <http://www.sec.gov/news/pressl2008/2008-44.htm>. The Chairman alsO

made similar statements in his letterto the Basel Committee regarding liquidity management; and

testimony (Turmoil in U.S. Credit Market Examining the Recent Actions ofFederal Rnancial RegUlators

Before US Senate Committee on Banking, Housing and Urban Affairs,11Oth Cong. (April 3, 2008)

(statement of Christopher Cox, Chairman, Commission».

51 As discussed in the Scope and Methodology section (see Appendix IV), we did not independently verify

(i.e., recalculate and determlne·the accuracy) Bear Steams' capital or liquidity amounts.

52 According to the Commission, Bear Steams had a high of $21 billion (in liqUidity) in early March 2008,

(I.e., before the week of March 10), compared to $7.6 billion in May 2007 according to TM data.

Source: Chairman Cox Letter to Basel Committee in Sypport ofNew Guidance on liquidity Management.

Commission. 14 March 2008. <htlp:llwww.sec.gov/newslpress/2008/2008-48.htm>.

63 The CSE firms operate under the Basel II standards.

64 Source: Chairman Cox Letter to Basel Committee in Support of New Guidance on liquiditY Management.

Commission. 14 March 2008. <htlp:llwww.sec.gov/neWstpressl2008/2008-48.htm>.

55 Sources of this information include:

• Risk Management and its Implications for Systemic Risk Before U.S. Senate Committee on

Banking, Housing and Urban Affairs, 110lh Congo (June 19, 2008) (statement of Erik Sirri; Director

ofTM, Commission); and

• Systemic Risk and the Financial Markets Before U.S. House of Representatives Committee on

. Financial Services, 110lh Congo (July 24,2008) (statement of Christopher Cox, Chairman,

Commission).

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

7
The mandatory consolidated supervision regime for

investment banks should provide the SEC

[Commission] with several specific authorities. .

Broadly, with respect to the holding company, these

include authority to: set capital and liquidity

standards; set recordkeeping and reporting

standards; set risk management and internal control

standards; apply progressively more significant

restrictions on operations if capital or liquidity

adequacy falls, including requiring divestiture of lines

of business; conduct examinations and generally

enforce the rules; and share information with other

regulators. Any future legislation should also establish

a process for handling extraordinary problems,

whether institution-specific or connected with broader

market events, to provide needed predictability and

certainty.56 ,-

• Requested dedicated Congressional funding for the CSE program and

increased CSE staffing from about 25 to 40 people;57

• Consulted with the CSE firms on their liquidity situation (e.g., funding

plans). Specifically, the Commission worked with the firms to:

o increase their liquidity levels;5B

o lengthen the terms of their secured and unsecured financing;59

o review their risk practices and models;6o

o discuss their long-term funding plans, including plans for raising

new capital by accessing the equity and long-term debt markets;61

o increase their public disclosures of their capital and liquidity;62

56 Source: Systemic Risk'and the Financial Markets Before U.S. House of Representatives Committee on

,Financial Services, 11Olh Cong. (July 24, 2008)(statement of Christopher Cox, Chairman, Commission).

57 Source: Risk Management and Its Implications for Systemic Risk. Before U.S. Senate Committee on

Banking, Housing and Urban Affairs, 11Oth Congo (June 19, 2008) (statement of Erik Sirri, Director ofTM,

Chairman, Commission).

58 Source: Turmoil in U.S. Credit Market Examining the Recent Actions ofFederal Financial Regulators,

Before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, 11 Oth Cong. (~pril 3, 2008)

(statementof Christopher Cox, Chairman, Commission).

59 Source: Turmoil in the U.S. Credit Markets: Examining the Regulation ofInvestment Banks by the

Securities and Exchange Commission Before the U.S. Senate on Securities, Insurance, and Investment

110th Congo (May 7, 2008) (statement of Erik Sirri, Director ofTM, Commission).

60 Source: Turmoil in the U. S. Credit Markets: Examining the RegUlation of Investment Banks by the

Securities and Exchange Commission Before the U.S. Senate on Securities, Insurance, and Investment

110th Congo (May 7, 2008) (statement of Erik Sirri, DirectorofTM, Commission). '

61 Source: Systemic Risk and the Financial Markets Before U.S. House of Representatives Committee on

Financial Services, 110th Congo (July 24, 2008) (statement of Christopher Cox, Chairman, Commission).

SEC's Oversight of Bear Steams and Related Entitles: The CSE Program September 25, 2008

Report No. 446-A

8
• Invited FRBNY examiners to review·the CSE firms' funding and how the

firms are managing their funding;63 and

• In July 2008, the Commission and the Federal Reserve agreed on a

Memorandum of Understanding (MOU) involving coordination and

information sharing.64 . _

Objectives

As a result of the collapse of Bear Steams in March 2008, we received a

Congressional request to perform this audit of the Commission's CSE Program,

in addition to an audit of the Commission's Broker-Dealer Risk Assessment

Program (see Appendix II).

The objectives of this audit were to evaluate the Commission's CSE program,

emphasizing the Commission"s oversight of Bear Steams and to determine

whether improvements are needed in the Commission's monitoring of CSE firms

and its administration of the CSE program.

The objectives of the audit on the Commission's Broker-Dealer Risk Assessment

Program were to follow up on recommendations made in the Office of Inspector

General's (DIG) prior audit report of the Risk Assessment Program (BrokerDealer Risk Assessment Program, Report No. 354, issued on August 13, 2002)

and to examine the Broker-Dealer Risk Assessment process to determine

whether improvements are needed. Audit report number 446-8 discusses the

Risk Assessment Program in detail and addresses these objectives.

- 62 Source: Speech by SEC [Commission] Chairman: Address to the Security Traders 12th Annual

.Washington Conference. Commission. 7 May 2008.

<http://www.sec.gov/news/speech/2008/spch050708cc.htm>.

63 Source: Turmoil in U.S. Credit Market: Examining the Recent Actions ofFederal Financial Regulators

Before US Senate Committee on Banking, Housing, and Urban Affairs, 110th Cong; (April 3, 2008)

(statement of Christopher Cox, Chairman, Commission).

.64 SEC [Commission], FRB Sign Agreement to Enhance Collaboration. Coordination and Information

Sharing. Commission. 7 July 2008. <http://www.sec.gov/news/pressl2008/2008-134.htm>.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

Report No. 446-A

9

September 25, 2008
Findings and Recommendations

Finding 1: Bear Stearns Was Compliant With The

CSE Program's Capital Ratio And Liquidity -

Requirements, But The Collapse Of Bear Stearns

Raises Questions About The Adequacy Of These

Requirements 65

Bear Steams was compliant with .the capital and liquidity

requirements; however, its collapse raises serious questions about

the adequacy of these requirements.

Capital 66

Adequacy of Capital Levels

In 2004, the Commission adopted rule amendments under the Securities and

Exchange Act of 1934, which created the CSE program and allowed broker-

. dealers to apply for an exemption from the net capital rule and instead use the

alternative capital method.67 The Commission designed the CSE program to be

broadly consistent with the Federal Reserve's oversight of bank holding

companies; However, the CSE I?rogram "reflects the reliance of securities firms

on mark-to-market accounting r1 as a critical risk and governance control.

Second, the design of the CSE regime reflects the critical importance of

maintaining adequate liquidity in all market environments for holding companies

that do not have access to an extemalliquidity provider." 69

If approved, a firm must comply with capital requirements at both the holding

company and the broker-dealer levels. The CSEs at the holding company level

are required to maintain an overall Basel capital ratio of not less than the Federal

66 The capital ratio requirement is stipulated by Basel II, which TM incorporated into the CSE program. TM

developed the CSE program's liquidity requirements.

66 Capital is the difference between a firm's assets and liabilities.

Source: Answers to Frequently Asked Investor Questions Regarding The Bear Steams Companies, Inc.

Commission. 8 March 2008. <http://www.sec.gov/newslpresS/2008/2008-46.htm>. .

67 The alternative. capital method is based on mathematical models and scenario testing while brokerdealers operating under the standard net capital rule must meet certain ratios and maintain minimum net

capital levels based on the type of securities activities they conduct.

68 Mark-ta-market accounting refers to a reqUirement that the securities must be valued at fair market value

in accordance with Generally Accepted Accounting Principles.

69 Source: Examining Regulation and Supervision ofIndustrial Loan Companies Before U.S. Senate

Committee on Banking, Housing and Urban Affairs, 110th Congo (October 4, 2007) (statement of Erik

Sirri, Director ofTM, Commission).

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

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10
Reserve's 10 percent "well-capitalized" standard for bank holding companies.7o

In addition, a broker-de~ler calculating its capital using the alternative method

must maintain tentative net capital71 of at least $1 billion and net capital of at

least $500 million. If the tentative net capital of a broker-dealer using alternative

method falls below $5 billion, it must nptify the Commission.72

According to Bear Steams' data, it exceeded the required capital amounts at the

holding company and broker-dealer" level the entire time it was in the CSE

program, including during the week of March 10,2008.73 Although Bear Steams

was compliant with the capital requirements, there are serious questions about

whether the capital requirement amounts were adequate.74 For instance, some

individuals have speculated that Bear Steams would not have collapsed if it had

more capital than was required by. the CSE program. In fact, a former Director of

TM has stated:75

The losses incurred by Bear Steams and other large broker-dealers

were not caused by 'rumors' or a 'crisis of confidence,' but rather by

inadequate net capital and the lack of constraints on the incurring

of debt.

Increased Access to Secured Financing

Notwithstanding the fact that Bear Steams was compliant with the CSE

program's capital requirements, there are serious questions about whether Bear

Steams had enough capital to sustain its business model. As the subprime crisis

unfolded, Bear Steams' cost of unsecured financing tended to increase. For

example, by March 2008, a ten-year bond wfJich had recently been issued at a

spread of 362 basis points over Treasury rates was trading at 460 basis points

over Treasury rates. The high spread indicates that market participants believed

that Bear Steams' creditworthiness was deteriorating in a manner consistent with

downgrades by ratings agencies. According to the expert retained by the OIG in

connection with this aUdit,76 the high cost of financing tended to undermine the

10 Source: SEC [Commission] Holding Company Supervision with Respect to Capital Standards and

liquidity Planning. Commission. 7 Mar 2007. <http://www.sec.gov/divisions/marketreg/hcliquidity.htm>.

11 T~ntative capital is net capital before deductions for market and credit risk. "

12 Source: Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of

Consolidated Supervised Entities (69 Fed Reg. 34.428). Commission. 21 June 2004.

<http://www.sec.gov/rules/finall3449830.htm>.

13 Source: Chairman Cox Letter to Basel Committee in Support of New Guidance on liquiditY Management.

" Commission. 14 March 2008. <http://www.sec.gov/news/press/2008/2008-48.htm>. .

14 It is worth noting that priorto the current mortgage crisis, a main concem surrounding the securities

industry was a real/perceived lack of competitiveness with overseas markets. One specific area of

concern was that U.S. firms were potentially at a competitive disadvantage because U.S. regulators were

requiring excessive capital compared to foreign banks. Source: Sustaining New York's and the US'

Global Financial Services Leadership (Recommendation 6, page 24) by McKinsey & Company.

15 Source: Pickard Lee. ·SEC's [Commission] Old Capital Approach Was Tried-and-True." American Banker

August 8, 2008.

16 Professor Albert S. (Pete) Kyle was retained by the Office of Inspector General (OIG) to provide

assistance with this audit. See Appendix III for Professor Kyle's Curriculum Vitae and the Methodology

section ofAppendiX IV.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

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11
September 25, 2008

viability of Bear Steams' business model, which relied heavily on leverage.

Therefore, to preserve the viability of its business model, Bear Stearns had a

strong incentive to lower its financing costs. One way to lower borroWing costs is

to raise new equity capital, thus providing a larger equity cushion to protect

unsecured lenders. To the extent that secured financing was cheaper than

unsecured financing, another way for Bear Steams to lower its borrowing costs

was to shift its funding model from unsecured to secured financing.

From April 2006 to March 2008, Bear Steams' Basel capital ratio

- : 77 . . . ': in March 2008, TM

inquired about whether Bear Steams was contemplating capital infusions, but \

. I does not suggest that TM exerted influence over Bear Steams to

raise additional capital.78 The DIG expert was unable to find . . . .

J that TM had formally required or informally pressured Bear Steams to

raise additional equity capital prior to March 2008. In this sense, TM acted as

though it did not believe it had a mandate to compel Bear Stea~s to raise .

additional capital as long as its Basel capital ratio was greater than 10%. In fact,

Bear Steams did not raise additional capital during this time in 2007 or 2008.

• I in

November 2006, Bear Steams initialea a plan to inCrease its availability of

secured funding at the holding company level.79 One component of this plan

involved a tn-party repurchase agreement80 with secured ·Ienders, giving Bear

Steams access to t Bear Steams' secured

borrowings were initially for terms of I with the goal of extending the

terms to . . . By May 2007, Bear Steams' short-term

borrowin~was,. secured and by September 2007, it was

secured. Finalll4 by.March 2008, Bear Steams' sho~-term borrowing .was

secured. Nevertheless, Bear Steams Was stili unable to obtain

ad~uate secured funding to save the firm in March 2008.

. -

80 In a tn-partY. repo arrangement, a third party I , • acts as a custodian for loans

between Bear Steams and other lenders. The custodian holds Bear Steams assets as collateral for the

loans from the other lenders. Bear Steams used this tn-party repurchase agreement (repo) facility to

finance assets which were otherwise difficult to fund,

---------_.......__..~----------......._---........;----- SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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Bear Steams' increasing reliance on secured funding indicates that, although it

appeared to be compliant with CSE program's capital requirement, the market

did not perceive it to be sufficiently capitalized to justify extensive unsecured

lending. In this sense, Bear Stearns was not adequately capitalized.

These facts illustrate that although Bear Stearns was compliant with the CSE

program's ten percent Basel capital requirement, it was not sufficiently

capitalized to attract the funding it needed to support its business model.

Although the Cpmmission has maintained that liquidity (not capital) problems

caused Bear Steams' collapse, this alidit found that it is entirely possible that

Bear Steams' capital levels could have contributed to its collapse by making

lenders unwilling to provide Bear Steams the funding it needed.

The fact that Bear Steams collapsed while it was compliant with the CSE

program's capital requiremerits raises serious questions about the adequacy of

the CSE program's capital ratio requirements.

The CSE capital requirements are· broadly consistent with the Basel"

framework. The Basel II framework is based on three pillars: (1) minimum

capital requirements, (2) supervisory review, and (3) market discipline in the form

of increased pUblic disclosure.85 CSE firms caiculate their capital ratios in a

manner consistent with a models-based approach of pillar 1. Under pillar 2,

supervisors are required to ensure that banks comply with the minimum capital

reqUirements of pillar 1; address risks not fully captured by pillar 1, including

liquidity risk and credit concentration risk; and encourage good risk management

practices. Under pillar 2, supervisors should expect banks to operate above the

minimum regulatory capital ratio~, and should intervene at an early stage to

prevent banks from falling below minimum levels required to support the risk

characteristics of a particular bank, inclUding requiring banks to raise additional

capital immediately.86 Pillar 3 establishes disclosure requirements that aim to

inform market participants about banks' capital adequacy in a consistent

framework·that enhances comparability.8? The Basel" framework does not

dictate a maximum capital ratio, but instead gives the supervisor the ability to set"

a high enough capital ratio to be consistent with the characteristics Qf the banks

it regulates.

Recommendation 1:

The Division of Trading and Markets, in consultation with the Board of Governors

of the Federal Reserve System and the Basel Committee should: (1) reassess

the gUidelines and rules regarding the Consolidated Supervised Entity (CSE)

85 Source: GAO. Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing

the Proposed Basel II Framework. Report No. 07-253, page 20. February 15, 2007.

86 Source: Basel Committee on Banking Supervision. International Convergence on Capital Measurement

and Capital.Standards, June 2006, paragraphs 9 and 756-760. < http://www.bis.org/publlbcbs128.pdf>.

87 Source: GAO. Bank Regulators Need to Improve Transparency and Overcome Impediments to Finalizing

the Proposed Basel II Framework. Report No. 07-253, page 91. February 15, 2007.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
firms' capital levels: and (2) identify instances (e.g., a firm's credit rating is

downgraded, or its unsecured debt trades at high spreads over Treasuries)when

firms should be required to raise additional capital, even if the firm otherwise

appears to be well capitalized according to CSE program requirements.

Liquidity 88

The Commission designed the CSE program to ensure that, in, a stressed

environment, a firm could withstand the loss of its unsecured financing for up to

one year,89 under the assumption that secured funding for liquid assets would be

available. In addition, the liquidity analysis assumes that any assets held in a

regulated entity are unavailable for use outside of the entity to deal with liquidity

issues elsewhere in the consolidated entity.9o The CSE program's gUidelines on

liquidity implement supervisory principles concerning liquidity in a manner that

attempts to be consistent with pillar 2 of Basel 11.91 .

According to agreements between the Commission and the United Kingdom's

Financial Services Authority entered into in April 2006, each CSE is required to

maintain a liquidity portfolio of cash or highly liquid debt and equity securities of

$10 billion, with the exception of Bear Steams, which was required to maintain a

liquidity portfolio Qf $5 billion. The liquiditY requirement for Bear Steams was

lower because it was the smallest eSE. Bear Steams was continuously

compliant with this reqUirement.

Bear Steams initiated a plan in November 2006 to increase its liquidity levels and

in fact (according to TM data), it significantly increased its liquidity levels from

. 88 According to the Commission, "Plt is important to realize capital is not synonymous with liquidity. A firm

can be highly capitalized, that is, can have more assets than liabilities, but can have liquidity problems if

the assets cannot quickly be sold for cash or alternative sources of liquidity, including credit, obtained to

meet other demands. While the ability of a securities firm to withstand market, credit, and other types of

stress events is linked to the amount of capital the firm possesses, the firm also needs sufficient liquid

assets, such as cash and U.S. Treasury securities, to meet its financial obligations as they arise.

Accordingly, large securities firms must maintain a minimum level of liqUidity in the holding company.

This liquidity is intended to address pressing needs for funds across the firm. This liquidity consists of

cash and highly liquid securities fur the parent company to use without restriction.·

Source: Answers to Frequently Asked InvestorQuestions Regarding The Bear Steams Companies. Inc.

Commission. 18 March 2008. <http://www.sec.gov/newslpress/2008l2008-46.htm>.

89 Source: Risk Management and its Implications fur Systemic Risk Before the U.S. Senate

Subcommittee on Securities, Insurance, and Investment Committee on Banking, Housing. and Urban

Affairs, 110th Congo (June 19,2008) (statement by Erik Sim, DirectorofTM, Commission).

90 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://WNW.sec.gov/divisions/marketreglhcsupervision.htm>.

91 Sources for this information include:

• Basel Committee on Banking Supervision. International Convergence on Capital Measurement

and Capital Standards, June 2006. paragraphs 738 and 741.

< http://www.bis.org/publlbcbs128.pdf>; and .

• Basel Committee on Banking Supervision. Sound Practices for Managing LiqUidity in Banking

Organizations. February 2000. <http://INWW.bis.org/publlbcbs69.pdf?noframes=1>.

SEC's Oversight of Bear Steams and Related Entities: The CSE Progr:am

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September 25, 2008
May 2007 until it suddenly collapsed during one week in March 2008.92

According to the Commission, Bear Steams collapsed because it experienced a

liquidity crisis when it lost its secured financing. The collapse of Bear Steams

thus indicates that the CSE program's liquidity guidelines (implementing the spirit

of pillar 2 of Basel II) are inadequate in two respects. First, the time horizon over

which a liquidity crisis unfolds is likely to be significantly less than the one-year

period. Second, secured lending facilities are not automatically available in

times of stress.

Bear Steams' liquidity planning indicates that Bear Steams was well aware of

these impractical aspects of the CSE program's approach to liquidity more than a

year before it failed. :, Bear Steams

. . it had developed a 60-day cash inflow and outflow analysis that it

could use to track cash flows ona daily basis.93 the

60-day stress test "provides a detailed cash inflows and outflows analysis during

the most critical part of a liquidity crisis."94 The 60-day analysisLhowever, did not

assume that secured funding was always available. Instead, the analysis

assumed the availability of existing credit Iines.95 A 60-day period corresponds

more closely than a one-year period to the timeframe over which a liquidity crisis

unfolds. A 60-day period also corresponds to a time period over which a firm

can raise new equity capital in an orderly manner. In this sense, Bear Steams

realized that the one-year period was not realistic and also recognized that

secured funding might not be available in times of stress. .

In November 2006, Bear Steams also undertook efforts to line up committed

secured lending facilities. The fact that Bear Steams made a special effort to

line up committed secured lending facilities indicates that Bear Steams did not

think that such facilities would automatically be available in a stressed

environment. f the secured funding initiative was

improving the firm's performance in the 60-day stress scenarios, because the 60-

day stress scenarios did not assume that secured funding would always be

available as contemplated by the CSE program's one-year liquidity stress test.

Bear Steams planned to extend its 60-day stress model to one year and to

modify its analysis to include unused credit lines only to the extent that they were

committed.9

.

6 As part of its secured funding initiative, Bear Steams planned to

use uncommitted lines of credit on an ongoing basis, thus increasing its access

92 According to the Commission, Bear Steams had a high liquidity level of $21 billion in early March 2008

(i.e., before the week of March 10) compared to $7.6 billion in May 2007 (according to TM data). Bear

StealT!s' rp.ouired liquidity was $5 billion.

, SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
to credit in a stressed environment where uncommitted lines might not be

available.97

TM believed that the secured funding

initiative helped Bear Stearns weather the credit difficulties it faced during the

summer of 2007, when two hedge funds sponsored by Bear Steams' Asset

Management (BSAM) failed. .

An

evergreen facility allows a borrower to lock in funding for a predetermined

minimum period of time. For example, in a six-month evergreen facility, the

lender must give notice to terminate the facility six months before being entitled

to start getting its money back. If Bear Stearns had such facilities, which were

terminated, such terminations would have created potential financial stress for

Bear Steams with a known, contractually predetermined time lag. Therefore, it

would have been important for TM to know about such terminations, in order for

TM to anticipate the potential financia1 stress. OIG has asked TM for information

concerning whether TM knew about terminations of any evergreen facilities

providing secured collateralized lending to Bear Steams, but OIG has been

unable to determine what additional information TM had about any such

facilities, including terminations.

To summarize, as early as November 2006, Bear Steams was implementing a

more realistic approach to liqUidity planning than contemplated by the CSE

programs' liqUidity stress test. While this more realistic approach may have

helped Bear Steams in the summer of 2007, it was not sufficient to save the firm

in March 2008. Bear Stearns'initiative to line up secured funding indicates that

the crisis which occurred in March 2008 was not totally unanticipated by Bear

Steams, in that Bear Steams had been taking specific steps to avoid such a

crisis for more than a year before it occurred.

According to the expert retained by OIG in conjunction with this audit, the need

.for Basel II films to undertake specific efforts to line up committed secured

funding in advance of a stressed environment depends on the extent to which

the Basel II firms can rely on secured lending facilities from the central bank

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
during a liquidity crisis. On the one hand, if it is assumed that secured lending

facilities will always be available from the central bank, lining up committed

secured lending facilities is not necessary. In this case, a liquidity stress test,

which assumes that secured lending facilities will automatically be available is

appropriate. On the other hand, if it is assumed that collateralized central bank

lending facilities might not be available during a time of market stress,-Baselll

firms have incentives to line up committed secured lending facilities, in advance,

from other sources. I.n the context of CSE.firms which are not banks, the policies

of the Federal Reserve towards making collateralized loans to non-banks

becomes an important element of their liquidity planning process.

Subsequent to the collapse of Bear Steams, the Basel Committee released a

draft set of updated guidelines concerning supervision of Iiquidity.99

Recommendation 2:

The Division of Trading and Markets, in consultation with the Board of Governors

of the Federal Reserve System, should reassess pillar 2 of the Basel II

framework and the Consolidated Supervised Entity (CSE) program gUidelines

regarding liquidity and make appropriate changes to the CSE program's liquidity

requirements. Changes should describe assumptions CSE firms shoulp be

required to make about availability of secured lending in times of stress

(inclUding secured lending from the Federal Reserve) and should spell out

circumstances in which CSE firms should be required to increase their liqUidity

beyond levels currently contemplated by CSE program liquidity requirements.

Finding 2: TM Did Not Adequately Address

Several Significant Risks That Impact The Overall

Effectiveness Of The CSE Program

TM did not adequately address several significant risks, which

affected the overall effectiveness of the CSE program.

.. .indicate that TM

often discussed risks, which turned out to be relevant, but the

discussions did not prompt TM to exert sufficient influence over

.Bear steams to make changes as a result of the risks identified.

Concentration of Assets

Bear Steams had a high concentration of mortgage securities. Prior to Bear

Steams becoming a CSE, TM was aware that its concentration of mortgage

securities had been steadily increasing.. For instance,

99 Source: Basel Committee on Banking Supervision. Principles for Sound Liquidity Risk Management and

Supervision. June 2008 - Draft for Consultation. <http://WINW.bis.org/publlbcbs138.pdf?noframes=1>.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

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17
TM staff even found that the amount of mortgage securities was ocCasionally

For instance,

Furthermore, according to TM's own documentation,

In the course of their activities, supervisors should assess the

extent of a bank's credit risk concentrations, how they are

. managed, and the extent to which the bank considers them in its

iritemal assessment of capital adequacy under Pillar 2. Such

assessments should include reviews of the results of a bank's

stress tests. Supervisors should take appropriate actions where the

risks arising from a bank's credit risk concentrations are not

adequately addressed by the bank.102

Yet, notwithstanding, . and warnings in the

Basel standards, TM did not make any efforts to limit Bear Steams' mortgage

securities concentration. .

Recommendation 3:

The Division of Trading and Markets should ensure that it adequately

incorporates a firm's concentration of securities ·into the Consolidated Supervised

Entity (CSE) program's assessment of a firm's risk management systems (e.g.,

internal controls, models, etc.) and more aggressively prompts CSE firms to take

appropriate actions to mitigate such risks. .

- - 102 Source: Basel Committee on Banking Supervision: International Convergence on Capital Measurement

and Capital Standards, June 2006. paragraph 777. < http://www.bis.org/pubVbcbs128.pdf>. .

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

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Leverage

Prior to the adoption of the rule amendments which created the CSE program,

the broker-dealers affiliated with the CSE firms were required to either maintain:

• A debt to net capital ratio of less than 15 to 1 (after their first year of

operation); or

• Have net capital not less than the greater of $250,000 or two percent

of aggregate debit items computed in accordance with the Formula for

Determi'}ation of Reserve Requirements for Broker-Dealers.

However, theCSE program did not require a leverage ratio limit for the CSE

firms. As a result, Bear Stearns was highly leveraged, with a gross leverage ratio

of approximately 33 to 1 prior to its collapse.103 Leverage can affect liquidity risk.

For instance:

• The Counterparty Risk Management Policy Group (in June 1999)104

stated:

The link between leverage and funding liquidity risk is

relatively straightforward: leverage amplifies funding

liquidity risk...

• The President's Working Group (PWG) on Financial Markets105 Report

(in April 1999) on Long-Term Capital Management (LTCM) stated:106

In addition, the liquidity risk of a hedge fund interacts

with and is magnified by leverage, most clearly in

distressed market circumstances.107

Although TM has maintained that leverage is not directly related to liquidity, it is

clear that if a firm experiences a lack of confidence, its liquidity can be adversely

affected and that leverage can influence confidence levels. Thus, it is entirely

103 There are many definitions of leverage. Other firms also had high gross leverage amounts (i.e., assets

divided by stockholders' equity). See Appendix VI.

104 "In January 1999, a group of 12 major, internationally active commercial and investment banks

announced the formation of a Counterparty Risk Management Policy Group (CRMPG). The objective of

the Policy Group, whose formation was endorsed by Chairman Greenspan [then Federal Reserve

Chairman], Chairman Levitt [then Commission Chairman] and Secretary Rubin [then Secretary of the

U.S. Department of Treasury], has been to promote enhanced strong practices in counterparty credit

and market risk management.' Improving Counterparty Risk Management Policies, Counterparty Risk

Management Policy Group 2 (June 1999). .

105 In 1988, Executive Order 12631 established the President's Working ,Group (PWG). The PWG's

purpose is "...enhancing the integrity, efficiency, orderliness, and competitiveness of our nations

financial markets and maintaining investor confidence..." The PWG members are: the Chairmen of the

Commission, the Commodities Futures Trading Commission, and the Federal Reserve; and the

Secretary of the U.S. Department of Treasury.

106 Long-Term Capital Management (LTCM) was a very large U.S. hedge fund that collapsed in 1998.

However, apparently some counterparties treated LTCM as an investment bank and not a hedge fund.

107 Although, Bear Stearns was not a hedge fund, we believe that the concept of leverage's relationship to

liquidity still applies, especially since apparently some counterparties treated LTCM as an investment

bank and not a hedge fund.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

19
possible that Bear Steams' high leverage contributed to a lack of confidence in

the firm (including unsubstantiated rumors) which had an impact on its collapse.

In fact, TM believed in early 2006 that Bear Steams was still managing its

balance sheet at quarter end, a practice which suggests that Bear Steams was

aware that its leverage ratios affected market perceptions.108 Although banking

regulators have established a leverage ratio limit, the CSE program has not

established a leverage ratio Iimit.109 The adoption of leverage limits must be

reassessed in light of the circumstances surrounding the Bear Steams' collapse,

especially since some individuals believe that this policy failure directly

contributed to the current financial crisis.

Recommendation 4:

The Division of Trading and Markets, in consultation With the Board of Governors

of the Federal Reserve System, should reassess the Consolidated Supervised

Entity (CSE) program's policy regarding leverage ratio limits and make a

determination as to whether, and under what circumstances, to impose leverage

. ratio limits on the CSEs. -

Bear Stearns' Model Review Process and Risk Management

Staffing Were Inadequate in the Area of Mortgage Backed

Securities

Prior to Bear Steams' approval as a CSE in November 2005d OCIE found

, ., 11 nor did it

Further, OCIE found

_ It was critically imperative for Bear Steams' risk managers to review

mortgage models because its primary business dealt with buying and selling

mortgage-backed securities.

During the initial CSE aoolication, TM staff .

109 However, there are some fundamental differences between commercial and investment banks. For

instance, unlike investment banks, commercial banks rely on customer deposits.

110 "Value at Risk (VaR) is the maximum loss not exceeded with a given probability defined as the

confidence level, over a given period of time." Source: Wikipedia- The Free Encyclopedia.

<http://en.wikipedia.nmlwi1dNalue._at risk>.

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September 25, 2008
At a meeting with TM on September 20,2006, Bear Steams' risk managers

provided TM with .

_ According to the DIG expert,

this information is consistent with the interpretation that pricing at Bear Steams

was based more on looking at trading levels in the market than on looking at

models. This information is also consistent with the interpretation that traders

used their own models (perhaps empirically based) for hedging purposes and not

the ones that the risk managers were reviewing. When markets are liquid and

trading is active, market prices can be. used'to value assets accurately. In times

of market stress, trading dries Up and'reliable price information is difficult to

obtain. Models therefore become relatively more important than market price in

times of market stress than in times when markets are liquid and trading actively.

Such stressed circumstances force firms to rely more on models and less on

markets for pricing and hedging purposes.

. _ .114 Trad~~s often

combine long and short positions together, using the short positions to hedge out

some of the risks associated with long positions..For example, a trader might

shon a government bond to hedge the interest rate risk associated with a

mortgage-backed security. To construct an appropriate hedge ratio, traders use

information such as the sensitivity of the value of the assets to interest rate

changes or interest rate spreads. - .

- .. -_ . - - A VaR model is intrinsically based on more information than a

sensitivity of value to interest rate spread. A VaR model also incorporates an

assumption about the ratio of spread changes in one'asset to spread changes in

another. A VaR model can therefore tell the trader an appropriate hedge ratio to

use to reduce risks ass~ciated With fluctuations in spreads. i

"'.In_.

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September 25, 2008
. .115 Since VaR measures of risk reported to

TM are based on the risk -managers' models and not the traders' models, the

reported VaR numbers suggested a risk that was different than the risks the

traders thought they were bearing.. . .

. . _ raises the question of whether VaR risk measures were

taken seriously enough by Bear Steams' traders.

The DIG expert believes that interestrate and spread sensitivities were actively .

used as part of the discussion between risk managers and traders at Bear

Steams, but the OIG expert did not see evidence that the

additional modeling assumptions incorporated into VaR models added much tq

these discussions.

'16 Model validation personnel,

modelers, and traders all sat together at the same desk.117 Acc..ording to the DIG

expert, sitting together at the same desk has the potential advantage of

facilitating communication among risk managers and traders but has the

potential disadvantage of reducing the independence of the risk management

function from the trader function, in both fact and appearance.

In 2006, the expertise of Bear Steams' risk managers was focused on pricing

exotic derivatives and validating derivatives models. At the same time, Bear

Steams' business was becoming increasingly concentrated in mortgage

securities, an.area in which its model review still needed much work. The DIG .

expert concluded that, at this time, the risk managers at Bear Steams did not

have the skill sets that best matched Bear Steams' business model.

For instance, TM's discussions with risk managers in 2005 and 2006 indicated

that.

_ . , it would

have been difficult for risk managers at Bear Steams to advocate a bigger focus

on default risk in its mortgage models.

There was also turnover of Bear Steams' risk management personnel at critical

times. - .

119 .At exactly this' point-in time, Bear Steams had a

tremendous'need to rethink its mortgage models and lacked key senior risk

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
.... _-_._--_.. _...-------,

t _ _ _ .. . - .r. l

:.!l In

the opinion of the GIG expert, difficulties in communication are a potential red

flag indicating thata risk manager could be telling the traders to take on less risk

than they would otherwise choose to do (i.e., information that the traders would

presumably not want to hear). . . .. .

As a result, the

GIG expert concluded that the reviews of mortgage models that should have

taken place before the subprime crisis erupted in February 2007 appears to have

never occurred, in the sense that it was still a work in progress when Bear

Steams collapsed in March 2008.

To summarize, TM was aware that risk management of mortgages at Bear

Steams had numerous shortcomings, including lack of expertise by risk

managers in mortgage-backed securities at various times; lack of timely formal

review of mortgage models; persistent understaffing; a proximity of risk

managers to traders suggesting lack of independence; turnover of key personnel

during times of crisis; and an inability or unWillingness to update models qUickly

enough to keep up with changing circumstances. In 2006, TM missed an

opportunity to push Bear Steams aggressively to add expertise in mortgage

modeling·to the risk management staff, to review mortgage models in a timely

manner, to add incorporate default rates into mortgage modeling, and to make

sure that mortgage risk management could function efficiently in a stressed

environment.

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September 25, 2008
Recommendation 5:

The Division of Trading and Markets (TM) should ensure that: (1) the

Consolidated Supervised Entity (CSE) firms have specific criteria for reviewing

and approving models used for pricing and risk management, (2) the review and

approval process conducted by the CSE firms is performed in an independent

manner by the CSEs' risk management staff, (3) each CSE firms' model review

and approval process takes place in a thorough and timely manner, and (4)

impose limits on risk taking by firms in areas where TM determines that risk

management is not adequate.

Risk Scenarios

When Bear Steams applied to be a CSE, TM reviewed the independent risk

management function at Bear Steams in 2005.126 In addition to VaR, Bear

Steams used stress scenarios to capture risks associated with history-based and

hypothetical scenarios. TM reviewed a sample of a U

••• ---- - .--- ---- .--- A ••_- - --_ ••• - *;JvU

Most of these proposed scenarios related to the

market for residential mortgages. For example, the proposed scenarios

contemplated shocking the credit spreads for both high grade and high yield

mortgage-backed securities separately.

Bear Steams' VaR models did not capture risks associated with credit spread

widening of non-agency mortgages that are prime or near-prime (Alt-A).l28. Thus,

the residential mortgage stress tests were potentially beneficial in that they

quantified potential risks not otherwise captured. The OIG expert did not find

documentary evidence indicating that these scenarios were actually

implemented or SUbsequently discussed with TM until 2007. Furthermore, the

OIG expert believes that meaningful implementation of high grade and high yield

mortgage credit spread scenarios requires both a measure of sensitivity of

mortgage values to yield spreads as well as a model of how fundamental

mortgage credit risk factors make yield spreads fluctuate. These fundamental

factors include housing price appreciation, consumer credit scores, patterns of

delinquency rates, and potentially other data. These fundamental factors do not

seem to have been incorporated into Bear Steams' models at the time Bear

Steams became a CSE.

( - ......_. t • ~-r-·"'·

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September 25, 2008
The presence of the proposed mortgage scenarios in the materials TM reviewed

in 2005 indicates that both TM and Bear Stearns knew that incorporating these

features into Bear Steams' risk management was important for effective risk

management. The absence of their implementation suggests that Bear Steams

did not have in place in 2005 the risk management technology needed to

implement the scenarios in a meaningful manner.

. __ The DIG expert

concluded ' _that Bear Steams' risk

managers analyzed these risks carefully. Additionally, TM collected a great deal

of information on other aspects of risk management, including the organizational

structure of the risk management process, model verification, and price

verification. -

The DIG expert however, also concluded that the internal TM memoranda

provide no discussion of the most serious forward-looking risk scenario that Bear

Steams might face, which was a complete meltdown of mortgage market liquidity

accompanied by fundamental deterioration in the mortgages themselves,

resulting from falling housing prices.

In April 2006 through June 2006•

• -_ ••&.

.: ....

..... " .. __ '" _ .. 131 In

TOcusing on Bear Steams' problems with this subsidiary, the OIG expert believes

that in 2006, TM identified precisely the types of risks that evolved into the

subprime crisis in the U.S. less than one year later. Yet, TM did not exert

influence over Bear Steams to use this experience to add a meltdown of the

subprime market to its risk scenarios. Moreover, TM did not use this event to

exert influence on Bear Steams to reduce its exposure to subprime Igans,as

previously discussed on page 17.

.J2006.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
In terms of large drops in market prices and large asset write-downs on

mortgager-backed securities, the subprime crisis beganto affect the U.S. around

December 2006. The drop in prices tended to hit residuals from mortgage

securitizations first. When mortgages or other assets are securitized, the

tranches, which have the highest certainty of payment, typically receive "MA"

ratings. The tranches with lowest credit quality are called "residuals," and these

tranches bear credit losses before the higher rated tranches bear credit losses.

In February 2007, Bear Steams told TM th~t it had written ,r,

; down by - , after writing the residuals down

by , . i2 Additional write-downs the foliowing month

brought total losses on second lien inventory t - - - - ----. I and total losses on

residential mortgage backed securities and structured products to ,

million.133 The write-downs during this Quarter were mostly on \. ..

by ~~ __.._ ,,_, . . __.. ... '''- .-_,._._ -----';;r-;;r--' .,.)0 TM

described the residual write-downs as a meltdown that was worse than what

Bear Steams could have predicted over a year before Bear Ste~ms collapsed.137

Prior to these write-downs,L __ .... . __ '... _. _. _..... .__ .J risks - - .

"._--" -

The OIG expert believes that the greater risk was that the mortgage market

would deteriorate further, with losses spreading from sub-prime loans to AIt-A

loans and even to higher rated agency securities.140 In fact, this scenario did

unfold. T: .

...~~.._. __ ._.. _ _ However, TM did

not appear to have sufficiently encouraged Bear Steams to incorporate into its

risk management forward-looking risk scenarios based on risks identified and

discussed during the regular monthly meetings between TM and Bear Steams.

Such scenarios could have included the consequences of much higher

delinquencies on subprime and Alt-A mortgages, the consequences of rating

4 •• _"

SEC,s Oversight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
downgrades on mortgage-backed securities, contagion and loss of liquidity from

losses on mortgage-backed securities. By July 2007, deterioration of mort~ages

had spread to. highly rated securities such as AAA paper backed by Alt-A

mortgages, and Bear Steams reported $570 million in losses for the month.142

Towards the end of 2007, Bear Stearns incorporated measures to reflect house

price appreciation or depreciation into its mortgage models. It also developed a

housing led recession scenario which it could incorporate into risk management

and use for hedging· purposes. By this time, Bear Steams had large inventories

of mortgage related assets, which had lost both their value and their liquidity.

Since it was difficult for Bear Steams to reduce its inventory by selling assets, .

this scen'ario helped Bear Steams focus its attention on ways to hedge its

mortgage risk by using more liquid instruments.

It is not the purpose of this discussion to claim that Bear Steams' use of scenario

analysis was better or worse than other CSE firms. TM asserts_that Bear .

Steams' use of scenario analysis was consistent with industry practices and the

entire banking sector failed to anticipate the magnitude and scope of the housing

decline that is still ongoing.

Recommendation 6:

The Division of Trading and Markets should be more skeptical of Consolidated

Supervised Entity firms risk models and work with regulated firms to help them

develop additional stress scenarios that mayor may not have not have been

contemplated as part of the prudential regulation process.

Recommendation 7:

The Division of Trading and Markets (TM) should be involved in formulating

.action plans for a variety of stress or disaster scenarios, even if the plans are

informal, including plans for every stress scenario that the Consolidated

Supervised Entity (CSE) firms use in risk management, as well as plans for

scenarios that TM believes might happen but are not incorporated into CSE

firms' risk management.

Non-compliance with Basel II

Mark Disputes

The subprime mortgage crisis began to affect the U.S. economy around

December 2006. As the subprime crisis continued into the summer of 2007, TM

learned that mark disputes were becoming more common.143 A markdispute

can occur when two parties to a derivatives transaction, such as a swap,

disagree over the value of the derivative. A mark dispute can also occur in a

repurchase agreement (repo) transaction, when the borrower and the lender

disagree over the value of the collateral. Mark disputes can lead the two parties

142 Source: TM's intemal credit meeting memorandumwith Bear Steams dated July 2007.

143 Source: TM's intemal credit meeting memorandum with Bear Steams dated July 2007.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program Septemb.er 25, 2008

Report No. 446-A . .

27
to a swap or financing transaction to each make margin calls on the other.

. ._. TM says that mark

disputes are an unavoidable issue faced by all dealers (particularly when

markets for underliers become less liquid), arid the total disputed numbers at

Bear Steams are much smaller than at other institutions.

145 L.-.

14

_.,. ""c

,.:fI'·....,.....--

", ........-..... ......: 1'-

_0 - -.'~n'''';:Ir')rJ· ••••_ ''''0 __

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

Report No. 446-A

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_September 25, 2008
Recommendation 8:

. The Division of Trading and Markets should take steps to ensure that mark

disputes do not provide an occasion for Consolidated Supervised Entity firms to

inflate the combined capital of two firrris by using inconsistent marks.

Inconsistent VaR Numbers

. ..'~ ••_. q For example:when markdowns on assets occurred,

Bear Steams' risk managers had difficulty explaining whether the markdowns

were a delayed response to market moves resulting in changes in VaRrisk .

factors or updates based on asset specific information (such as delinquency

rates on individual assets).

In some cases, Bear Steams' risk managers had difficulty explaining how

firmwideVaR numbers were related to desk-specific VaR numbers. The OIG

expert believes that this occurred because each of Bear Steams' trading desks

evaluated profits and risks individually, as opposed to relying on one overall firm- .

wide approach. On some occasions, Bear Steams' several trading desks had

opposite positions in various instruments (e.g., some desks were long sUb-prime

while other desks were short sUb-prime), and Bear Steams used VaR numbers

more for regulatory reporting than for internal risk management. This .

inconsistency between use of VaRfor internal and regulatory reporting purposes

does not comport with the spirit of Basel II and makes it harder for TM to

understand what is going on inside the firm. TM encouraged Bear Steams to do

a better job of presenting risks in a manner that made it easier to understand the

relationship between firm-wide desk,..level risks. Bear Steams' risk management

was working on improved reporting, perhaps influenced by TM's encouragement.

Recommendation 9:

The Division of Trading and Markets should encourage the Consolidated

Supervised Entity (CSE) firms to present VaR and other risk management data

in a useful manner, which is consistent with how the CSE firms use the

information internally and which allows risk factors to be applied consistently to

individual desks.

Bear Stearns' Capital Requirements for Illiquid Assets and Stressed Repos

Require Careful Oversight.

As the subprime crisis worsened in June 2007, the market began to freeze up

and formerly liquid assets lost much of their liquidity. .

_ _ _. TM stated that, in

some instances, TM required a full deduction for certain illiqUid assets, such as

mortgage residuals. Since the decline in liquidity of many mortgage-related

SEC's Oversight of Bear Steams and Related Entities: The CSE Program·

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September 25, 2008
assets was so unprecedented, and the decline in liquidity increased the

difficulties associated with valuing such illiquid assets, it would have been

prudent for TM to consider expanding the list of assets that require a full

deductio'n from capital. The DIG expert was unable to find documentary

evidence that TM considered expanding the list of assets that required a 100%

capital deduCtion. -

When the Basel Standard is operating correctly, firms take markdowns on the

value of trading book assets as the value of the assets decline. When market

illiquidity increases and assets become more difficult to value, these markdowns

should include valuation adjustments which not only take account of declining

. market values but also add an element of conservatism based on widening bidask spreads and the high costs that would be been incurred by a firm to liquidate

its assets ina stressed environment.149 These markdowns result in a decline in

Tier 1 capital.

At times of market stress, when banks often need to take large markdowns,

raising additional Tier 1 capital is often very expensive, due to factors such as a

bank's falling stock price and negative signaling concerns, which could cause a

bank's stock price to fall even further. In such circumstances, ban!<s have a

perverse incentive (associated with what is called "moral hazard") to postpone

taking markdowns that would require the banks to raise.additional capital. As an

alternative to taking markdowns while continuing to hold assets whose value is

questionable, banks have an incentive to consider selling such assets into the

market. When selling an asset, Tier 1 capital is reduced by the amount of losses

on the sale, but capital requirements are also reduced by removing the asset

.from the bank's portfolio. A bank looking to improve its Basel capital ratios by

selling assets therefore has a perverse incentive not to sell assets that have

modest capital requirements relative to the markdowns the banks should have

taken but has not yet taken. This perverse incentive tends to amplify the

tendency for markets to freeze up and become illiqUid by reducing trading

volume that would otherwise occur as banks sell losing positions into the market.

On the one hand, these perverse incentives are mitigated to the extent that

capital reqUirements on such assets are high and valuations are appropriately

conservative. For assets that face a 100% capital haircut, for example, the bank

gains no improvement in its ,capital ratios by avoiding'taking a markdown, and

the bank increases its capita] by the 'proceeds of any asset sales. On the other

hand, these perverse incentives are worsened to the extent that supervisors.

allow banks to avoid marking assets down quickly enough, to avoid taking

appropriate valuation adjustments in a timely manner, or to understate assets'

risks.

As the subprime crisis worsened, numerous Bear Stearns' repo counterparties,

such as hedge funds with positions in mortgage related assets, suffered losses

149 Source: Basel Committee on Banking Supervision: International Convergence on Capital Measurement

and Capital Standards, June 2006, paragraph 700. < http://www.bis.org/publlbcbs128.pdf>.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25; 2008

Report No. 446-A

30
and demands for redemptions. Some of these hedge funds became financially distressed. r'~! a.' -.

• . - - - . - - -g-

. . Consistency with tile spirit of Basel II requires that the

capital for a stressed repo counterparty (with no assets other than the collateral it

has posted) be at least as great as the capital requirement Bear Stearns would

face if it purchased the collateral for the amount owed on the repo transaction.

The OIG expert believes that suggest that Bear Steams

may have been taking a smaller capital charge than Basel II requires. In

addition, . do not indicate that TM pressured Bear.

. Steams to take more aggressive capital charges on stressed repos.

..

Lastly, BSAM's "High Grade" hedge fund became a very large, stressed repo

counterparty to Bear Steams during the summer of 2007.151 As of June 2007,

Bear Steams loaned . .0 BSAM's "high grade" fund. The loan was

collateralized with assets estimated to be worth' 3y the end of

June 2007, asset sales had reduced the amount loaned to the fund down to

'el

Although the BSAM investors may have benefited to some extent from increases

in the value of the collateral, Bear Steams bore all risks associated with the

downside. Since Bear Steams bore all downside risks, sound risk management

(consistent with Basel II) requires that the impact on Bear Steams' capital

associated with these rapos should have been at least as great as the impact

Bear Steams would incur if it held the assets in its own trading book at the end of

June 2007.

. According to the OIG expert, a stressed repo is conceptually similar to a portfolio

with a call option written against it, where the portfolio is the repo collateral and

the call option is the upside gains to the stressed counterparty. Such a stressed

repo is worth less than the portfolio itself, since the call option might have some·

value. In addition, the value of this stressed repo should have reflected the

posSibility that Bear Steams might not benefit fully from potential upside gains in

the value of the collateral. Furthermore, to the extent that the .

collateral was illiquid and would·take time to liquidate, Bear Stearns should have

valued the collateral conservatively, reflecting appropriate valuation adjustments.

- ._., 0.

150 SOl

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- - - -"',I ._"".,

September 25. 2008
--·r - -

portfolio with a call option written against it.

" ..--_." ..- •....... This arrangement is similar to a

The DIG expert did not find any evidence suggesting that TM exerted influence

on Bear Steams to take significantly larger capital charges in conjunction with

the BSAM financing than would have been appropriate if the repo were not

stressed. For instance, ' . . 0 ._._ •

.......-.- -_._._--~ -..--- _.. - - - .

TM staff could have used much tougher language to describe (to senior TM

management) the very risky situation in which Bear Stearns had put itself and

exerted influence over Bear Steams accordingly. For example, TM staff could

have stated that Bear Steams' financing of the High Grade fund appeared to

have allowed Bear Steams to delay taking a huge hit to its capital, as required by

Basel I!.

Bear Steams' financing of the BSAM funds is conceptually similar to implicit

support. According to Basel II, "Implicit support arises wh~n a bank provides

support to a securitization in excess of its predetermined contractual

obligation.,,155 Although the BSAM funds are not themselves, literal

securitizations, the funds invested in securitizations, and Bear Steams' financing

of the BSAM funds is a form of support in excess of Bear Steams' contractual

obligations to the funds. The repo structure created the potential for Bear

Steams to overstate the amount of risk borne by BSAM and understate its own

exposure; as a result, .Bear Steams' capital calculation'would understate its true

risk.1!X! Basel II also requires that "When a bank has been found to pr~:)Vide

implicit support to a securitization, it will be required to hold capital against all of

the underlyin~exposures associated with the structure as if they had not been

securitized.,,1 In the opinion of the DIG expert, it would have been approp·riate

••• a _ ••

x r ..... - --- .--.r;.....- .

SEC's Oversight of Bear Steams and Related Entities: .The CSE Program September 25, 2008

Report No. 446-A

32
for TM to have treated the BSAM financing in a manner parallel to the way in

which Basel" mandates that implicit support be treated.

In fact, Bear Steams eventually acquired much of the remaining portfolio and

wrote its value down by : ., . ;

Recommendation 10:

The Division of Trading and Markets should ensure that the Consolidated

Supervised Entity take appropriate valuation deductions for illiquid, hard-to-value

assets and appropriate capital deductions for stressed repos, especially stressed

repos where illiquid securities are posted as collateral.

Tolerance for Risk

TM's oversight of the CSE firms did not include assessing the risk tolerance

(e.g., concentration of assets) of the CSEs' Boards of Directors_and other senior .

management (e.g., CEO). In fact, TM staff never contacted these individuals

about any matters relating to risk tolerance at any of the CSE firms, including .

Bear Steams prior to its collapse. .

We conclude based on our research that discussing risk management practices

and risk tolerance with the CSEs' Boards of Directors is a prudent oversight

procedure.159 This type of assessment would as.sist TM staff to evaluate

governance issues in the CSE firms. For example; in the case of Bear Steams,

an assessment could have been useful when there was evidence that the staff

kept increasing the firm's exposure to mortgage securities. TM staff could also

assess whether firms are inappropriately increasing leverage to help meet a

revenue level that is tied to compensation that is proVided to the CSEs' senior

·officers.160

Recommendation 11:

The Division of Trading and Markets (TM), in consultation with the Chairman's

.Office, should discuss risk tolerance with the Board of Directors and senior

management of each Consolidated Supervised Entity (CSE) firm to better

.understand whether the actions of CSE firm staff are consistent with the desires

of the Board of Directors and senior management. This information would

159 Sources for this information include:

• Risk Management and its Implications for Systemic Risk Before the U.S. Senate Subcommittee on"

Securities, Insurance, and Investment Committee on Banking, Housing, and Urban Affairs, 110th

Congo (June 19,2008) (statement of.Erik Sirri Director ofTM, Commission);

• The Comptroller of the Currency. Liguiditv and Funds Management Manual, February 2001, page

27; and

• The Counterparty Risk Management Policy Group. Containing Systemic Risk: The Road to

Reform. August 6, 2008, page 18.

SEC's OverSight of Bear Steams and Related Entities: The CSE Program

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September 25, 2008
enable TM to better assess the effectiveness of the firms' risk management

systems.

Finding 3: TM, Without Explicit Authority, Allowed

The CSE Firms' Internal Auditors To P.erform

Critical Work

TM, without explicit authority, allowed the firms' intemal auditors to

perform critical work involving the risk management control

systems. As a result, there are significant questions as to whether

the work that TM relied upon in fulfilling its oversight role was as

. thorough or meaningful as the Commission intended in approving

the rule amendments.

The CSE firms are required by the rule amendments which created the CSE

program (see 17 CFR §240.15c3-1g(b)(1)(iii)(B» to have their external auditors

report161 on the firms' risk management control systems. This review is critical

because TM designed the CSE program to focus on a firm's risk management

systems (e.g., internal controls, models) and their financial condition (e.g.,

compliance with capital and liquidity reqUirements), which was to be the focus of

the external auditors' work. However, after the Commission approved the rule,

TM decided that the firms' internal auditors could perform this critical work,

instead of the external auditors.

We reviewed the delegations of authority from the Commission to TM and found

no explicit authority for TM to approve this change. In addition to the apparent

lack ofTM's legal authority, there are serious questions about the wisdom of this

decision. The rule's requirement that external auditors perform the risk

management work helps to ensure the independence and quality of this critical

audit work. The external auditors' work is more strictly regulated as the Public

Company Accounting OversightBoard (PCAOB) regulates external auditors.162

161 The report is referred to in the rule as the -Accountanfs Report on Internal Risk Management Control

System.·

162 The Sarbanes-Oxley Act of 2002 (SOX). Public Law No. 107-204, was enacted in July 2002 in response

to numerous financial statement accounting scandals involving public companies (e.g., Enron and

WorfdCom) and their auditors (e.g., Arthur Andersen). Among other reforms, SOX established the

Public Company Accounting Oversight Board (PCAOB) as a nonprofit corporation. The PCAOB's

statutory mission is "to oversee the audits of public companies that are SUbject to the securities laws,

and related matters, in order to protect the interests of investors and further the public interest in the

preparation of informative, accurate, and independent audit reports for companies the securities of which

are sold to, and held by and for, public investors: (Section 101{a) ofSOX, 15 U.S.C §7211{a». SOX

reqUires that accounting firms be registered with the PCAOB, if they ·prepare or issue, or participate in

the preparation or issuance of, any audit report with respect to any issuer" as defined in Section 3 of the

Securities Exchange Act of 1934.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

34
. __ ••• __ 10.110.""'"

As a result of TM's decision to allow CSE firm's internal auditors to perform the

work, there are significant questions as to whether this work that TM relied upon

was as thorough or meaningful as the Commission intended in approving the

rule.

Recommendation 12:

The Division of Trading and Markets should require compliance with the existing

rule that requires external auditors to review the Consolidated Supervised Entity

firms' risk management control systems or seek Commission approval in

.accordance with the Administrative ProceduresAct164 for this deviation from the

current rule's requirement.

Finding 4: TM Did Not Review·The

Communications Strategy Component Of Bear

Stearns' Contingency Funding Plan After The

.Collapse Of Two Of Its Managed Hedge Funds

TM did not review the communications strategy component of Bear

Steams' Contingency Funding Plan (CFP) after two of its managed

hedge funds collapsed in June 2007. Questions regarding Bear

Steams' effectiveness in communicating with its investors and the

pUblic were raised after the collapse of its hedge funds and again

after the firm collapsed in March 2008.

163 Given the scope of our audit, we have no evidence linking these ·significant deficiencies' with the cause

of Bear Steams' collapse. .

164 The Administrative Procedu~es Act (5 U.S.C. §500 et. seq.,) sets forth the basic procedural requirements

for ~g·ency rulemaking. It generally reqUires (1) publication of a notice of proposed rulemaking in the

Federal Register, (2) opportunity for public participation in rulemaking by submission of written

comments, and (3) pUblication of a final rule and accompanying statement of basis and purpose.not less

than 30 days before the rule's effective date.

SEC's Oversight of Bear Steams and Related Entities: The CSE Program September 25,2008

Report No. 446-A

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TM reviewed Bear Stearns' CFP during its application process. The review

included an assessment of its internal and external communications strategies.

According to TM:

The goal of the contingency funding plan is to manage liquidity risk

and communicate effectively with creditors, investors, and

customers during a funding crisis. 165 .

In June 2007, two of Bear Stearns' managed hedge funds collapsed. After the

. collapse, questions were raised about the lack of involvement by some of Bear

Stearns senior management in handling th~ crisis. For instance, according to

media reports, at an August conference call with investors, the conduct of a

senior Bear Stearns official (i.e., their lack of involvement in the telephone. call)

did not apparently help to restore confidence in the firm (which.was the purpose

of the meeting). .

TM did not reassess the communication strategy component of Bear Stearns'

CFP after the collapse of its hedge funds. Although there was contact between

TM and Bear Stearns (about many issues) after the June 2007 collapse of its .

hedge funds, at no point did TM discuss Bear Stearns' communication strategy.

This proved particularly problematic as questions were once again raised about

some of Bear Steams' management166 regarding its handling of the crisis dUring

the week of March 10, 2008.

Conversely, some individuals praised Lehman Brothers Holdings Inc. (Lehman

Brothers) management for its handling of a crisis it previously experienced (e.g.,

Lehman Brothers provided talking points to its traders to use with its trading

partners). In fact, some of these individuals credited Lehman Brothers'

management with helping to save the firm during/around the week of March 10,

2008, when Bear Steams collapsed.167

It is undisputed that a firm's communication strategy can affect confidence levels

in the firm. Bear Steams' collapse illustrated the importance of confidence for an

investment bank's survival.

Recommendation 13:

The Division of Trading and Markets ~hould ensure that reviews of a firm's·

Contingency Funding Plan include an assessment of a Consolidated Supervised

Entity firm's internal and external communication strategies.

165:-' .

16€ vve ala nor·asses the performance of Bear Stearns' management during the collapse of the hedge funds

or Bear Steams.

167 While Bear Steams collapsed in March 2008, concerns about Lehman Brothers' survival began to

circulate and on September 15, 2008, Lehman Brothers announced that it would file for bankruptcY.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

36
Finding 5: TM's Monitoring Staff Do Not

Adequately Track Material Issues -

TM's monitoring staff identify numerous issues involving internal

risk management systems (e.g., the ad~quacy of CSE staffing

levels in various departments, the functioning of the internal audit

office, ano the adequacy of documented policies and procedures)

which require action by the CSEs and a resolution. However, TM

does not adequately track the issues. .

Develop a Formal Automated Tracking Process

TM's monitoring staff does not have a formal proce-ss (e.g., automated) to track

material issues to ensure that they are adequately resolved. The monitoring staff

mainly identify issues through meetings with CSE firm staff. Currently, TM staff

document some issues (e.g., the adequacy of the CSE staff levels in various

departments, the functioning of the internal audit office and the adequacy of

documented policies and procedures) in e-mails and organizes them by firm

while other issues are documented in monthly memoranda to senior

management (e.g~, the Division Director).168

However, these current methods are not reliable and do not provide an audit

trail. Our review of TM's documentation supports this assertion because we

assessed twenty issues169 that TM and OCIE identified with the CSE firms and

we asked TM to explain how the issues were resolved. In some instances, the

staff needed to perform detailed research in order to determine how the issues

were eventually resolved. For example, OCIE staff found that Bear Steams'

Legal & Compliance group did not have any formal documentation that identified

and assessed all of the applicable rules, laws, regulations, requirements and

risks. pertaining to the entire organization. TM could not readily tell us how and

whether this issue was resolved. The follow-up of issues that OCIE identified is

further discussed on page 38.

In a somewhat similar recent situation, the Government Accountability Office

(GAO) criticized OCIE for its .informal method- of tracking recommendations

regarding its Self Regulatory Organization (SRO) inspections. GAO stated:

OCIE's informal methods for tracking inspection recommendations

contrast.with the expectations set by federal internal control --

standards for ensuring that management has relevant, reliable, and

169 As discussed in the Scope and Methodology Section (see Appendix III).

SEC's Oversight of Bear Steams and Related Entities: The CSE Program

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37

September 25, 2008
timely information regarding key agency activities. These standards

state that key information on agency operations should be recorded

and communicated to management and others within the entity and

within a time frame that enables management to carry out its

internal control and other responsibilities. 170

Given all the facts discussed above, TM cannot provide reasonable assurance

(consistent with internal control standards) that issues are adequately resolved.

Furthermore, we believe that the risk of an issue being overlooked (i.e., not

adequately resolved by a firm) increases if, the CSE program receives additional

staff (as requested by Chairman Cox) because presumably more issues will be

identified and require resolution.

Recommendation 14:

The Division of Trading and Markets should develop a formal automated process

to track material issues identified by the monitoring staff to ensure that they are

adequately resolved. At a minimum, the tracking system shoutd provide the

following information:

• The source of the issue;

• When the issue was identified;

• Who identified the issue;

• The current status of the issue (e.g., new developments);

• When the issue was resolved; and

• How the issue was resolved.

Follow-Up on Prior OCIE Findings

In March 2007, Chairman Cox decided to transfer inspection responsibility from

OCIE to TM (responsibility was transferred to TM in March 2007 for four of the

five firms, and for the last firm (Morgan Stanley) following the completion of the

ongoing OCIE exam of that firm in September 2007). Thus consolidating the

oversight of the CSEs at the holding company level within TM. 171 OCIE

continues to perform inspections of the CSEs' broker-dealers.

170 Source: GAO. Securities and Exchange Commission: Opportunities Exist to Improve Oversight of

Self-Regulatorv Organizations, Report 08-33, November 15, 2007.

171 The transfer was in response to a GAO audit report (Financial Market Regulation: Agencies Engaged in

Consolidated Supervision Can Strengthen Performance Measurement and Collaboration. Report 07-

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- .

. TM stated that after Chairman Cox

transferred the inspection authority from OCIE to TM, not to follow-up

on issues that OCIE identified because they did not view the OCIE issues as

material and they assumed that these issues were OCIE's responsibility. OCIE

stated that they did not follow-up (i.e., conduct a new inspection) on the issues

because it was no longer their responsibility once Chairman Cox transferred the

inspections autho~ity to TM. 172 Although TM stated that it had communicated with

Bear Stearns about resolving this issue,

Bear Stearns' assertions that it had addressed this issue. Further,OCIE

As discussed in the Scope and Methodology section in Appendix IV, we

performed testing on TM's tracking of material issues. Our testing found

instances where TM's monitoring staff failed to ensure that issues identified by

OCIE were adequately resolved.

154, March 15,2007) recommendation. In response to the report Chairman Cox told GAO: "To

implement this recommendation, I have carefully considered the question of which organizational

structure will best achieve the goal of the CSE program. I have concluded that the success of the CSE

program will be best ensured if the supervision of the CSE firms is fully integrated with, rather than

merely coordinated with, the detailed onsite testing that is done of the documented controls at CSE

firms. As a result, I have decided to transfer responsibility for on-site testing of the CSE holding

company controls to the Division of Market Regulation [now called TM]. This will better align the testing

and supervision components of the CSE program, will strengthen its prudential character, and will most

efficiently utilize the Commission's resources. With the new structure, ongoing supervision activities will

be more directly informed by the results of focused testing of controls, and field inspections will be more

precisely targeted using information from ongoing supervisory work. In addition, the Commission's

expertise related to the prudential supervision of securities firms will be concentrated in the Division of

Market Regulation, which will foster improved communication and coordination among the staff

responsible for administering various components of the CSE program." The Chairman made his

decision after carefully evaluating proposals from TM and OCIE, and after consulting with the four other

Commissioners, who unanimously supported the decision to consolidate CSE oversight under TM.

172 After the Orders allowing the firms to use the alternative capital method were issued (from December

2004 to November 2005), OCIE retained the inspection authority until March 2007 for all the firms except

Morgan Stanley, which OCIE retained until September 2007, allowing OCIE to complete its inspection.

173 These issues were identified in a memorandum from OCIE to TM dated November 4, 2005.

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....." .... "'."':~"._ . _.. _. ._. _ The OIG expert found

similar problems with Bear steams' VaR models, which raised serious questions

about TM's oversight of Bear Steams.

As a result, it is possible. that other issues identified by OCIE were significant and

were not adequately followed up on by TM.

Recommendation 15:

The Division of Trading and Markets should: (1) reassess all the prior Office of

Compliance Inspections and Examinations (OCIE) issues. to ensure that no

significant issues are unresolved (givEmthe belief that OCIE followed up); and (2)

follow up on all significant issues.

Finding 6: The Commission's Orders Allowing

Firms (Including Bear Stearns) To Use The

Alternative. Capital Method Were Generally

Approved Before The Inspection Process Was

CompletedThe Commission approved firms to use the alternative capital

method before OCIE completed its inspection process.

OCIE's and TM's inspections of firms are a significant part of the application

process, and -are supposed to be completed prior to a firm's approval as a

CSE.174 The purpose of an inspection is to verify the information provided by the

firm and to "assess the adequacy of the implementation of the firm's internal risk _

management policies and procedures.,,175 However, four of five Commission

Orders approving the firms (those without principal regulators) to use the

alternative capital method were issued by the Commission before the inspection

process was completed, thereby rendering the application process less

meaningful.176 TM acknowledged that they were aware that OCIE did not

complete the inspection process prior to the Commission's approval.· Yet, TMrecommended to the Commission-

:without first completely verifying the information it was

174 As a result of the organizational change atthe Commission, OCIE would no longer be involved in the

application inspection.

175 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreglhcsupervision.htm>. .

176 Other than the inspection performe(j"during Bear Steams' application process, neitherTM nor OCIE

performed any additional inspections of Bear Steams involving firm-Wide issues (e.g., risk management)

. prior to its collapse. However, this does not include any inspections (e.g., financial and operational) that

FINRA performed of Bear Steams' broker-dealers.

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supposed to be relying upon and without ensuring thatthe firms had adequately

implemented internal risk management policies and procedures.

Specifically, we found that:

• In,' instances, the Commission approved the Order before OelE sent

the firms a formal letter (i.e., the deficiency letter) describing the issues '

, that were identified during the inspection. Bear Steams was one of these

firms. In fact, as previously discussed in Finding 5, during Bear

Steams' iospection, OCIE identified a significant issue involving Bear

Steams not retaining internal audit'workpapers. In fact, according to an

internal memorandum, TM and OCIE both agreed that they must reach an

agreement with Bear Steams on this issue prior to the approval of its CSE

application. While TM believes that Bear Steams implemented corrective

action, TM never verified Bear Steams' assertions that it had resolved this

i$Sue, as TM did not follow up on many of the OCIE issues.

• In two instances, the Commission approved the Order before the firms

responded to the deficiency letter.

TM indicated that they discussed the issues orally with the firms and were

comfortable with their responses and, as a result, recommended that the

i. OCIE stated that it was not involved in this

decision process at all.

Recommendation 16:

The Division of Trading and Markets should ensure that they complete all phases

of a firm's inspection process before recommending that the Securities and

Exchange Commission allow any additional Consolidated Supervised Entity firms

the authority to use the alternative capital method. '

Finding 7: Collaboration Between TM And Other

Commission Divisions/Offices Should Be

Significantly Improved

TM should improve its collaboration with the Division of Corporation

Finance (CF), OCIE, and the Office of Risk Assessment (ORA) in

order to achieve efficiencies and the overall effectivene~s of

Commission operations.

Collaboration with CF

The CF staff who review company filings (e.g., Form 10-K) are assigned to

Industry Groups within CF.' CF assigns firms to a particular group based 'on their

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September 25, 2008
Standardized Industrial Classification code. 177 Periodically, CF management

reassigns firms to adjust the staff's workload. During the past two years, CF

twice transferred the CSE firms to different Industry Groups.

CF staff stated that they received a briefing from TM regarding how the CSE

program operates. However, according to CF, TM did not provide any specifics

regarding the information that the CSE program obtains from the CSE firms.

We believe that the information that TM obtains could substantially improve CF's

filing review process. For instance, CF could evaluate whether the information in

the filing (e.g., mark to market accounting, VaR models, funding sources) is

consistent with TM's information. Furthermore, as a result of Bear Stearns'

collapse, CSE firms are now required to disclose additional information regarding

capital and liquidity. Also, Basel's Pillar 3 standard (when implemented) will

require additional disclosures regarding capital, risk exposures, and risk

assessment. TM stated that the CSE firms would incorporate all of these new

disclosures mainly into their CF filings. These additional disclesures will,

therefore, increase the need for collaboration between TM and CF..

Our audit found that CF could not opine on the potential usefulness of TM's

information on the filing review process since they are not aware of the

information that TM receives on the CSE firms. The effectiveness of CF's filing

review is potentially diminished because CF is not incorporating TM's information

on the CSEs into its review process.

Recommendation 17:

The Divisions of Corporation Finance (CF) and Trading and Markets (TM) should

take concrete steps to improve their collaboration efforts and should determine

whether TM's information on the Consolidated Supervised Entity (CSE) firms

could be used by CF in its review of the CSE firms.

Collaboration with OCIE

GAO found that TM and OCIE should improve communication (e.g., information

sharing) between their offices. 178 Although TM and OCIE informed GAO during

its audit in 2007, that they were working on an agreement to improve

communication, they never finalized the agreement.

In March 2007, Chairman Cox decided to transfer inspection responsibility from

OCIE to TM (responsibility was transferred to TM in March 2007 for-four of the

177 "The Standard Industrial Classification was created by the United States government as a means of

classifying industries by the use of a 4-digit coding system to collect economic data on businesses."

(Source:

http://www.business.com/directory/management/strategic_planning/business_information/industry_resea

ch/classification_systems/standard_industrial_classification_sic/.

178 Source: GAO. Financial Market Regulation. Agencies Engaged in Consolidated Supervision Can

Strengthen Performance Measurement and Collaboration, Report No. 07-154. March 15, 2007.

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42
five firms, and for the last firm (Morgan Stanley) following the completion of the

ongoing OCIE exam of that firm in September 2007). However, despite this

organizational change, TM and OCIE could still improve their collaboration

involving the broker-dealers of the CSE firms. OCIE stated that TM does not

provide it access to information that TM obtains from meetings with CSE staff,

filings submitted by the CSE firms, and other sources of information. OCIE

stated that all of this information could improve their risk-based broker-dealer

inspections. A senior staff official at a CSE firm stated there is no coordination

between TM and OCIE and this creates a challenge. OCIE stated that it believes

that it would still be useful to finalize the agreement to improve collaboration and

TM has not identified any substantive reasons to oppose finalizing the

agreement.

Recommendation 18:

The Division of Trading and Markets (TM) and the Office of Compliance

Inspections and Examinations (OCIE) should develop a collaboration agreement

(e.g., discussing information sharing) that maintains a clear deHneation of

responsibilities between TM and OCIE with respect to the Consolidated

Supervised Entity program. They should inform the Chairman's Office of any

disagreement(s) so that the issue(s) can be resolved.

Collaboration with ORA

The missions of ORA and the CSE programs' have certain similarities. ORA's

mission includes identifying emerging issues and market risks179 while the CSE's

program mission states that its purpose is to:

... allow the Commission to monitor for, and act quickly in response

to, financial or operational weakness in a CSE holding company or

its unregulated affiliates that might place regulated entities,

including US and foreign-registered banks and broker-dealers, or

the broader financial system at risk. 180 [Emphasis added]

We believe that a formal understanding between ORA and TM would increase

the likelihood that ORA achieves its mission while potentially minimizing

duplicative efforts in identifying and analyzing risks.

Recommendation 19:

The Division of Trading and Markets and the Office of Risk Assessment should

develop an agreement outlining their roles and responsibilities, as well as

methods for information sharing such as communicating project results. These

179 Source: Jonathan Sokobin Named Director of SEC's Office of Risk Assessment. Commission. 28

February 2008. <http://www.sec.gov/news/press/2008/2008-24.htm>.

180 Source: SEC [Commission] Consolidated Supervision of Broker-Dealer Holding Companies Program

Overview and Assessment Criteria. Commission. 16 Mar 2007.

<http://www.sec.gov/divisions/marketreg/cseoverview.htm>.

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two offices should inform the Chairman's Office of any disagreement(s) so that

the issue(s) can be resolved.

Finding 8: CF's Filing Review Of Bear Stearns'

2006 10-K Was Not Timely

CF is responsible for reviewing filings of all public reporting

companies, such as Bear Stearns. However, CF's review of Bear

Stearns' 20U6 1O-K was not timely.

Review of Bear Stearns' 10-K Filing

There are significant issues regarding CF's review of Bear Stearns' 2006 10-K

filing dated November 30, 2006. The filing review emphasized Bear Stearns'

disclosures involving its exposure to subprime mortgage securlties.181

Bear Stearns submitted its 2006 1O-K filing to the Commission on February 13,

2007. The CF staff accountant completed the initial review of Bear Stearns'

2006 1O-K filing on· : I, approximately months after Bear Stearns

submitted the filing. Another CF staff accountant completed a second level

review on September 27,2007, nearly months after the initial review. CF

could not provide a specific reason as to why the second reviewer did not

perform the review in a timely manner.

CF sent a comment letter182 to Bear Stearns on September 27,2007, which,

among other things, requested additional information on Bear Stearns' exposure

to subprime mortgage securities. Thus, it took CF nearly 7% months, after Bear

Stearns' initial filing, to send a letter to Bear Stearns requesting additional

information.

CF's policy is to send a comment letter to a firm prior to the firm's next fiscal

year-end. In the case of Bear Stearns, its next fiscal year-end was November

·30, 2007 and the Commission received its 2007 10-K on February 13, 2007.

According to CF's policy, CF needed to provide Bear Stearns with a comment

letter before November 30,2007. 183 In this way, the firm would have an

opportunity to incorporate appropriate changes into its next year's 1Q-K filing.

However, other than this policy, CF does not have any internal guidelines

regarding timeframes within which to review filings and issue comment letters. 184

181 CF staff performed a targeted review that focused on subprime mortgage exposure and revenue

recognition.

182 The staff provide firms with a written memorandum (i.e., a "comment letter") describing the staffs filing

review comments.

183 In this instance, CF met its policy of issuing a comment letter prior to Bear Steams' fiscal year end.

184 The Sarbanes Oxley Act of 2002 also requires CF to review each public reporting company at least one

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

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We believe that a five-month timeframe to complete a second review coupled

with a total time of 7% months to send a comment letter to Bear Stearns was

simply unacceptable in this particular instance, because this filing review focused

on the material issue of subprime mortgage securities (which was adversely

affecting the securities industry worldwide).

Bear Stearns' response letter (coupled with CF's comment letter) contained

material information that investors could have used to make well-informed

investment decisions. 185 For example, Bear Stearns' response letter described

its criteria for classifying loans as sub-prime, information about its risk

management philosophy, how it defines non-performing loans and a

quantification of its investments in securities backed by subprime mortgages.

The OIG eXfert believes that all of these criteria would have been helpful to

investors. 18

We did not perform audit work to determine CF's timeliness in-reviewing 10-K

filings in general. Despite the lack of information about other filings, based upon

CF's review of Bear Stearns' 1O-K filing, we believe that the filing review process

lacks the appropriate internal controls (i.e., timeframes for conducting second

level reviews) to ensure timely reviews.

Recommendation 20:

The Division of Corporation Finance should: (1) develop internal guidelines for

reviewing filings in a timely manner, and (2) track and monitor compliance with

these internal guidelines.

Bear Stearns' Response to CF's Comment Letter

Pursuant to CF policy, firms are supposed to reply within 10 business days to CF

comment letters. Thus, Bear Stearns' reply was due on October 12,2007. Prior

to this due date, Bear Stearns asked CF (in writing) and received an extension

until early November 2007 to file its response. However, Bear Stearns did not

respond by this new due date. Bear Stearns then orally asked for and received

additional extensions. Bear Stearns finally submitted its comments to CF on

January 31,2008, nearly 3% months after the initial due date. 187

185

time

This information

every three years._

was especially material given that Bear Stearns' stock price went from a one-year

closing price high of $158 (April 25, 2007) to a closing price high of $77 the week before March 10,

2008. The final price was $10, the sale price that JP Morgan paid.

186 CF does not consider its public comment letters and firms' response letters as a means of disseminating

(i.e., disclosure) information about public companies. Rather, CF believes that changes to a firm's

filings, as a result of CF's comment letters, should be the primary disclosure method. In fact, CF does

not post its public comment letters and a firm's response letters to the public site of EDGAR until an

issue has been fully resolved.

187 Two other CSE firms did not respond in a timely manner to comments on their 2006 10-K filings. These

filing reviews also emphasized subprime mortgages.

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As a result of Bear Stearns' delays, the CF staff accountant did not complete the

initial review of Bear Stearns' response until March 4,2008 and the second

reviewer did not complete her review until April 2, 2008, by which time Bear

Stearns had already collapsed.

It is our understanding that Bear Stearns' delay in responding to the comment

letter was not a unique situation and CF routinely grants extensions to firms to

address CF's comment letters. Further, CF informed us that it only requests a

firm to contact CF within 10 days of receiving a comment letter and does not

require a substantive response to the issues within the 1O-day timeframe. Thus,

while CF imposes a timeframe for a firm to contact CF, CF does not have a

policy prescribing when firms are expected to respond to the issues raised in

CF's comment letters.

While there are several consequences that may be imposed on a firm for not

responding timely (e.g., the firm may be required to make additional disclosures

in future filings regarding the outstanding staff comments or the staff may refer

the matter to the Commission's Division of Enforcement for investigation), in the

case of Bear Stearns, none of these consequences occurred. Furthermore, by

granting repeated extensions, the filing review was rendered less meaningful

since the staff completed the filing review after Bear Stearns collapsed. As a

result, we believe that investors could have used this material information to

make well-informed investment decisions. In addition, the information (e.g., Bear

Stearns' exposure to subprime mortgage securities) could have potentially been

beneficial to dispel the rumors that led to Bear Stearns' collapse.

Recommendation 21:

The Division of Corporation Finance (CF) should (1) establish a policy outlining

when firms are expected to substantively respond to issues raised in CF's

comment letters, and (2) track and monitor compliance with this policy.

Finding 9: Certain Firms May Pose A Systemic

Risk Because They Are Not Supervised On A

Consolidated Basis

Certain firms may pose a systemic risk because neither the

Commission nor any other regulator currently supervises them on a

consolidated basis.

Several large firms, other than the CSEs, have many customer accounts, hold

large amounts of customer funds, and have unregulated affiliates. The brokerdealer affiliates of these firms are subject to the Risk Assessment program, but

neither the Commission nor any other regulator supervises these firms on a

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September 25, 2008
consolidated basis.188 In most cases, these firms would be ineligible to apply for

group-wide supervision under the CSE program. In some cases, these firms

could voluntarily elect to be supervised under the Commission's CSE program or

under the statutory supervision regime created by Gramm-Leach-Bliley Act,189

but these firms are not required to elect this supervision.

Several firms both inside and outside the CSE program collapsed or-otherwise

experienced serious financial difficulties between March and September 2008. 190

As a result, we believe that if one of these other (non-CSE) firms failed or

experienced another significant problem, the broader financial system could be

adversely affected, thus impacting the Commission's mission of maintaining fair,

orderly, and efficient markets. We did not perform an in-depth assessment of

the risks that these firms present or the costs/benefits of supervising these firms

on a consolidated basis because of resource constraints. However, we believe

that in light of the impact of Bear Stearns collapse, it would behoove the

Commission to perform such an analysis.

Recommendation 22:

Chairman Cox should create a Task Force led by the Office of Risk Assessment

(ORA) with staff from the Divisions of Trading and Markets, and Investment

Management, and the Office of Compliance Inspections and Examinations. The

Task Force should perform an analysis of large firms with customer accounts

that hold significant amounts of customer funds and have unregulated entities, to

determine the costs and benefits of supervising these firms on a consolidated

basis. If the Task Force ultimately believes that the Securities and Exchange

Commission (Commission) should supervise these firms on a consolidated

basis, it should make a recommendation to the Commission that involves

seeking the necessary statutory authority to oversee these firms on a

consolidated basis.

188 Some of the firms are also subject to the Investment Advisers Act of 1940 and the Investment Company

Act of 1940. As a result, OCIE is responsible for inspecting these firms and the Division of Investment

Management is responsible for the regulations.-

189 "The Gramm-Leach-Bliley Act of 1999 ("Act") will significantly impact the financial services industry. By

repealing provisions of the Glass-Steagall Act, the Act facilitates affiliations between banks, securities

firms, and insurance companies."

Source: Banking Information: Overview of the Gramm-Leach-Bliley Act. Federal Reserve Bank of San

Francisco. < http://www.frbsf.org/publications/banking/gramm/grammpg1.html>.

190 Between March and September 2008, Bear Stearns, Lehman Brothers, Merrill Lynch, mortgage

originators Fannie Mae and Freddie Mac and the American International Group, Inc., all experienced

major financial difficulties and collapsed, filed for bankruptcy, or were purchased or taken over by

another entity.

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Finding 10: TM Should Address Organizational

Issues Involving The Future Of The CSE Program

We identified several organizational issues involving the future of

the CSE Program, which could significantly improve the CSE

program.

Changes to the CSE Program

Due to the collapse of Bear Stearns in March 2008, the bankruptcy filing by

Lehman Brothers, the purchase of Merrill Lynch by Bank of America, the planned

change in status to bank holding companies for Goldman Sachs and Morgan

Stanley, 191 and the changing economic environment, the future of the CSE

program is uncertain.

Since the collapse of Bear Stearns, several aspects of the CSE program's

oversight activities have changed and other changes are being contemplated, as

follows:

• The CSE program staff now closely scrutinize the secured funding

activities of each CSE firm, with a view to lengthening the average term of

secured and unsecured funding arrangements;

• The CSE program staff now obtain more funding and liquidity information

for all CSEs;

• TM is in the process of establishing additional scenarios that entail a

substantial loss of secured funding. The scenario analyses help TM to

determine whether firms could survive in a stressed environment;

• TM is discussing with CSE senior management their long-term funding

plans, including plans for raising new capital by accessing the equity and

long-term debt markets.

• The Commission plans to request legislative authority to regulate the

CSEs at the holding company level as well as the authority to require

compliance. Currently, participation in the CSE program is voluntary. TM

claims that the voluntary nature of the program does not capture all

systemically important broker-dealer holding companies, as companies

may not opt for such supervision. Additionally, the ability of a holding

company to opt out of supervision creates tension when the-Commission

wishes to impose more rigorous requirements or mandate CSEs to

address specific concerns, according to TM;

191 On September 21,2008, the Federal Reserve approved, pending a statutory five-day antitrust waiting

period, applications from Goldman Sachs and Morgan Stanley to become bank holding companies.

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• Chairman Cox has discussed the CSEs programs' need to have systems

in place to systematically unwind or liquidate a failing institution at the

holding company level. Currently, regulators are only permitted to

intervene in the liquidation of a holding company's subsidiaries, such as

broker-dealers and banks.

According to TM, intervention at the holding company level would aliow

the Commission to operate a failing institution for a limited period of time

and would protect the institution's customers and counterparties. Such

holding companies typically have substantial activities outside its U.S.

bank or broker-dealer. TM believes that the Commission's lack of

authority to- intervene at the holding company level could lead to massive

liquidations of collateral by counterparties to unregulated or non-U.S.

regulated affiliates, which in turn, could cause market dislocations and put

severe stress on other systemically important financial institutions; and

• The Commission has contemplated ways to improve the efficient and

orderly operation of the tri-party repo market. FinanciaLinstitutions rely on

the repo market to finance proprietary and customer positions. If a repo

clearing entity is unable to conduct business in an orderly manner, or if a

major firm does not have ready access to the repo market, it could have

systemic effects on a large number of financial institutions. Bear Stearns

was not able to access the repo market on normal business terms, which,

according to some accounts, led to its demise.

Changes to the program will require Chairman Cox, Congress, and TM to reevaluate the needs and priorities of the CSE program.

Recommendation 23:

The Division of Trading and Markets, in consultation with the Chairman's office,

should determine what additional changes need to be made to the Consolidated

Supervised Entity (CSE) program in light of the collapse of Bear Stearns and

changing economic environment.

Program Staffing

The CSE program consists of a small number of staff, several of whom have

worked in the CSE program since its inception in 2004. The Office of CSE

Inspections currently has only two staff in Washington, DC and five staff in the

New York regional office. It also does not currently have an Assistant Director

(i.e., an office head).

In March 2007, Chairman Cox decided to transfer inspection responsibility from

OCIE to TM (responsibility was transferred to TM in March 2007 for four of the

five firms, and for the last firm (Morgan Stanley) following the completion of the

ongoing OCIE exam of that firm in September 2007). However, as of midSeptember 2008, TM staff had not completed any inspections in the 18 months

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September 25, 2008
since the Chairman's decision in March 2007. Three inspections are in varying

stages of completion. These inspections act to "assess the adequacy of the

implementation of the firm's internal risk management policies and

procedures".192 No milestones are in place to ensure that inspections are

completed in a timely manner.

Furthermore, staff at the CSE firms informed the DIG that the inspections

information would be useful to them, especially because it would provide the

CSEs with information regarding best practices and where the firms stand in

relation to each other. It is imperative to receive this information timely to ensure

that the information does not become outdated.

Recommendation 24:

The Division of Trading and Markets (TM) should fill critical existing positions,

and consider what any additional staff it believes will be needed to carry out the

CSE program's function going forward. TM should also establish milestones for

completing each phase of an inspection and implement a procedure to ensure

that the milestones are met.

Ethics Manual

In 1997, OCIE developed an ethics manual for its Inspection staff because it

wanted to formalize standards of behavior and ensure that inspeGtions are

conducted in a fair and impartial manner. This manual has been revised and

expanded several times since 1997. We believe that a similar manual would be

beneficial for TM's monitoring and inspection staff given their close working

relationship with the CSE staff.

Recommendation 25:

The Division of Trading and Markets, in consultation with the Office of

Compliance Inspections and Examinations and the Commission's Ethics office,

should develop an ethics manual.

Coordination with Other Regulators

The CSE program staff are increasingly working with the Federal Reserve and

other Federal regulators in its administration of the CSE program. Increased

coordination with the Federal Reserve is particularly important because the

Federal Reserve, unlike the Commission, is in a position to provide emergency

funding to distressed firms. Improved communication and information sharing

among Federal regulators should also reduce overlaps and alleviate the firms'

need to produce duplicative information for each entity. The memorandum of

understanding that the Commission and the Federal Reserve entered into in July

2008 is a positive step.

192 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreg/hcsupervision.htm>.

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Additionally, we believe that the CSE program staff will need to further recognize

the interconnectedness between securities firms and banks. A general

perception, as communicated by a staff member at a CSE firm, is that if a

broker-dealer fails, the Commission seems to worry only about customer assets,

and if a bank fails, the Federal Reserve seems to worry only about depositors'

accounts. Neither regulator appears to focus on systemic risk, nor hpw the

interconnectivity among securities firms and banks affects the overall landscape.

Recommendation 26:

The Division of Tfading and Markets should continue to seek out ways to

increase its communication, coordination, and information sharing with the

Federal Reserve and other Federal Regulators

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APPENDIX I

Acronyms

BORA

Bear Stearns

BSAM

CF

CFP

Commission

CSE

EU

FINRA

Federal Reserve

FRBNY

GAO

JP Morgan

Lehman Brothers

LTCM

Merrill Lynch

MOU

OCIE

OIG

ORA

Broker-Dealer Risk Assessment

The Bear Stearns Compani~s, Inc.

Bear Stearns Asset Management

Division of Corporation Finance

Contingency Funding Plan

Securities and Exchange Commission

Consolidated Superv~ed Entity

European Union

Financial Industry Regulatory Authority

Board of Governors of the Federal

Reserve System

Federal Reserve Bank of New York

Government Accountability Office

JP Morgan Chase & Co

Lehman Brothers Holdings Inc.

Long-Term Capital Management

Merrill Lynch &Co

Memorandum of Understanding

Office of Compliance Inspections and

Examinations

Office of Inspector General

Office of Risk Assessment

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OTS

PCAOB

PWG

Repo

SOX

SRO

TM

u.S.

VaR

APPENDIX I CONTINUED..

Office of Thrift Supervision

Public Company Accounting Oversight

Board

President's Working Group

Repurchase Agreements

Sarbanes-Oxley Act of 2002

Self Regulatory Organizations

Division of Trading and Markets

United States

Value at Risk

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APPENDIX II

Congressional Audit Request

t\Sltt4 ~_ S- . ~~o-.lfN.AHeE

·.·~l:>C_~e·

April 2, 2008

Via Electronic Tnnsmission

The BOllorablet>avid I<otz

mspect6r General '.'

US SecUrities and Exchange Commission

lQOF Stree~:NE

Was,hmgton,:bC 20549~2736

DearInspector General Kotz:

According.to regUlatory filUigs and~ December 2007 Wa11'$~~t.r(J.urnal article;

the SECEnforcementDivision declined to bring a elise llgainstaeat Stearns fQr

JmpropeI:ly vll1ufug:mortgage.-telated mvestmenis~ Given the Ia"tercolillpseand federaIly

hacked bail-out of~ear Stear,ns,Congress needs;'tol1nderstandmore about this case and

whythe SECuItimlltely'sought noenfofcement a:c~iOh.

Moreover, I ~particularlyiilterested in this case in light ofthe SEC's failed .

investigation ofP.equotCapitalManagement .As you know, iIithe final rePQrtofthe'

Senate'sinqllity.into thatmatter,we found that.scUipt SECofficials showed

extraordinary def'~ce to apamcuIar witness because ofbis"prOnUnence" asthe. head.

ofMorgan StaDiey. .

Request'for hvesti~;ltion

In light ofmyearliednvestigati<m I·l1eedtokilowwhetherlhesame problems

identified in the P«J.uot lnvestigationwere r¢peated ,inlheaearSteams ~e. .

Accordingly. I request that you conducta thorough ·inV~$tigatiOIl into the fads and

circtimStanees surrounding the decision to not ptirsueanenfo~entaction against Bear

Please provide a finl1lreport on whetberthete was anyhnproper action or

D1isoonductreIating toSEC investigationQfBearStearosMdits decisiontoclQse the

investi~Qn. Th~te.poit shQuldaJsodesciibeand~esll:

r.the~, ~aJld prQpri~ty ofCOininunicatiClllS h.etweenBeat Stearns

executives or·theirorepresentatives·and seniotSECofficials;

2.th-e.decision-maldng process which ie<ito.the SEC'sfai!ure to bring an

enfotcementaetionfollowingth~ draftingofaWdls,'nonce;'

3. tIi:e: teasQrtsfor declining to l'roceed with an enforcement action; and

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APPENDIX II CONTINUED..

4. thedegr~to whicbmore aggressive, action by the Enforcemellt Divl$i(m

may have led to an e~uiier and more: com}J,lete underst~ding oftheis1!ues

that contributed to'the c~llapse oiBear Steams.

Request.fol' Audit

InadditiontQ this i,nvestigative,re.ques1, I Would also like your office tofoUow-up

on prevlousalldh work relevant to issues surrounding13'earSteams. The Division of

trading and Markets (Division) is responsible for regulating the largest broket-dealets

and the associated holdmg companies. Offices within the Division are staffed. with

accountants. and economistswho are respomible for reviewing the market and Ptedit..risk '

exposures ofthe proker d~lers ...1'heineviewincludesll$$ess1ng.broker-dealers'

'quarterly financial fllin.~, ensuriIlg broker,;.de.alersar¢ineeting ilet-capitil requirements

and that other financial ratios, 'Such. as liqu'j.clit;yrl!-tios~ ar:eadequate. Theteis,/Jspecial,

emphasisin teviewing the five very largebroker-dea1ers~in.ciudlng .~. S~al11s, kn()\'(Il.

as the Gonsolidll.~ 8uperv·ised E~tity (CSElProgtatn. the.DiviSion staffexercise$

additionaloverslghtofth~se fUms ande~ines tbeinisk models.

I und~fstanathat: tAeOIQC\onduct¢d:a'pnor auditofthese,responsibilities in:

2002. PJease'provide;an update ofthepreviQq$, (IDdings, determine whether earlier

recommendations were'iinplemented, and analyze the'currentftmctiQn ofth*Qffices.

'l:'bereview shoUld include a description and asse.sSInent oftheir,missions; hO'!the

programs are run" their policies and procedwes, the adequacy ofany reviews conducted

regatdingBear Steams; and recommendations f~r improvementsin the process..

Ifyou have an.y questionsa"'Qut theser~llests~, pleasecorttactJason 'Foster or

Emilia DiSanto8t(202)225-4515.

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APPENDIX III

Curriculum Vitae (Albert "Pete" Kyle)

CURRIcULUM VITAE

Albert S. "Pete' Kyle

~: FebrUary 2;'i,2QQ7

Cwu:ut Position: Charles K Smith Professor ofFinance, Robert H.Smith SchOol of Busille~

Bu$iness Adl,kess: University ofMaIyland, 441ta Van MunchingHall, College Park, MD 20742

Business Phone; 301-405·9684 <UMD'voice); <JOh'314-,5828 (ll'MP fai()

F;Mail: ilkylerillth$mith.wnd.edu

EDUOATION

• Ul1ive,~tyOfChicago"1971-1979, 198Q,.198I.PhD., Economics, 1981.

Dissertation:, 'An'EquilibriumModel ofSpeculation and HedgUJg:

Advisors:]oseSCheinkD1;l.il(chair)" RobettE.Lpqag,kstet Telser. '

• NUffield College, Oxford Uliiversity, 197&1977. Field:Eco~lomiCS;Adv,iSor. James Min-lees.

Met all requirementsfor B.Phil,degr~(Jiow t:;il!ed M.1'hiI.}e~cepJ: tw~ye!.lf residencyrequirement

• Merton College, Oxfoz:d.Uujversity, 1914-1976.. ~-A.. M;uh,aiid PhilosQphy, class hOllOrs, 1976.

• Davidson College, 197·0,.1974. B.S..Mathematics,sumrna cum laude;

• Charles E. Smith PtofessorofFlllance (with tel1ure~, Robert H. Smith School ofBusilless, University of

MaIylaI1d, f\.ugust ~006 to PteseJlt .

• Professor ofF1Ill!Jlre and Economics (with tenure), I>Ulre Uuivmity, :Fuqua School ofBilMess ;nid

Depanmento(Economlcs,]anUaIy29Q2-2006{app6in.tr:nwtpredominandylllFuqua SChoolof.BusiJ~) .

• American Stiiidard VlSifuJg PtQfessor, Said Busilless School, <)XfQrdUmversity (8t Edmwld J-Iall),]une

2Q04,]WIC 2005~l\1ile 2006.

• VISitingScbolat,.Princeton Ulli,versity,DepartmentofEconomics, Fall 2004 (while Oilsabbaticalleave from

Duke UniverSity).

• Cousultailt,.Morgan.st~nlc:y andCQmpally, December 1996 - December 1998, full tim!: while onilllJiaid

leave from Duke University, Proprietary trading researth,

.. &soci;J,te Professor of F"mance (With. ienure). Duke UniversitY, FUqUa Schoo) 6fBw;i.ness,]u!y 1992~U/y

2002 (ollwlpaid leave for cideudai::\'earS 199'7,1998). ...

• ~.ProfessorofFmance (with. t'enute)"University ofCalifonria,atBerkeley,Haas·SchoolofBusiness,

July l~JUne 1992. .

.. VISiting &bolar.DUke Uilhrersity; Fuqua &hoQlPf Business,September 1991-;June 1992 (on sabbatical

leavefrom UC Berkeley FlII119911, .."

• AssistailtP)7(jf.ofFutallt;e, Uluv;ofCallfomiaatBerkeley, Haas Sch90l of Busine~s,]uly·1987::J\ll)(l 1990.

• AssistailtProf. ofEc<)Jlomics andPliblicAffairs,WQodrowWtlsonSchooi, Princetonl,lniversity; 1981-87..

• .vISiting. Fellow, Yale School of Organization and Managemetlt, SjJrlllg 1984 (011 sabbatical leave frOm

P1:41cetdll Uiuvetsity), .

• VtsitingResean:h. Fellow, Centre ofPolicy Studies, Monash University, A\lstralia, Fal11983-{on sabbatical

leave from Princeton lJluversityy.

j PitTradlllg and Risk Mimagement, GoodIilalI-Manastet <ludComp;m}>, ChicagQ, 1979-1980.

.. Staff Economist, Chicago BOO!rlofTradl:,part-tiri'ie, 197~1979,

1

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APPENDIX III CONTINUED..

PUBLJCATIONS INREFERREP JOURNALS

(In co-authoredartides,all authors have equal seniority !Illd approximately equal contribution,)

• AVlnash K.Dixit and Albert S, Kyle, "The Use of Protection!llld SubsIdies for Entry Promotion and

Deterrence,' American EconOlnic Review, VoL 75, No, 1, 1985, pp, 139-152,

• Albert S, Kyle, 'Continuous Auctions and InsiderTrading,' Econometrica53, 1985, 1335-1355,

• Albert S, Kyle, 'Improving the. PerforIDmce ofthe Stock Market,' CalifomiaManagementReview, 30:4,

Summer 1988, 90-114,

• Peter R. Hartley and Albert S, Kyle, "Eq1.1ilibrium Illvestmentinan Industry with Moderate Investment

EconoInics ofScale:The EcdnoInic Joumal. 99:396,]wle 1989, 392-407,

• PeterR.Hartley md AlbertS, Kyle, 'RealRates and Home Goods:ATwo. Period Model,"The EcOlloIniC

Record. 1)4:186, September 1988,16IM77,

• AlbertS, Kyle, "IluonnedSpeailationWith ImperfectCompetition,' Review ofEconomic Studies56:3.1'110.

187,July 1989, 317.a.56. .

• Alb¢It S. Kyleandj¢aIl Luc Vila, 'NoiseTrad4lgandT:lkeOvers: llil1ldJollfnalofEconomics.V9L22,No.

1, Spring lQ91, pp. 54-71.

• JohnY. Campbellll1)d Albert S. Kyle, "SmartMoney, Nois¢Trading, andStQCk Price Behavior,'Reviewor

EcononlicStudies 1993, 60 pp.. I-34.

• Albeit S. KyleanelA!bertWang, "SpeculationDUOJlOlyWithAgreementto Disil.gree: Can Oven;ollndence

Smvive the MarketTest?" Joumal ofFinlince, volume LII, number5. Decemberi997,pp. 2073-2090.

• Albert S.Kyle!llldWeiXiong, "Contagion as a Wealth Effect," IoumalofFinlince. volume LVl, No.4,

August2001, pp, 1401-1440.

• Albert S. Kyle, Hui On-yang, and Wei Xlong, "ITospect Theory md JiqtridanonDecisions,'JOllfnalof

EcOIlOIniC Theory, Elsevier, vol. 127 (1),July 2006, pp. 273-288.

• AlbertS. K)'le, 'IrrtperfectComp¢uuQll. M<irketDyn;units, andRegulatory Issues,'inFillallcialMarketS and

hlcompleteInformation: Frontiers ofModemYlllancialTheory:V91. 2, editedby SudiptoBhattacharyaand

GeorgeM. Constantinides, Rowman and Jittlefield, 1989, 153-161.

• Albert & Kyle, "A Theory of Futures Market Manipwations,'The Iildustrial Organization ·of Futmes

MaIkets. edited by Ronald W. Anderson. Lexington, Mass.,. Lexillgton Books, 1984, pp. 141-173, also .

reprinted ill Paul Weller (editor),The Theory ofFutmes MarketS, Blackwell, 1992 pp. 272.303.

PUBLJCATIONS IN lJNREFE:RElID CONFERENCEVOLUMES

.• Albert S. Kyle, 'TradlllglIaltS !Illd Price JiInits,'The Review ofFutures· MarketS, 7:3, 1988, 426434.

• Albert S. Kyle, "Market SlIUctme, Mormation, Futures Markets, and Price Forrnation,' in Intematlonal

AgriculturalTrade: Advanced Readings ill Price Forrnation. MarketStructure, and Price Instability, edited

byGaryG. Storey, Andrew SCbIIlitz, and AlelCa11detH. Sarris, Bouldet, Westview, 1984, pp. 4.5>64,.

• Albert S. Kyle, "Discussion of'The Pritll:tg ofOil !Illd Gas: Somc:Fm-ther Results',' (by Merton Miller and

Charles Upton), The IoumalofFinance, Papers and Proceedlllgs,VoL 40, No. S,July 198.5,1018-102Q.

• Pe~rR.. Hartley and AlJ>ert S. Kyle, "The EconoInics ofMedical hlS\IDllICe,' illMedicaICare and Medical

Ethics. edited byC.L BuChanan andKW, Prior.WlnChester, Mass.,Allell&Unwiil hlC., 1985, pp. 77·104.

2

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MISCELLANEOUS PUBlISHED ARTICLFS

• AlbertS.;KYleandTenyA. Marsh, 'Computers and the Crash: Is Technology the·Problem·orthe Solution?'

hlstitutionaIhlVestorFmancialTechnology FoIUIil 2,June 1988,·pp.6-7.

·UNPUBliSHED PAPERS

• AIbe~ S, .Kyle, 'A Rational. Expectalions Modcl of EqUiliblium in SpeculatiYe Markets with lmperfect

liquidity and Costly hJforInation,' Thesis'seminarandjob-rnarket paper, 1989..

• AlbertS. Kyle; "TheEfficientM:arketslIypothesis and the Supply ofSpecuIa:tive Services;'manuscript, 1982..

.Alb¢rt S. Kyle,. 'A!I Equilibrium Model of Speculation and Hedging;' UniversitydfChicago Ph.D.

Dissertatiou(Economics), 1981.

• Peterl{. Hartley and Albert S. Kyle, 'Equilibrium in.aModel withLumpy lll.vc;Stm¢l)t,' :m~luscript (now

subsumed In ~uilibriummve5tment in an Industry with Moderate InvestffieutECoil.Q!:Iiics," 1983;

• Avjnash KDixitaud Albert S. Kyle, 'On the Use of Trade Restrictions forEnllY .Promotion and

Det:errCll.ce:Ecoll.OmicsDiscussiQi~PaperNo. 56,WoodrowWilSon Schoi>l,Priucetol) UJuversity, 1983.

• AibertS.Kyle; 'Equilibrium in aSpeqIlative M;rrketwith Strategic InformedTrading, W ~vised ~'I:ilformed

. Speculation with Im.perfect CompetitiOlI). 1983.

• AlberlS;Kyle. "InfoIlll4tiolUilEffjcieilC}'and,Liquidity in aCon~uousAucti~1Fu,turesMarket,'Cen~ for

theStuqy ofFUtures Marltets, ColWiibia Business School.Wo.rkiJl$ Paper S¢ries #CSF.M-75j 1984.

• .AlbertS.Kyle, 'An~cit.:Modelof Smart'MoneyiUid:NoiS(:Tradiug,' mauuscr1pt(nQwsubsumed in

'Smart¥ondy, Noise Tnteling, and Stock Price ~vior), 1985.' .

• Albert S. Kyle, •AnhlJ.lJ.itivemtJ:oductil:in tQAgenC}' Theorywith Applicatiousto MoneyMauagemeJJt,' QGrollpT;illt, fuanusgipt, Aprii 1989. .

• Albert·S. Kyle aiJd Ailsa Roell, ComilieJ'lis ,OJ~ Recent Developments and Proposals Conceming DealiJ)g

Practices in the1JK EqUityMarlret," manuscrlpt, 19B9.

• ftlbert S. Kyle and Terry A. Marsh" 'On the Economics -of Securities of Clearing alJd&ttlement,'

IJI.il))usaipt, 199.3.

• Mb¢nS; Kyle; 'Ouhleeniives to AcquirePIlvate hlforrnationwiih ContinuousTradiJ)g,.' :manuscript, 1935;

• ~It·S,Ry1e, "Dealer Coropetition Against an Organized Exchange: manuscript;Jwle 1987.

• ,!\.lbe!tS. Kyle, "Madtet;Fai)wes ;uid the Regui;uion ofFlllanciaiMarkets,'.manuscOpt,.1992.

• Gc;~ Gennotte iUl.d,Albert S, Kyle, 'huertempoial lnsidel' Tncliug with a Smooth 'Order Flow:

~l\1SCtipt, 1993.

.AlbertS~ KyleaiJdTaoLin, 'Continllous Speculationwith Overconfident Competitors: ma1Juscript,2002.

.Al~ert S~ Kylea!idTaoLin, 'An AnalYsis ofExcessive TradingVolume with DifferentBeiiefs,'manuscript,

'2002. . .

• Alben S. Kyle 3Jl.dRujing Meng, "Strategic Acquisitions and hlvestmentln a Duopoly Patent Race under

Uncertainty/, manuscript, 2003.

• MingGuo and AlbertS. Kyle,"An IntemporalAsset Pricing Model with Strategic IIJfo~ed Trading ~xd

Risk-Averse MarketMakers,' m~1I1script,2004.

• Albert S. Kyle,"ATwO'Factor Model ofValueatld Growth witlJ AdjustmeJil<.Costs,' IIJaliuscript, 2004.

• Alex Bouiatov and Albert S. Kyle, "Uniquen<:!i$ of Equilibrium ittt!teSiilg!e-:p¢riod I(yJe.'!l5Model,"

matJUsaipt, 2005.' . .

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APPENDIX III CONTINUED..

RES:EARCitCONTRACTS AND GRANTS

• Researth Consultant, Bell Laboratories, 1982.

• ResearCh Associate, Center for !he Study of Futures Mar.kets, Columbia Busuiess Scbool, two mOll:thsof

summer support, ~983.

• Prillcipal Investigator, NSF Grant (lnfoi:malion Science):'Organi7.ed Exchanges, Dealer :Markets, and.

AiiOliymou.s'J:X'i!diitg,'I'riIiceton (.hIiversity,Two.summers ofsummersupport, 1985,1986.

AcademicY~itor, Fedet3l Resenre.Bank, Waslllngton, I),C.,June 6-10, 1992.

• Aca4emic V.\Sitor, Fedei<II Reserve Bailk, AtlaiIta; GA. 5 days, 2003. .

FEILOWSHIPS,PR!ZFS, AND ACADEMIC AWARDS

• Phi BetaKappa, DavidsonCollege, 1974,

• HOlloraryPOStmastership,'Merton College, 1976-1977.

• Geo~Webb Medley PriZe in Economics,MertoltCollege,Oxford University, 1976.

.Rh.9d~ Scholarship (l'exas), Davidson Coilege, 1974-1977.

• Sch.w;iIxtcher Fellowship, HaasSchool ofBusmess,1988-1989.

• Batl:erymar¢!IFdloW5.hip, 199(),:1991.

• NSF Gradqate Fdlowsbip, univemIY.of Chi~9, 1977i-l979, 1980.1981.

• KcynoteSpeaker,Wes.temFlll3.lIt:e 4.ssQt:iation, P;rrlt Gity,Utal!,JU11e.~,20.02; "M:arketMicrostrocture."

• Keynote Speaker, Twelfth Alw.ua1 Col)feten.c:;eO!,1 The lheoriesaud l?I:actices of SecuritiesMaritets.

National SUll Yat~ University, Kaohsiung. TaiWaJi,. "Insider Trading and Corporate Govemance,"

December 17;2004.

• A;ssurantLectim:. A,ss~t/Georgia Tech futematiOllalF"wance Conference, "MarketMicrostructure and

lWioua1 ExpectatioIls; APriwert AprIl8,20ns.

• Fellow, EcOlioIn¢tn¢ SOciety. 2002.presenL

• Clarendolll.ecl.).ltesin Fmallce, O,aord U'~:iiversity.JU1le2006.

PH:D.DISSERTA'l'ION ADVISING

(Initial aCademicplacements are tellure track'assistantprofessors or equivalent, uil\ess otherwiseilidicate<l)

I'riil<:eton JJtIiVersitv:

Steve Kea1hofer (Chair, 19lt3), Columbia UiIiversityBuslliess School; KMV.

George Mailath (SecOlld Reader, 1984), 'Un~ve.r$ity ofPel1lisylvaiJia; Department ofEconorriics.

LorettaMester (1985), FederatReserve :Board. Philadelphia.

MeuaehemStemberg(SecondReader, 1983>, Commodities Corporation.

Mark Dudey (Secol{d ..Reader,1984),. Rice U)liversity.

LelUly Nakamura.(SecCitl<lReader.J985>,f¢deral Resi:t'YeBWrd,. Philadelphia.

IiIIl Gale (CIJair,1985); Uiuversity of Wi~consin, Federal Reserve Board, Cleveland.

Julie Nels,Ciu (Second Reader.l~ll6), NewYork University Business School.

MaltSpiegel(SecolliLReader,1987), COlumbia University,UC Berlteley, Ya1e University.

Jean Luc Vua (Secop,d ~der, 1987). New YorkUuive~ty, MIT. .

Blaise Allaz(Secolrd Reader, 1987).'lJniver~ity ofLausalUle.

University ofCalifonria. Berkeley:

TheC>doreStem~erg (Chair,l989), Vanderbilt Utriversity.

Helena MulliilS (C~t,1990), Ullivetsity of Oregtl1l.

RichJiIldsey (Ch;lir,1991), Yale U'trivers'ity; Bear Stearns Securities.

Peter Algert (CIJair,1991), University ofCalifonUa,. Davis; BarciaysGlobal lnve$lpr Services.

4

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APPENDIX III CONTINUED..

Jim Allgcl (Chair,1991), Georgetown Uiliversity.

leWis Lu(Chair,1992), University ofHong Kong.

TakeshiYama:da; (Ch<!ir.1993). HongKongUniv.ofSciellceaildTeclulo!ogy; Nali6ilal DIliv. ofSiIlgapore.

Duke DlUversitv:

JOIuI Graham (Chair, FJ1~ce, 1994), University of Ul3h; D~ University~

SusallMouaeo (Chair, Fiilailce, 1995), Universityofhldi311a.

Lu Fellg (Chajr, FUl31ice,1995);Salomon Brothers; Stark lnveslmellts.

Jainlin Zhai (Chair, Economics, 19%),.Fedeial Horne Loan Bank, Iowa.

JemUfetBabcock (AccoWltlIl8, '997), sro311~hoolof Blls4I~s,MlT.

Mary.Beih FISher (Maihematies, 1998),BBT Bank.

Briail BaJy~t, (Chair, Fillailce, 1998),Texas MM.

WeiXiollg (Chairi FUI31lCe, 2001), Benclheiin FW3llce Center,Princeton University.

Jon Wongswan(Fang) (EcoIlomics,2002), Federal Reserve Board, Chicago.

Bell ZhaIlg'(Economics, 2002), Moodies,KMV; Fitcl).

Lin:PeJ)g(~, Flll3nce. 2002), City UmvqsityofNY. BaruCh CQlle~.

Fmnia R;Wcl(Chair,Fwance, 20(3), Duke University·<l..eGturerl . GeZhang (F1ll3l1Ce, 2003), University ofNew Orleans. '.

JulkLltvinova(Economics; 20_03), The Bratilc: GIl>Up.

IIi;j. Tsetliil (Decision Sciellces, 20(3).!NSEAD SingallQre.

'I:aQ Lin (Chair, Fmance,20(3), UniyemtrofHongKong.

Krislula Narisimb311<FJnancei2(04); Wharton Business Schooi(Visitor).

'R4iiilg Meng(Chair, Fin311ce,2004), University ofHong Kong.

MOhall GOpal311 (Fii!a11ce, 20(4); Barclays GlobalJuvc:slors, Loudon.

l.;Ikshman Easwata!1(Fiilailce, 2004), Lehmail!lBr6ihei:$.

Hapfei Cheu(Ecolio~Csi exPected 2()()$),GoldmaIl Sachs, HOllgKong.

S~<ha Ilzarazo (Econoniics, 2()()5), lTAM, Mexico City.

bksanaLoginova(Ecolloniicsi 2005), University'ofMissouri, Golwribia.

Will Xu (Chait-, Economics, 2005), HongKOllgUiliveriity.

Ming Gl,1o(Chai.. Ecol,1omics.2005),Gi.~elhlVe!\lIIlelltGroUp.

F/'orui ;oorobilolitl1 (EC~lliomics. expected 2006).

BilJ Wei (Co-chair,Fii13l1Ce, expected 2(07).

Fei Ding (Chair, FlU3llte, expected 2007),. '

Bruce Carun(Co-c.h<!ir, J"iilanl;!:; .expected2007).

NorihCaroliilaState Uiuversitv:

Lu Na (Decision ScienCeS, 2004), Medital :College ofWist()nsill; BioStatistics Consulting Center staff'.

DniversittofNorihCarolula. Chapelllill:

AlbertWang (Chair, FUl)nICe, 1994), Colwribia University. Rice University.

TEACHINGlEslimated,Enrollments)

.UlliVersj~ofMarvIiUld:

BDFN 758": Special Topiq iiI FUl311ce: Veuture Capii-,alandPrivateEqnity

FiilI2OQ9: 3'5slUdents.

BMGT 80ar: Doctoral'Seminar: MarltetMicrostructuJ:e an'dlIi4u&tryEquilbirium

Fall 2006: 10 students (iilcludiilgauditors)

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Duke Ulliversitv: (Onedaytitne MBA course,meets for 2 hours 15tninutes twiceaweeldor sixweeks,plus

eXlWl..Ph.D.courses are olle a semester system.)

FInance.!" FlI'St~year FOlance Theorycourse forPh.D. students

Fall 2002: 30 students~

Fall:2001:· 20 students.

Fall2QOQ: 20 students.

Fall 1999: 20 students.

Fall 1996:. 15 studeJlts~

Fall1995}15 students.

Fall 1994: 15 students.

Fall1998: 10 studelits.

Fall. 1992: 10 students.

Fnl;lll~,m - Second-year Finance Eective for PhD, studeilts.(Market Microstructure and Derivatives)

Spring 1998:15 students.

Venfure Capital and··Private: f4.uity;

SiiIiui:i¢t ~4: Week,-efu,l MB.i\, one. S¢clioi;J;.so s~dellts. .

F'Ill2oo3: Global Exetutive·MBAOne-Day Mini-course; 55 students,

FaU2003: Day~t:ime MBA, two sections. with RebeccaZarutskie. 100 students.

Fan :2003: Cross-Col1bueutExerotive MBA.·50-students, taught asAdvanced CC:lIporate:FUl3lrce.,

Summer 2004~ Week~~ohe section,5(}studenLs.

Fall '2002: GltiJl;il ~etutiveMBAOll:e~Day Milli-eojIiSe; 50 stu<!eIiLs. .

Fall 2002: Day-tinteMaA, twosections,wi.ih Stephen Wallenstein, 110 students,

Fall.~003: Cross-ContinentExecutive MBA, SO students, taught as "AdvancedCorpomte Finance."

Fall 2001: Global Executive,MBAOne"Day Mini-course,50.Sl1ldents.

Fall 2001: Day-fune MBA.. twosecti()ns,wj~ Steph~lWallenS~l, 11Qstud¢iits.

Fau200I;Cr~Coufulent EiCetutive MBA, 2S ~tu<l¢llts, ta,ughtas "Advanced Corporate F.iliance."

Fall 2000:D<!.y-:time l\-m:t\, two sections, with StepheIl WalleIlSteln, IIOswd¢]its.

Advanced Corporate Finance:

F;!lI~QOO:Day.funeMBA, two,S;ectiQns, 70stud.ellts.

Fall199S: m~MBA,-two sectiOllS,90 students.

FalU994: Daytime: MBA, two sections: 90 students.

Fall 1991l:'Daytime MBA, two sections, 90"swdents~

Corpot;lte Fillallce:

SUmmer 2005: Week-end MBA,one seCtlOll, 55 stud.ents.

Fall 2005: DaytimeMBA, four sectiolls,210 swdents.

Fall 1996: Daytimd4BA, two sectiOilS; 1()() students.

Fall1995: Daytime MBA, twosectlons, 10Qstudeilts. _

Fall 1994:J;)aytlmeMBA,JwosectiOl\S, 106 stud.ents..

Fall199B: Da.ytime MBA, oil~ sectiou, 60s~deil.ts.

Fall 1992:Daytime 'MBA, ollesection:, 60 students.

University ofOrlifomia:, Berkeley (MBA audPh.D. courses on semester system)

FUlance I - First:yea;rJ'OlanceTheory comseforPh.D. students

Fall 1989: 15 students.

Fall ~9~~: ]5 stildel\ts.

Fall1987:15 students.

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FinanciiiTheoI)': Gateway IilVesbnentselective for MBAstudents:

Spring 1988:'Daytime MBA, two sections, 80 swdents.

Spru.~ 1989: Daytime, MBA, three sectiolls, 130 students.

Corporate Finance: Elective for MBA students:

Fall 1990: Dayiime:MBA, lwosections, 80'students.

f<ill1Q90: Evellilig ¥BA, olle sectioll,40swdol!s.

Fall 1989: Evening MBA, olle sectiOl.l; 40 stuelits.

Fuiuresand Options: Advance Undergraduate Elective

Spru.lg 1989:WithDayid Modest, 20 students,

Pnnceton University (Com:ses on sernestersystem):

Finance I FlTSt-yearFmance TheOlycourseforPhD. students

Fall 198hWith Rayin6ndHill, 20 students.

Fall 1982: l5sl!Ideuts.

Fall1984: 15 students.

Fall 1985: With Sanford Grossman; 15 students.

Fall 1986: 15studeuts.

Financial Markets -FJUallCe E1ective.for WoodroWWllsoil Masters ofPublic Affairs students.

Fall 1981: 25 students.

Fall 1982: 25:students.

Falll984:2,5stud~1ls·

Fall 1985:25 studeuts.

Fall 1986: 25studeI1ls.

Topics iti Micro,eCOllomiCS - Elective for WoodrowWilsou'Masters ofPublic Aff.Urs,students.

Fa)l1981:25sll.nlents,

7 Fall 1982: 25 students.

Fall 1985: 25 students.

UNIVERSITY SERVICE,

University ofMaryland:

BusinessSchoolPh.D. Oversight Committee,2006-2007.

l"itlaJ,lce Area Ph.D. ColIlmittel:,200Q-,2007.

l"in,ance Art:a ReeruibnoitCommiUl:e,20()6..2007•

Finance Area StrategyCowlciI, 2006:2007.

Business S<!hooll"itunciaiLabCommittee, 2006-2007;

Mentorto Assistlilt Prof~ot'Geol'giQsSkoill~

Duke University:

Ml:mbl:r,Dl:an's AdvisoI)' Gommittee, 2002-2003.

MemboI)'; Duke Global CapitalMarkets AdvisoI)' Committee, 2000';2004.

Filillll(;e Nea CO(>rdillatOr, Fall 1995. ,

Flllance Ph.D. Program Administrator, 200Q-2003.Help¢d with Ph.D.~6]lS o.ther ye;u-s,

Health Sector Management CurricufumReview Committee,2003.

J'ercJ)ata Genter'Resear¢h Review Commil,tee. 2Q02·2()()4.

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FacultyTeclulOlogy Committee, 2000.

Organized Dukdl/YSE Conference. on Market Microstructure, 1995.

ExtenwAd Hoc Cornn:Jiftee Chainnatd996.

Internal Ad Hoc CommitteeChaitro<!Jl: 1992, 1993. 1995.

Internal Ad Hoc Committee M.ember:2003,~004.

Curriculum Committee, 1995-1996.

Elected Academic Council RePteselltative, 1994-1995.

Rhodes SchQ1;U-ship AclVisory ColIirtiifu:e, 2001-2004.

JWllorand Seillor Faculty Recruiting, 1992-2005,iucluding interviewingatASSAmeetillg5 most years.

Camegie Competition Advisor,1999.2002. .

UlliversityofCalifornia. Berkeley:

Ph.D. ProgrounAdmiIIistrator, 198.8-1991.

Faculty Recruiting', 1987-1991, including interviewing at ASSA meetings,

Elected i\cademic Cowlcil Representative, 19ss.1989..

A<:!ive Particip;jht;ill ~eyprOg@n ul!f111311Cl;, 1987'-1991.

Active PaI:ticipantin Fmauci3lhlVesbnentTecllllology(&eclitive F.<lUcatlOll) Program, 198~1991.

Princeton Ulnversii.y:

Rhooes$(:ho!a:rshipAd)!i$ory' ComrttitU:e, 1984-87,

Finance F<Icu1ty Recruifulg, 1982~7;il1cludinginterviewillgat ASSA rneetiIIg5 several years.•

WoodrowWalsonQualliyingExamCommittee, 19.84-87.

Woodrow WIlsOll p!t,n.Cornrnittee, 1985"87.

EcOllqrniCS DepartniemPh.D. AdrnissiQl1S,1984-85.

PROFESSIONAL SERVICE

• IWERResearch Associate, 1982-1985.

• institute fQrtlie. Study ofSecurities Markets, Member, Board .C>fDirectors, 1988-1992,

• E¢oIeNatiolwe des POll!s.et Chaussees,VisitillgUctut~, twp.weekfin<l,ill':e cowse, 1991, 1992,1993,

• CEPR SUinmerlnstilllte, Getzciuee,SWit?;etlanp, PaI:6¢ipant,J\Ily 11.23, 1991l.

•. Frankfurt "(j'rliver$ity,Gue5t LeCtuter;Ph.D.l~es blltnat~t;nIitrqstructute; Aug 13-15,19!l9.

• Rhode,sScholilrShlp SelettitmCornmittee,Dlillois (l9Z9, 1980), Flonda (1998, 1999,2000,2001,2002).

• A1'm:riC31i-FiI).anc<; A$sociatiQIl; Board tifDite4bt5, Member, 2Q04.-jJrl:sem.,

• NASD~Q, EcotIoznicAdvisory Board, Meniber,2005-presenl

• I typically referee6-10papers peryear.

• I occasiollallyserve on program committeesftir<coluerences.

..Referee Reports,and Extenlal Reviews, 2004: Jounw ofFJ:nancial.EcollomiCS(~)J0W11alof F"Ul3nce (2),

·Reviewof FUia11QalStuJ:lies,},.meriC3Jl.EcollonUcReview; E¢ollornetrica,Jourual·()fPolitical EcollOmy,

JoUriIa1 ofEcollOnUCTheory, EcOllOuIiaJc>UriIal, NSF~ several reviewsfor ,tellureor jJromotion.

• Utah WnIter Fl11allceCOlUerellceI'rogratfi Committee. 2004, 2005.2006. .

..".

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SELECfEI) CONSULTING

•. Goodman-Mallaster and Company, 1981. Futures trading, riskmanagemeilt .

• Pepper, Hamilton, ancl Scheetz, 1984-1986, expert witness. Railroad deregulation. Reportswith Robert'

Willig.

• Consultants in Industry :Economics, Inc. 1983-1986, 1988, expertwitness. Anti-trust

• New YorkStock Exchange, 1987, 1990, consultant Market surveillance,insider trading.

• Coinmodity Futures Trading Commission, 1986.1989,expertwitness~ HUiit silver ma:r]ret IIianipulaticm.

Report -

• Staff Member, Presidential Task Force. on Market Mechanisms (Brady COmmiSS~Oll), 1987-198~.Stock

marketcrash of 1987, stoekitidex futures,llldex arbitrage, portfolio lllsurance.

• Options ClearingCoJlX>ration. 19~9. Clearing alld settlement

• Berkeley FU13l1clalTechnologies, 1989-1991.1..ectures·onfutUres and optioQS.

• Expertwibless for Robert Griffm, 1991. Angeloetalvs.CFTG (I'reasuryBond Fut:ures ticksize). Report

and testimony.

• Law and.Economics Consulting Group, 1991, mauipulati6n.

•• BARRA, 1991,measuringmarket liquidity.

• 1'heLong'Term Credit Bank ofJapan, 1991c1996 interest rates alld derivatives priCing.

• Natioha1EconOmlC Research Associates,1996, expertwillless,secnrities.fraud, damages.

• SalolXlonnrothers <Wachtel1, upton, Rosen and. Katz). 1991~1992iexpert witness. Cocoa futures trading,

damages. Deposition.

• hitemal,Revenue service, 1996. Expertwil1less. Treasury Bond Futures traditlg.

• Justice Depa.rtIileJ.l.t,1996. ExpertwilllesS. NASD marketmaker competition and tick size.

• Chase Securilies, 2000, Foreign Exchange Order Flow

• Expert Wil1l¢Ss, AJle~d POce M;uiipula:tiOllOfNYMEX Elect:ricityFut:ures InvolvlllgCash-Settled OTG

Periyarlves, 2003-2004. Report .

• Ex!Jert'Wil1less, natrick. Cold CorporatiOll, 2004-2005,Prlce manipulation, damages.

• hldustry Dynamics and. Valuation of Frrms: All Integration of COJlX>ra.teFitlance aIld Industrial

Orgauizatio1l

• Cash Settlement, Market Miilupulation, aIld the Mpcligli;uli"MillerTheorem

• Trading Volume and Overconfidence

• Applications ofNumerical Techniquesin Fitl3llce.

• SettlementNegotiations with Ehdog¢l1Ous Discover}'

• FUl3l1clalContagion.

• Moral Hazard in Continuous Time.

• Tradingwith'rraI1SactiOll Costs.

• AlgonthmsJor Priciilg Interestrates and Derivative Assets.

• Continuous'I'raditlg with ManyInformed Traclers and Risk Aversion.

• OptimalInsiderTraditlgwith SmoothNoise Order Flow.

• Applications ofcomplexaIlalysis to fInance.

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CONFERENCE PRESENTATIONS

• USDA Universities Iiiteruational Trade Consortium Meeting, December 1981. "Market Structure,

Information, Futures Markets, and Price Formation."

.. Center for the Study of'FuturesMarkets, .1982. "A Theory of Futures Marltet Manipulations_"

• NBER-KGSM Conference onTune and Information in EConomics, February1982. "'"The EfficientMarkets

Hypothesis and the Sl.\pply ofSpeculative Services~" .

• Centre ofPoticy Studies Conference on Distributional Issues in Health ~e, i983. ''The£Conomics of

MedicalInsurance" {with Pe(erHartley). .

• Australian.Meetings ofthe Econometrics Society, AugusI19.83. "Equilibriwnin a SpeculativeMarket with

Strategichlfortned Tradillg." .

• Mlied Social ScienceAssociatiolls Nationll1 Convention, December1984.BC$$iG;lnChainn:Ul.. DiSCt\Ssant in

!Wi>.s¢ssions.

• Betkeley Program ill Filiall¢ Semiitat, Trading Costs '311d TradiIlg Strategie~, April, 1984. "'TradiIlg ill

~ketS Where :ijliyers May}Iave BelterhU6rmati<>n;"

.. NBER - NYC Collferencc ()>> Appli~on~of Ga¢e Theoljr to )!nialice,.Decem1:let 1985. "hlfonilCd

Specul;lIiouwith imPerfect Competition:;' .

• AsSA. Convention, December 198.5: "on hlC;eutlves to Acquire Private lufoI:Iil<ltiou with Continuous . Tradlllg." .

• Confereuce~on MarketMakiug,June 1987, London SChool of£Conomics; "DealerMarkets and Organized

'Exchangt:s."

• A5sACOnvention, Discussant(three differentsessions).

• ASSA COnvelltion, ~cember 1987. "Dealer Markets i!lld OrganizedExchanges."

• Discover Cal, Berkeley, February 12,19S8. Discilss,ioil ofstQCk marketGTa$h.

• Fll1;ulc.iill InvestmentTe¢,hllology Progtlrti,;1krkeley, Febi1,iaty 1988. LectllJ'eson fut:ll:r¢S markets.

• lJ.lS,tit;p.tit>llal hlV~to~ Pellsit>ll Roundatable, J.<>sAngele,5, F~~@ry25,1988. faIlcl diOCUssit>nOnthe;S\Ocl:t.

matl<,etcrash.

• 'l'ij'JER Ct>Afe~llct:;, ..Catnbridge,MA~ 10-11,.1988. P;n.l~tdisCUS,SiQu on thc::stockmarketcrasq.

• l;kIteJeyPrOgrarh iIiFll$l(:eS~Stock: and Fulut~ Markets: l.essollsandPI:os~cts, March 28-30,

19a9, SantaJlatbara.'CA. "Whatl;Iappe'iled -During the. Week ofthe Crash'" (with Tell:}'MiltSh).

• WellS;l."argo:hl\fc:stmeut Adv.isor~ 8elIiiti;jr,$311 Fr3l1cisco, Aprilll, W88. DiscUssiQil ofthe stqck li)arket

crash.

• CRSPSeIIlluar, Drake Hotel, Chicago. May 1981\.PaneldiScussi!}l!. causes 3l1d COuseqlienceS otthe Stock

MarketCrash.

• blStltliteforliJdudaryEducation, C~e1 "Valley. RanCh, CA. May 198RPand discusSionon the 1987 stock

markelcrash.

• Westen! EconomicAssoc., Meetings,JUly I, 1988.

• Berkeley Programul Flllance Semlllat. OnTradlllg and.Fund Management The Role ofTeChnology.

Septemher23-27.1988, Silverado, CA. Co,.Qrganizer (With Terry.Marsh).

• CalBusiness AlUmlll,MeriifuulHotel, San Francisco,Odober20, 1988, discussion on "The Stock Market

C~h,A Y~allcla.;Day ~."

.. AdV3liced Flii<l1ici4TeclmologySc::miiiati;>fFilbltes Market,$, December 6-10; 1989,Toityo,JectU!'es with I)a~M Modest. . -

• ChicagoBoard ofTrade Conference on.Futures MarketRegUlari.oll,November 19,1988, Mayflower Hote!,

Washington,D.C, "TradiligHalts and Price Limits." . .

• A-SSA Convention, December 1988. Discussant

• ASSAConvention, December 1988,"EStimatlllglIltradayPliceVolatility durillg the Crash, presented pal1of

."Improvillll" the PerfOrtn3llce .ofthe Stock Market."

• ll1stitlite ft>r QmultilativeResearchinFii\aIlce (Q-Grt>up),SpmlgSemiilar, Odando, Floridil. April 1B, 1989,

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"An IUliJitive, Iillroductioil to Agency Theory with Applic;i\tion~ to M<>lley Management."

• NewY6tK Stock Exchange Academic SeJIJin~,. M<l-Y 5, 1989. Roundtable cUsCUSSi<>ll'

.STEP~CEPR ,sei:nillaf"Bocconi l]niversity",Miliiu Italy, May 26, 1989."SIPart MoneY,.Noi~~T:I;lding, .<Uld

Stock.Price Behavior;" .

• University ofBonll SummerWorkShop, BonnW. Germany,June 28·}uiy 8, 1989; lIwited guest.

• French Flllmce AssociationConference (AFFI),Jwle 28, 19&9; "SmartMoney, Noise Trading <uld Stock

Price Behavior;"

• NewYorltStockExch<ulge/I.ondonSchool ofEconornics COluerence·onMarketMicroslruclllrc, London,

England, November 15, 1989. DiscuSS<Ult.

• WashingtonlJnlversity,. Regional 'FnmlceCOJucrcncc, November 1990,Jectureon tradingwith asymmetric

uUo11natlon.

• UniversityofIowa, Market Microstructure COJuerence, November 1990. "DealetMilrkets 3l1.d Organized

ExchangeS."

• Chicago Board ofTrade Conference, V<uld.er}jiltUluverSity, December 3, 199(). Dj~i::Us~ant.

• ASSAConvention, WasliliJgton, D.C., Dcce:mber 30, 1990. Session chair.

• Berkeley Progr.un in Fnmlce, April 5-7, 1992. Discnssmt

• AtI<Ulta,Federnl ReserveB<uik, February 20, 1992...Discuss3nt.

• New York Stock&cbangeConference, Los Augeles. CalifonJia,March, 1992. DiSCllSS<Ult.

..CommoWt¥Futures TiaditJgCommissiou,' March30:.3i,i992~ . -

.. Kons.t;tnz, GeIim\1iy, April 34,.1992, "1ntertempornl hlsiderTrading......

• J~em, March 11, 1992. "!lltertemPoru )1iSiderTradiug.,." .

• Wesiem FUlance·Association,j1,llJt22-24, 1992. DiscUSSiiUt.

• Stocldrolm, Swedell,.!\.ugust21'22, 1992. "Markf;tFaihtr~ <uId the Regulatioll ofFllliillqial Markets."

• Allied Social$ciences Association,Jau:uary 5-7,1993. Discuss<Ult.

• Berkeley Pr~gram inl'umlce, LakeTahoe,. California, March 14-16, 1993. ColuerenceSWIimarizer.

• Allied Social SCiences Association, Bo&toll,JmuaryfhS, 1994, Discnss<ult.

• Western FnmlCe Association, Santa Fe,Jwle ~26; 1994. Discussant.

• Natiohal BJireau '<>f'Ecooornic 'ResearchCOluerence, Key Largo,"Florida,July 11-12. 1994. Discussant.

• Federal Resetve B;UJk ofAtlantaConferellce,MiamJ, March 3-4, 1995~ Discussmt.

• Q.GroupColuerence, Nov~f 22~29,1995.' ",ACtiveMi,smanagemeilt.

• Allied Social.Sciences.AssociatioJi,.sanFI;l1icisto, 1996. seSSiOllChait~

• Berkeley Program in FUliUlce, Santa'Barbara,.septembet29-Oetober 1, 1996. Essay in HonotofFisciler

Bl<l-cl<"

• We~temFul1Ulce AssQciatiol,l. Meetiilgs,Los Ang!:les,Juiie 19, 1999, di~CUSS<Ult.

• Dp.ke l]luversi/:YGlo4al CapitalMa!'ketsCeli~r; Coi!f~Jice ollBolidMarlretMiq~t:nJcture, Washington

DC, October 19, 1999,presenteT.

• SI1\ CA Mini-Conference on.Insider'I'rading, Sychley, Australia, NovemberS, 1999, keynote speaker,

"hlSiderTradlng;,' .

• Duke Unveristy'GlobaiCapitalMarkets Center, Coluerenceon Hedge FWlds,Dwham, NC,November 19,

1999,medemor.

• NBER Asset PricingConference,}3oston, May 5,'2000, discussant.

.WestemFlllance AssociatiOli, SUll ValleY,Jdaho,jwle21-24,2000, disCUSS<Ult.

.·Reviewor EcOlJomic Slildies .C(llUerence, Fraukfu)t, Germany, juile30, 2QQO, "ContagiQlias a Wealth

Effect." • Federal Reserve ij;uIk ofAtianta,.Co.lit"etence, AtIa11ta; september 15,2000; "Contagionas aWeal\hEffect..

• :Fedetal Reserve BroIk ofAtJaijta, Coiiferenceoii e-FiI~ii::e, OCtober 14,2000,d1srnss<ult.

• Betke!c:Ji Program:ulFuliulce; Squaw Valley, CA; March 17" 2001, ,pmgram discuss<ult.

• N3SA M¢etlllgs, NewOde<ulS,IA,jamiary 6, ·2001, "Contagion asCi Wealth Effect."

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• Q-Group, Tampa, FL, April 4, 2001, "ConiaglOU;lS Wealth Fifeet."

• Westen) FUlance Assn., Tucson,AZ,JWle ~2-23, 2001, seSsion chair (Market Mierostnlctlire),disi;ussaut.

.. NewYorkBtockExch;ul~ Coufere).lce,InstitUtional1rading,PahhBea(:h,FL,Dec. 6; 2001, s¢'~siQnc!:lair.

• Utah WUlterFman~ Conference, Saltl..ak.e City, Utah,February26-28, disci.JsSant.

• RFS COluerence, Northwestern. Uhiversity, AJiril26-28; ,2"002, disCUSsaJ1L

• Fe4era1,Rese~'Barik ofAtlanta,Conferente 011VentureCapital, Sealslailg, GA, May 2-4, 2002~~S5allt

• Conference in fIOlltJr bfDavid Whitcomb, Rutgers UniverSity; OctOber 11,2002, discussallt

• SEC Roundtable DiseussioilOIlMarketTrlUisparency; November 12, 2002, participant

• NYSE Roundtable Discussio1lon Market QUality Statistics, December 6, 2002,participalit

• ASSAColiveulion. Contagiou.January4" 2003, session chair. • UtabWiuterFinance Conference, February 6, 2003, d1scUSSallt

• FRB Atlanta Conference on Business Method 'Patents; Sea lslalld, GA, April 3. 2003, discussant

• NBER MatketMicrostructure Meeting, Chicago, April 12, 2003, discussant

• ASS1\. SanDiego,J~uary5, ~004,discuSSalll

• Utah Wl1lterF"l1)31lceConfereuce, February 6,2004, dis<;USSal\t:.

• nuke!NYSECoiueri:1ice on !utemalioual Cross-Listll~, Sarasota,FL, March 11-13, Dukl; GCMe

representative.

• NewYo£kStockExchangeConference,MarketMii;rQstrtlctlire,P;ihnBeach, FL,December 12,2oo3,pallel

oulllllJ'ket IIUCrOStructure. . .

• FRB Atlanta COluereuce,on MarketTransparency; SeaIsIand, GA, April 15,2004; discussalit

• 2004 HKUST FUlalll:e SYmposium, HOl)g Kong,. "A TwO-Factor Model of V~lie and Growth with

AdjustmeutGosts/' :December.13, 2004.

• ' Keynote $peaker;'twelfth Annual Conferenq: ouThe The.orieS and Practices of SeCwltl¢s Markets,

National Suit'Yat-sen IJniversity, Kadhslwlg; TaiW3ll, "Insider Trading audCorporate Govenlallce," .

DeeemQer 17;2004.

• ASSA, Philade1phis,JlI1luary 8, 2005, diSCUSSalit.

• Utah Wlliter¥jj)31lce Conference, February 10, 2005, discussant

• Assllrallt/GeorgiaTech hiternaiionalFUlalu:eC<lIuerence,.AssurantLecture, "MarketMicr.ostructure and.

RaiionalExpecialions: A Primer, April B, 2005.

• Oxford FDlance,SwnmerSymposium; "ATwo-FaelDrModefofValueand Gl'OwthWithAdjustmeutCosts,"

June 15, 2005.

• COiUereiice.on hifortnationlUldBehavioralBiasesiuFmancialMarkets,.FuiiClacionRamonAreces,.Madrid,

"An tnteiilpPnilAssetPricingM(JIiC::lwithStra,ll:gicltuoO'nedTradiJtglUll!Risk-Averse Marj(et},Ifakers;"July

8,2005. .

• OxforoSuinn:ier!"inanceSymposimn,"ATwQ-F<lCti:>r MQdel ofValiie and GroWtA,"JlJne 16,2005.

• Conference 011 hlfonnatioil aild Behaviorallli<iSe5 inF'liial1(;ialMarkets, Madrid, Spalll, •Aillilteniporal

Asset PncingModel with Strategic Informed TradulgiUldRisk-Averse Market Makers,'Juiy .7.2005.

• Alpha Strategies ColJferenceon QmUltitatiVeMoney Managemen~ commentator, APri110-12,2006.

• Clarend.ollLectureS)l1Fil1ance "Stock PriceDYli;mU,CSlUll!Uldustry Equilibrium>" Juile 12-14, 2006..

.I.SEComere).ice 011 New Direetionsin Asset Priclllg <uld'Risk Manageme1it, "J)ymunicS~gidilformed

Tradlltgwith Rlsk-AverseMarket Make~," June 16, 2006. .

• Western Filiance.Asst>cialion, session:chair, discussant,JWle 2i"22,2()05.

• EuropeanSummer Symposium in FinandaIMarkets, Gerzensee, Switzerland,focus session chan-,July24- 2~;20ti6. . .

12.

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! .

APPENDIX III CONTINUED..

lNvrTED'UNIVERSITYRFSEARCH SEMINARS

• SChool of Organiz;!,tion and ManageJhen(; Ydle University, March 1982.

• New York UniverSity, April 1983.

• A,uSlJ;lJi;ul NatiotW lhiiversjty" October 1983.

• University piNew England,.A.nm4:11e, NSW, AuslI'ali;l, October 1983.

• AUStiaiiail Gra4tgie School ofMaI~eut, University 6fNewSouthWales, October 1983.

.. Centre ofPolicyStudies, Monash'University, Mdbouro.e, AUgUSt 1983 and November 1983.

• School ofOrganizatioll'and Management,'Yale University, March 1984..

• Columbia UniversityBusinessSchool, Apiil1984.

• University ofRochester, April 1984.

• NBER. Trade Group, April 1984.

• NBEltFinand<l1Markets Group, November 1984.

.. lIamfdBusiness School, May 1985. '

• Uni\(etsityofChi~ BUsil.les$&:hoOl, MaY,Hl8.5.

• J{tllpgjfGraduate SchoolofManagement, NOrthwestenl Ullivet$ity, May 1985.

.. ' Sloan School, MIT, October1985.

• Graduate School ofBusiness,Stuu6!d University, Match 1986.

• Graduate Schpol.ofManagemellt,Rutgers University; April 1986.

• Columbia Uliiverslty BusinessSchool, Septenilier 1986.

.CSIA, Camegle~MetIonUniversity, SeptemheI;, i986.

• Uni~sity,ofChkagoBusinessSchool, c>ctobed986:.

• KelloggGraduate SChool ofManagement, Northwesterii University, October 1980.

• SchoOlof Btjsiliess~ Washingtdl.lUiuversity, St Louis, February,1987.

• GradUate Scl160lofManagemetit,;Ru~ets Unj,versilY, Febru:;ny 1987.

• Gr.l(lua~ ~Odl Qf:Business,SIall[6rd lJIwersity,JaIl~aty 1987.

.. School 6f.;BU$inesg, Ul~Yersity of Califorpi~ BeQteley,Jamwy 1987.

.. School ofMaIIagl:ment,RiceUniversity,February 198'7.

• Business Sch6ol,University ofMiclugan, February 1987.

• Business School and Economics, Uluversity ofWlSconsin, February1987.

• Economics Department, University ofPittsbur8b, February 1987.

.WIwton Business School, UniversityofPewlsylvania; Febru;u:y 1987.

• :economics DePartment, BrownUluverslty, Febru2ry 1987.

• SChool ofOrganizatiOll aIld M;uIagl:ment,Yale Uluversity, Apm1981.

• EtoMD:!ics Departmejlt, Vll"giniaPol~ticJllStiM~,Jujlt; 1981.

• UClA,Uil$Ule$$ S!:hQol, May 20, 1988 'Si:ilaIt M:oij~y,,1'rojg~ Tra.ding, and Stock, Price Behavior:

• Ul}iversity of Cali.fomia, SaIlta Cruz, Ecoiiomi¢sDepattmellt, October 25, 1988, "Dealer Markets aIld

Organized ExchaI)ges;'

• Allderson School of MaIlagement, University ofNew Mexico, November 18, i98S'1)ealer MarketsaIld

OrgaIJized Exchanges:

• BocconiUniversity,Milanllaly; "Asymmetric Illfonnation aIld Market Microstructllre,' May ~,19S9.

•• Commodity'Fuinres Trading.Commission, November i989~

• 'UniVersity ofBritish Columbia, FUWlce Seminar)t)ecember 1989~ 'NoiseTradiugand Takeovers:

• VaIlllerbl1tUlliversity, F"nlaIICe Seminal" November 1989, "Noise Ti:a:dii.lgal~d Takeovers.;

• University ofUtah, F'lllaI1CeSerniuar, December 1989. "Interl.emPOldlJnsider Trading...

• Uiriversity of hl<!iaIla, FUl311Ce Semular, September 1990. "Intertemporal hlsiderTradillg...

• 'Eco1e' Nationale des Pontset Chaussees, Pari$ Fnl3ll'ce Seminar,]anuary 1991. "Intertemporallnsider

Trading..;"

13

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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September 25, 2008
APPENDIX III CONTINUED..

• Uluversity of NO$Carolina, 'February 18, 1992. ·lnte~temporal hlSiderTradiJIg With Smooth Order

F1ow.H

• Northwestem Uluversity, KelloggGraduateSchool ofManagement,J~le 3-4, 1992. "IntertemporalInsider

TradiJrg'With Smooth OrderFlow.H

• NewYorkUluversity, September 22; 1993. ·Speculation Duopoly..:

• tJCi.A, November 5, .1993. "Speculation Duopoly...

• 'Vanda:biit University, April 14, 1995. "Speculal1on Duopoly:.;"

• Uluversit)lof Michigan, December 6,1996. "S~ulation DuopOly with Agreement to Disagree."

• Rice Uiuversity, October 1, 1999, "COnt!8ions as aWealth Effect ofFinanciallllt.ermediaries."

;, SYdney U1uVersity, Sydney, Austnilia; November 2. 1999. "Contagion as a'WeaIth Effect of FlIlancial

Intermediaries:

• CamegieMellon Uluversily, GSlA, February 23, 2001, '''CoJitagion as a Wealth.Effect;'

• Stanford Uiuversily,Graduate SChool ofBusJneSs, March 14,2001, "ContagionasaWca!th E'lt"ect"

• U1uversily Qf CalifopJia, Berkeley, Hfuts$choo) of BusiJless, March 15, 2001, ·Contagion.as a Weaith

Effect" .

• Umversily ofIndi;Wa,"April Zl,2001, "Contagion as a WeaIthEffect."

• Londou School ofEconomics, May 9. 2001, "Coii!agion as. a Wealth Effect"

• Umversily ofTe~,Austill, Oetober2Q, 2001, ·Continuous SpeculationwithOvercoMdentTraders."

.. Norwe~ SchOQI OfManag,ement, Os,1o,JWle 5,- 2002; 'ContinuousTtadingwilh Heterog~neous ,.....

.. HumboldtUniversity, Berlin,JUi1e 7,2002, "Cqlllinu9usTradingwith Heltl:ogelleoUsBdiCifs,..."

• OxfordSummerF111ance]uslitute,JW1e 11,2002, "ContiJiuousTl1ldingwith.:IIeterogcneous~ers and No

NoiseTr;iljing.· .

• Oxford SumiIler. F"l11311ce Institute, june 12; 2003,·CoIP9rate .F"mance audlndustriaI Organiz;a!iol1.;'

.. NewYorkUniveris!:Y,·Strat.egic Acqu$tiOllS ... ~,No;>v~l;lt~t 5, 2003. .

• UIUve~ty ofVrrginia, "Prospcct'I'heory .:. ~,Febrriaryl4, 2003.

• IN'SEAD, PariS, ~Strategic Acquisition ... ", April 2, 2004"

;, BEC, M, "StrategicAcqUisitious ... ~; April 1, 2004..

;, University. ofAmsterdam, "StrategicAcquiSitions ... ", March 30,2004.

.. Umvemly ofTJih\1rg, ·Strategic Acq~itions ,.. ~, March 29,,2004.

• Pniv~tY Qfl'ompeu Fa1:>ri, Bax:telQ~> "St:rategic AtquisitiOlJS ...., March 24, 2004.

• P.rincet~>1\ Univ~rSity, "S)rat.egic Aitqlii$itiOl)S .•.: Marclt 3, 2004.

-UIUversiiy ofMai1'J3l1d, "Strategic Acqlii$itiol1S ..... April 23, 20Q4.

• Federal Reserte Board, Washington,.pC, "Sltalegie~cqlii$itiOllS ..," AuglJ.st, l7. 2004.

• BaruCh College, CUNY, "Strategic AcqUisitions ;u)cl :blVestIne.J!ts i:J.J 'a Duopoly P,atellt Race Under

Uncel,"t;jjwr" November 17, 2004, .

• INSEAD Sulg;tpore, "VaJueallil. Growth .•.," Deceml!<:t 7, 2004.

• NatioJ:la1 UluY!:r5ity of Siug;l»ore, •A Two-FactotModcl ofValue and Growth with Adj\1.st!n¢nt 'Q;>Sts,"

DecelJ1ber9,2M4,

• UllivetsityQfM;Il)'lallcl,"ATvvo-FactorModelofYaliieal1d Growth With AdjUStme.Jlt COsts: rvlay9,200S.

• ImperiaJ College, LongQl1, "ATwo-Factor Model ofValue aud Growth ..... MaylI,2006. .

.. WatwicrtUluversity,·Sll"ategicTradUJ.gwithRiskAverse Market Makers," May 31,2006...

14

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APPENDIX IV

Scope and Methodology

We conducted this performance audit in accordance with Generally Accepted

Government Auditing Standards. Those standards require that we pJan and

perform the audit to obtain sufficient, appropriate evidence to provide a

reasonable basis for our findings and conclusions based on our audit objectives.

We believe that the evidence obtained provides a reasonable basis for our

findings and concJusions based on our audit objectives.

Scope. We performed our audit from April 2008 to August 2008. Our audit

scope included a review of the CSE and Broker-Dealer Risk Assessment

program, as requested. Although our audit scope focused on TM's oversight of

the CSE firms, we also considered the role of other Commission divisions and

offices (for a Commission wide perspective) in the oversight oithe CSE firms.

Our scope emphasized the CSE firms (especially Bear Stearns) that do not have

a principal regulator because the Commission has much greater oversight

responsibility for these firms. Our period of review was from October 2002 until

August 2008. However, it varied depending on the nature of the issue. The

scope of our review considered when:

• Bear Stearns collapsed;

• The subprime mortgage crisis started to become apparent (based on our

audit work, we used December 2006);

• Two of Bear Stearns' managed hedge funds collapsed; and

• The CSE program began and the Commission issued the Order for the

particular firm.

Lastly, our scope either did not include or was limited in the following areas:

• We completed our audit fieldwork prior to September 15, 2008 when

Lehman Brothers announced it would file for bankruptcy protection and

Bank of America announced that it agreed to acquire Merrill Lynch &Co.

As a result, our fieldwork did not emphasize these firms, unlike Bear

Stearns;

• We did not evaluate the effect(s), if any, that mark to marker(i.e., "fair

value") accounting had on the valuation of mortgage securities and the

ensuing write-downs which subsequently caused the firms to raise capital;

• We did not evaluate the role of rating agencies in the securitization

process of mortgage loans;

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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APPENDIX IV CONTINUED..

• We did not visit the CSE firms and perform an independent assessment

of the firm's risk management systems (e.g., internal controls, models,

etc.), or their financial condition (e.g., compliance with capital and liquidity

requirements). As a resuJt, we may not have identified certain findings

and recommendations (i.e., improvements);

• We did not determine (i.e., recalculate and determine the accwacy) of the

capital and liquidity data provided by the CSE firms to TM: OGlE and TM

performed some inspection testing on the financial data during the

application inspection. Also, the Financial Industry Regulatory Authority

(FINRA) routinely performs inspection testing on the registered brokerdealers capital calculation;

• We did not determine the cause of Bear Stearns' collapse. For instance,

some individuals have speculated that short sellers may have caused

Bear Stearns' collapse by intentionally spreading false rumors. This issue

is beyond the scope of this audit;

• The CSE program consists of four interrelated activities: an application

process, inspections, the review of required filings, and periodic meetings

with CSE staff. 193 We performed limited testing on some of these

processes, as discussed below: 194

o TM relies mainly on meetings with the CSE staff to administer the

CSE program. As a result, we viewed compliance testing in this

area to have limited value; instead we (our expert, primarily)

focused on the substance of these meetings. Thus, we excluded

the meeting process from our compliance testing; and

o In March 2007, in response to a GAO audit report (as discussed in

the Prior Audit Coverage of this Appendix); Chairman Cox decided

to transfer inspection responsibility from OGlE to TM (responsibility

was transferred to TM in March 2007 for four of the five firms, and

for the last firm (Morgan Stanley) following the completion of the

ongoing OGlE exam of that firm in September 2007). OGlE

retained within the Commission, the responsibility for conducting

inspections on the CSE's broker-dealers. TM had not completed

any of these inspections as of mid-September 2008. As a result,

we only performed limited compliance testing on TM's inspection

process. Instead, we emphasized the design of the TM inspection

program;

• The Congressional request also asked the DIG to investigate the closing

of a Commission enforcement investigation involving Bear Stearns. This

193 Source: SEC [Commission] Holding Company SupelVision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreg/hcsupelVision.htm>.

194 The purpose of our testing was to determine whether the CSE program is compliant with its policies and

procedures and the CSE rule.

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APPENDIX IV CONTINUED..

issue is beyond the scope of this audit, but is the subject of a separate

investigative report; and

• The role of federal regulators (e.g., the U.S. Department of Treasury) in

the sale of Bear Stearns to JP Morgan is beyond the scope of this audit.

Methodology. Our methodology included reviewing required filings, Jnspection

reports, and documentation surrounding periodic meetings between TM and

CSE staff. We also reviewed other types of supporting documentation such as

TM's policies and procedures, prior GAO audit reports, newspaper articles, etc.

We also conducted interviews with staff from the Commission, CSE firms, GAO,

and the FRBNY.

Lastly, we hired a contractor (i.e., an expert) to provide us with technical

expertise. 195 The expert reviewed the adequacy of TM's review of models,

scenario analysis, etc; as well as, the associated internal risk management

controls. We have incorporated the expert's opinions, finding~ and

recommendations into this audit report. The expert focused his review on the

Commission's oversight of Bear Stearns.

Internal/Management Controls. We did not review management controls

because they did not pertain to the audit's objectives. However, we identified

several improvements in the CSE program's internal controls (e.g., tracking of

issues).

Use of Computer-Processed Data. We relied on data from the Commission's

Broker-Dealer Risk Assessment (BDRA) computer system. Firms use the BORA

system to electronically transmit filings (and BDRA stores the filing) to TM. The

BDRA system does not process any of the data contained in the filings. As a

result, we considered the relevant risks to be:

• TM's failure to re.ceive a filing sent by a firm; and

• Whether information in the BDRA system could be compromised

(information security risks).

We did not identify any instances where TM failed to receive a filing that a CSE

firm transmitted through the system. However, TM told us about situations

where firm filings made under the Broker-Dealer Risk Assessment program did

not completely transmit to TM through the BDRA system. Given how we used

the BORA data in this audit, if a similar situation occurred with the CSE filings,

we would have been aware because the firms transmit the filings at known

intervals (e.g., month end).

We considered the risk surrounding information security. The Commission's

Office of Information Technology recently certified and accredited the BDRA

195 See Appendix III for our expert's (Albert "Pete" Kyle) Curriculum Vitae.

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APPENDIX IV CONTINUED ..

system, as required by the Federal Information Security Management Act of

2002. Therefore, we believe that we can rely upon the information in the BORA

system as it pertains to information security.

We identified a few issues with the BORA system, but they do not affect the

reliability of the data. We discuss the issues in our related audit report (No. 446-

B).

Judgmental Sample. We judgmentally selected twenty issues that TM or OCIE

staff identified for our testing on TM's tracking of material issues (see Report

Finding No.5). Our sample included issues from all the CSE firms including

those with principal regulators, although our audit work emphasized Bear

Stearns. We generally selected specific issues such as an internal control

weakness, as opposed to more generic issues (e.g., exposure to subprime). We

selected samples from:

• The TM action memo recommending that the Commission issue the

Order; -

• OCIE inspection reports; and196

• The monitoring staff's monthly memoranda (which discuss significant

issues) to senior TM management.

Although we believe that our sampling methodology is reasonable and

representative, our results should not be projected onto the universe of issues.

Use of Technical Assistance. We received technical assistance from an

expert, as discussed in the Methodology section of this Appendix. His expertise

is described in his Curriculum Vitae in Appendix III.

Prior Audit Coverage. GAO Report Financial Market Regulation: Agencies

Engaged in Consolidated Supervision Can Strengthen Performance

Measurement and Collaboration, GAO Report 07-154, dated March 15, 2007 on

strengthening performance measurement and collaboration for the agencies

(i.e., the Federal Reserve, Commission, and the Office of Thrift Supervision

(OTS» involved in consolidated supervision. They made several

recommendations involving the Commission:

GAO Recommendation: To better assess the Commission's achievements,

the Chairman of the Commission should direct his

staff to develop program objectives and performance

measures that are specific to the CSE program.

196 We did not use TM's inspection reports because they had not completed any inspections (as of when we

performed our testing) since the Chairman transferred (from OCIE to TM) the inspection authority for the

consolidated entity. Lastly, TM has implemented an automated method to track the inspection issues

(i.e., findings).

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The Commission has developed program objectives and performance measures.

These documents are available on the Commission's website. 197 .

GAO Recommendation: To ensure they are promoting consistency with

primary bank and functional supervisors and are

avoiding duplicating the efforts of these supervisors,

the Chairman of the Federal Reserve, the Director of

the OTS, and the Chairman of the Commission

should also direct their staffs to identify additional

ways to more effectively collaborate with primary bank

and functional supervisors. Some of the ways they

might consider accomplishing this include:

• Ensuring common understanding of how the

respective roles and responsibilities of primary bank

and functional supervisors and of consolidated

supervisors are being applied and defined in

decisions regarding the examinatio-n and supervision

of institutions; and

• Developing appropriate mechanisms to monitor,

evaluate, and report jointly on results.

In response to Bear Stearns' collapse, the Commission and the Federal Reserve

have agreed on a MOU involving coordination and information sharing.

GAO Recommendation: To take advantage of the opportunities to promote

better accountability and limit the potential for

duplication and regulatory gaps, the Chairman of the

Federal Reserve, the Director of OTS, and the

Chairman of the Commission should foster more

systematic collaboration among theiragencies to

promote supervisory consistency, particularly for firms

that provide similar services. In particular, the

Chairman of the Commission and the Director of the

OTS should jointly clarify accountability for the

supervision of the CSEs that are also thrift holding

companies and work to reduce the potential for

duplication.

The Chairman and the Director of OTS are still discussing the jurisdictional

issues raised by the recommendation. This issue was recently discussed at a

Congressional hearing. 198

197 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreg/hcsupervision.htm>.

198 Source: Risk Management and its Implications for Systemic Risk Before the U.S. Senate Subcommittee

on Securities, Insurance, and Investment on Banking, Housing, and Urban Affairs, 11 oth Congo (June 19,

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APPENDIX IV CONTINUED..

GAO Recommendation: The Chairman of the Commission should direct the

staff to develop and publicly release explicit written

guidance for supervision of CSEs. This guidance

should clarify the responsibilities and activities of the

OCIE and TM's res'ponsibilities for administering the

CSE program.

The Chairman transferred the inspection authority of the consolidated entity from

OCIE to TM. 199 However, as discussed in the audit report, TM and OCIE can

still improve collaboration. Lastly, the Commission developed and publicly

released written guidance describing the CSE program (e.g., TM's roles and

responsibilities).

2008) (statement of Erik Sirri, Director of TM, Commission).

199 The transfer was in response to a GAO audit report (Financial Market Regulation: Agencies Engaged in

Consolidated Supervision Can Strengthen Performance Measurement and Collaboration. Report 07-

154, March 15, 2007) recommendation. In response to the report Chairman Cox told GAO: "To

implement this recommendation, I have carefully considered the question of which organizational

structure will best achieve the goal of the CSE program. I have concluded that the success of the CSE

program will be best ensured if the supervision of the CSE firms is fully integrated with, rather than

merely coordinated with, the detailed onsite testing that is done of the documented controls at CSE

firms. As a result, I have decided to transfer responsibility for on-site testing of the CSE holding

company controls to the Division of Market Regulation [now called TM). This will bet.!er align the testing

and supervision components of the CSE program, will strengthen its prudential character, and will most

efficiently utilize the Commission's resources. With the new structure, ongoing supervision activities will

be more directly informed by the results of focused testing of controls, and field inspections will be more

precisely targeted using information from ongoing supervisory work. In addition, the Commission's

expertise related to the prudential supervision of securities firms will be concentrated in the Division of

Market Regulation, which will foster improved communication and coordination among the staff

responsible for administering various components of the CSE program." The Chairman made his

decision after carefully evaluating proposals from TM and OCIE, and after consulting with the four other

Commissioners, who unanimously supported the decision to consolidate CSE oversight under TM.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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APPENDIX V

List of Recommendations

Recommendation 1:

The Division of Trading and Markets, in consultation with the Board of Governors

of the Federal Reserve System and the Basel Committee should: (1} reassess

the guidelines and rules regarding the Consolidated Supervised Entity (CSE)

firms' capital levels; and (2) identify instances (e.g., a firm's credit rating is

downgraded, or its unsecured debt trades at high spreads over Treasuries) when

firms should be required to raise additional capital, even if the firm otherwise

appears to be well capitalized according to CSE program requirements.

Recommendation 2:

The Division of Trading and Markets, in consultation with the Board of Governors

of the Federal Reserve System, should reassess pillar 2 of the Basel II

framework and the Consolidated Supervised Entity (CSE) program guidelines

regarding liquidity and make appropriate changes to the CSE program's liquidity

requirements. Changes should describe assumptions CSE firms should be

required to make about availability of secured lending in times of stress

(including secured lending from the Federal Reserve) and should spell out

circumstances in which CSE firms should be required to increase their liquidity

beyond levels currently contemplated by CSE program liquidity requirements.

Recommendation 3:

The Division of Trading and Markets should ensure that it adequately

incorporates a firm's concentration of securities into the Consolidated Supervised

Entity (CSE) program's assessment of a firm's risk management systems (e.g.,

internal controls, models, etc.) and more aggressively prompts CSE firms to take

appropriate actions to mitigate such risks.

Recommendation 4:

The Division of Trading and Markets, in consultation with the Board of Governors

of the Federal Reserve System, should reassess the Consolidated Supervised

Entity (CSE) program's policy regarding leverage ratio limits and make a

determination as to whether, and under what circumstances, to impose leverage

ratio limits on the CSEs.

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APPENDIX V CONTINUED..

Recommendation 5:

The Division of Trading and Markets (TM) should ensure that: (1) the

Consolidated Supervised Entity (CSE) firms have specific criteria for reviewing

and approving models used for pricing and risk management, (2) the review and

approval process conducted by the CSE firms is performed in an independent

manner by the CSEs' risk management staff, (3) each CSE firms' model review

and approval process takes place in a thorough and timely manner, and (4)

impose limits on risk taking by firms in areas where TM determines that risk

management is not adequate.

Recommendation 6:

The Division of Trading and Markets should be more skeptical of Consolidated

Supervised Entity firms risk models and work with regulated firms to help them

develop additional stress scenarios that mayor may not have not have been

contemplated as part of the prudential regulation process.

Recommendation 7:

The Diyision of Trading and Markets (TM) should be involved in formulating

action plans for a variety of stress or disaster scenarios, even if the plans are

informal, including plans for every stress scenario that the Consolidated

Supervised Entity (CSE) firms use in risk management, as well as plans for

scenarios that TM believes might happen but are not incorporated into CSE

firms' risk management.

Recommendation 8:

The Division of Trading and Markets should take steps to ensure that mark

disputes do not provide an occasion for Consolidated Supervised Entity firms to

inflate the combined capital of two firms by using inconsistent marks.

Recommendation 9:

The Division of Trading and Markets should encourage the Consolidated

Supervised Entity (CSE) firms to present VaR and other risk management data

in a useful manner, which is consistent with how the CSE firms use the

information internally and which allows risk factors to be applied consistently to

individual desks.

Recommendation 10:

The Division of Trading and Markets should ensure that the Consolidated

Supervised Entity take appropriate valuation deductions for illiquid, hard-to-value

assets and appropriate capital deductions for stressed repos, especially stressed

repos where illiquid securities are posted as collateral.

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APPENDIX V CONTINUED..

Recommendation 11:

The Division of Trading and Markets (TM), in consultation with the Chairman's

Office, should discuss risk tolerance with the Board of Directors and senior

management of each Consolidated Supervised Entity (CSE) firm to better

understand whether the actions of CSE firm staff are consistent with the desires

of the Board of Directors and senior management. This information would

enable TM to better assess the effectiveness of the firms' risk management

systems.

Recommendation 12:

The Division of Trading and Markets should require compliance with the existing

rule that requires external auditors to review the Consolidated Supervised Entity

firms' risk management control systems or seek Commission approval in

accordance with the Administrative Procedures Aceoo for this deviation from the

current rule's requirement.

Recommendation 13:

The Division of Trading and Markets should ensure that reviews of a firm's

Contingency Funding Plan include an assessment of a Consolidated Supervised

Entity firm's internal and external communication strategies.

Recommendation 14:

The Division of Trading and Markets should develop a formal automated process

to track material issues identified by the monitoring staff to ensure that they are

adequately resolved. At a minimum, the tracking system should provide the

following information:

• The source of the issue;

• When the issue was identified;

• Who identified the issue;

• The current status of the issue (e.g., new developments);

• When the issue was resolved; and

• How the issue was resolved.

200 The Administrative Procedures Act (5 U.S.C. §500 et. seq.,) sets forth the basic procedural requirements

for agency rulemaking. It generally requires (1) publication of a notice of proposed rulemaking in the

Federal Register, (2) opportunity for public participation in rulemaking by submission of written

comments, and (3) publication of a final rule and accompanying statement of basis and purpose not less

than 30 days before the rule's effective date.

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APPENDIX V CONTINUED..

Recommendation 15:

The Division of Trading and Markets should: (1) reassess all the prior Office of

Compliance Inspections and Examinations (OCIE) issues to ensure that no

significant issues are unresolved (given the belief that OCIE followed up); and (2)

follow up on all significant issues.

Recommendation 16:

The Division of Trading and Markets should ensure that they complete all phases

of a firm's inspection process before recommending that the Securities and

Exchange Commission allow any additional Consolidated Supervised Entity firms

the authority to use the alternative capital method.

Recommendation 17:

The Divisions of Corporation Finance (CF) and Trading and Markets (TM) should

take concrete steps to improve their collaboration efforts and should determine

whether TM's information on the Consolidated Supervised Entity (CSE) firms

could be used by CF in its review of the CSE firms.

Recommendation 18:

The Division of Trading and Markets (TM) and the Office of Compliance

Inspections and Examinations (OCIE) should develop a collaboration agreement

(e.g., discussing information sharing) that maintains a clear delineation of

responsibilities between TM and OCIE with respect to the Consolidated

Supervised Entity program. They should inform the Chairman's Office of any

disagreement(s) so that the issue(s) can be resolved.

Recommendation 19:

The Division of Trading and Markets and the Office of Risk Assessment should

develop an agreement outlining their roles and responsibilities, as well as

methods for information sharing such as communicating project results. These

two offices should inform the Chairman's Office of any disagreement(s) so that

the issue(s) can be resolved.

Recommendation 20:

The Division of Corporation Finance should: (1) develop internal guidelines for

reviewing filings in a timely manner, and (2) track and monitor compliance with

these internal guidelines.

Recommendation 21:

The Division of Corporation Finance (CF) should (1) establish a policy outlining

when firms are expected to substantively respond to issues raised in CF's

comment letters, and (2) track and monitor compliance with this policy.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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APPENDIX V CONTINUED..

Recommendation 22:

Chairman Cox should create a Task Force led by the Office of Risk Assessment

(ORA) with staff from the Divisions of Trading and Markets, and Investment

Management, and the Office of Compliance Inspections and Examinations. The

Task Force should perform an analysis of large firms with customer accounts

that hold significant amounts of customer funds and have unregulated entities, to

determine the costs and benefits of supervising these firms on a consolidated

basis. If the Task Force ultimately believes that the Securities and Exchange

Commission (Commission) should supervise these firms on a consolidated

basis, it should make a recommendation to the Commission that involves

seeking the necessary statutory authority to oversee these firms on a

consolidated basis.

Recommendation 23:

The Division of Trading and Markets, in consultation with the Chairman's office,

should determine what additional changes need to be made to the Consolidated

Supervised Entity (CSE) program in light of the collapse of Bear Stearns and

changing economic environment.

Recommendation 24:

The Division of Trading and Markets (TM) should fill critical existing positions,

and consider what any additional staff it believes will be needed to carry out the

CSE program's function going forward. TM should also establish milestones for

completing each phase of an inspection and implement a procedure to ensure

that the milestones are met.

Recommendation 25:

The Division of Trading and Markets, in consultation with the Office of

Compliance Inspections and Examinations and the Commission's Ethics office,

should develop an ethics manual.

Recommendation 26:

The Division of Trading and Markets should continue to seek out ways to

increase its communication, coordination, and information sharing with the

Federal Reserve and other Federal Regulators.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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September 25, 2008
APPENDIX VI

Chairman Cox's Comments

September 25, 2008

MEMORANDUM

TO:

FROM:

H. David Kotz

Inspector General

Christopher Cox

Chairman

SUBJECT: Draft Report on SEC's Oversight ofBear Stearns and Related

Entities: The Consolidated Supervised Entities Program

Thank you for the opportunity to review the Draft Report on SEC's Oversight

ofBear Stearns and Related Entities: The Consolidated Supervised Entities

Program. I welcome your report and recommendations on the CSE program.

There is much value that the agency can take from an independent and

arms-length review of its programs, and your report provides an invaluable and

fresh perspective for the agency to carefully review and consider. The staff ofthe

Division of Trading and Markets and the Division of Corporation Finance, who as

you know have been working around the clock for months in the current market

turmoil, have provided detailed comments on specific aspects of the analysis in the

report. As head of the agency, I would like to address your major findings and

recommendations.

Your report makes 26 specific recommendations to improve the CSE

program, all of which are well-considered and worthy ofsupport. Some of these

recommendations had already been undertaken and many will have potential

applicability beyond the CSE program.

Your report also underscores the fundamental flaw with the CSE program

that I have reported to the Congress on several occasions in recent months:

voluntary regulation does not work. When Congress passed the Gramm-LeachBliley Act, it failed to give the SEC or any agency the authority to regulate certain

large investment bank holding companies. Because of the lack of explicit statutory

authority for the Commission to regulate the large investment bank holding

companies, the Commission in 2004 created a voluntary program, the Consolidated

Supervised Entities program, in an effort to fill this regulatory gap.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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APPENDIX VI CONTINUED..

The inherent weakness ofthe CSE program from the beginning wasthat

investment banks could opt in: or out of supervision voluntarily. The program had

no explicit statutory authority to require these investment bank holding companies

to report their capital, maintain liquidity, or submit to leverage requirements. The

fact that investment bank holding companies could withdraw from this voluntary

supervision at their discretion diminished the perceived mandate of the CSE

program, and weakened its effectiveness in a number of ways.

Lacking a statutory mandate to regulate these investment bank holding

companies, the CSE program was patterned after the regulation of commercial bank

holding companie,s. It used the capital and liquidity measurement approaches from

the commercial banking world - with unfortunate results.

Thus, as your report confirms, at the time of its near-failure Bear Stearns

had a capital cushion well above what was required to meet supervisory standards

calculated under the internationally-accepted Basel framework and the Federal

Reserve's "well capitalized" standard for bank holding companieS.

Your report also highlights the consequences of a critical issue that existed

throughout the financial services sector. Prior to the spring of 2008, the bank risk

models in use throughout the U.S., including those relied upon by the CSE firms,

did not include scenarios premised on a total mortgage meltdown on a scale so

devastating that it would cause the failure of Fannie Mae and Freddie Mac.

Throughout this year, national and international banking regulators have worked to

strengthen and improve the capital and liquidity standards that are used

throughout the banking system. The SEC has been a leader in this process through

institutions like the Basel Committee on Banking Supervision, the Senior

Supervisors Group, the Financial Stability Forum, and the International

Organization of Securities Commissions. Those efforts are ongoing and vital.

I am pleased that the SEC has already undertaken several of the actions

listed in your recommendations, and look forward to working with you to implement

others'. Thank you for your role in helping to ensure that the SEC is faithfully

executing its mission to protect investors, facilitate capital formation, and maintain

fair and orderly markets.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VII

Management's Comments

DIVISION OF TRADING AND MARKETS MANAGEMENT COMMENTARY

The Division of Trading and Markets ("Division") appreciates the opportunity to

comment on the Office of Inspector General ("OIG") Report "SEC's Oversight of

Bear Stearns and Related Entities: The Consolidated Supervised Entity Program"

("OIG Report"). This comment process is of critical importance to the Division

because previous modes offeedback to OIG have proven ineffective in correcting

what the Division .believes are factual errors and unsupported conclusions. This

OIG Report therefore becomes the mechanism by which the Division can attempt to

set the record straight.

We believe the OIG Report is fundamentally flawed in its process, premises,

analysis, and key findings. The Division understands the importance of an active

and independent OIG, and supports full and fair investigations of matters by the

OIG. However, with respect to this OIG Report, the Division's calls to correct

mistakes, misunderstandings, and misrepresentations have had limited effect on

the final document. It is our view that the resulting OIG Report starts from

incorrect assumptions and reaches inaccurate, unrealistic, and impracticable

conclusions.

Few would argue that the demise of Bear Stearns was a significant event for the

U.S. financial markets. This demise deserves a careful analysis to assess its causes

and to prescribe future actions. This OIG Report does not provide such an analysis;

rather, it attempts to explain Bear's collapse in nutshell fashion. The Division

believes that the OIG Report is flawed in several respects.

As a threshold matter, the Division believes it was not provided with a fair and

meaningful process to address the issues raised in the OIG Report. In particular:

• OIG failed to interview the Division's senior management. Senior managers

were in a position to address many of the concerns raised in the OIG Report

and provide information that OIG could not obtain from staffworkpapers.

• OIG did not interview Bear Stearns managers regarding critical aspects of

the OIG Report. Firm management constitutes a primary source of

information that could serve to meaningfully support or refute a number of

the OIG Report's statements about the Division's CSE supervision ofthe

firm. Such a cross-check and verification should be incorporated in such a

OIG Report.

• OIG's expert spent only three hours with Division staff before preparing his

portions ofthe OIGReport. The issues associated with supervision of a

complex firm such as Bear Stearns cannot be evaluated without developing a

context for the information. Without the benefit of conversations with

Division staff, such context is missing and the OIG's conclusions are destined

to lack proper foundations.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VII CONTINUED..

• Large portions of OIG's Report - and in particular the portion prepared by

the OIG expert - rely extensively, if not exclusively, on information

contained in informal Divison staff memoranda that recorded notes, not final

conclusions, and do not represent all the facts or work performed by Division

staff. These notes were not a final work product and were not even

circulated to the Division's senior management.

• The OIG Report cites staff notes out of context, giving the impression that

the Division, at some point, shared such views but failed to act prudently.

The OIG Report should have distinguished between its own findings and

opinions, and those of Division staff.

• The OIG Report's assessments contain numerous factual and analytical

errors, and weakly supported conclusions, perhaps reflective of the process

used and the tight time, informational, and resource constraints under which

it was prepared. Each error is, in and of itself, understandable. Untangling

capital from liquidity, market risk from funding risk, risk weighted assets

from less liquid assets, is difficult even for many practitioners and regulators

involved in day-to-day consideration of the issues. Unfortunately, the

cumulative effect of the errors led to less informed and more assertive

conclusions than would have been the case had the process had the luxury of

more time and greater resources.

This process has produced findings that are materially in error, including the

following:

• As the Division has expressly informed OIG in informal comments, CSE

holding companies are not subject to a capital requirement - they are

required to report a capital ratio calculated under the BaselII Standard.

• As the Division has expressly informed OIG in informal

comments, paragraph 777 of the Basel II Standard, quoted in the OIG

Report, describes requirements related to credit risk. Yet the text of the OIG

Report cites this paragraph to make an argument that the Standard was

applied imprudently with respect to market risk concentrations.

• As the Division has expressly informed OIG in informal comments, the OIG

Report improperly criticizes CSE oversight, noting "that pricing at Bear

Stearns was based more on looking at trading levels in the market than on

looking at models." Marking positions based upon recent trading activity is a

higher valuation standard in the accounting literature and should be used

above marks produced by models.

This OIG Report considers an isolated set of data about Bear Stearns~ yet it makes

sweeping statements and comes to broad findings about the CSE program in

general. In doing so, it does not consider the events in our markets following the

collapse of Bear Stearns. Since that time, we have seen the failure of IndyMac

bank, the bankruptcy of Lehman Brothers, the purchase of Merrill Lynch by Bank

of America, the Federal government's explicit actions to guarantee Fannie Mae,

Freddie Mac, the injection of Federal money into the insurance company AlG, the

attempt by the U.S. Treasury to create a $700B purchase facility for distressed

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VII CONTINUED..

assets from the financial sector, and the conversion of Morgan Stanley and Goldman

Sachs to bank holding companies.

[REDACTED PARAGRAPH]

This chain of events raises very significant questions about the supervision of all

types offinancial institutions, not just investment banks. For our part, the Division

has engaged with domestic and international regulators in a concerted effort to

answer what are very fundamental questions about how large and complex financial

institutions should be supervised, capitalized, and kept liquid. With respect to Bear

Stearns, the staff applied the relevant international standards for holding company

capital adequacy in a conservative manner, and added a holding company liquidity

requirement: and yet they could not withstand a "run-on-the-bank." Where the

globally accepted standards required an eight foot high levee, Division staff raised a

ten foot levee, which was of course little use in the face of a fifteen foot storm surge.

The relevant question now is not whether the levees were high enough, because

they clearly were breached. Rather, the central issue is whether levee systems, no.

matter how high, afford sufficient protection from the financial environment, or are

additional measures needed to complement the levees?

In particular, there is widespread recognition that the international standards for

holding company capital adequacy, relied upon by both commercial and investment

banks, require revision. Also, new standards for liquidity need to be calibrated and

applied to large institutions. There are many venues in which relevant discussions

are progressing and where guidance will soon be issued. The Commission staff has

been active in all of these, including the Senior Supervisors Group, the Basel

Committee, the Financial Stability Forum, and the International Organization of

Securities Commissions. Rather than wait for this collaborative work to be

complete, however, the Division responded quickly to thr collapse of Bear Stearns

by requiring the remaining CSE firms to increase their liquidity pools, which

already were significantly in excess of any applicable international standard.

Given continuing market events, we feel it is not possible to responsibly make the

type ofstatements that were made in this OIG Report about the demise ofBear

Stearns, and the role of the CSE program. We expect that after these data are

analyzed with proper care and reflection, responsible lessons can be drawn. But the

events subsequent to the failure of Bear Stearns strongly suggest that the

statements made in this OIG report are premature at best. For our part, we believe

that the key conclusions of the OIG Report are inaccurate and without empirical

foundation. .

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

85

September 25, 2008
APPENDIX VII CONTINUED..

()IGR~port446-A: SEC'sOVemght .,tBear St,e.amsand Related Entities: Th.e

CO:rlSQUliatedSu.pervls¢tlE:fitltyProgralll

Please illdicatedyourconcUITence·ornoJl.,oonculTence~ith.eachreoommeudation

that.applies myour Dhisio'n.ot·Qffite.

Recommendation1:

TlieDlvlSIol1 6f'1)'ading aiid ]\;llai1(etS~ih coilStiltationWith the BaafdofGOvehiorsofthe

FedetalReserve.Systetrtan,diheBasel CQlll111Ittee$hQuld: (t)re~~ess the@idelinesatld

t:ul~sregardi't1gth:e€ol~pli4~~E!d'Sqper:v~E!dF:rttity(GS~)f111lw' dapita.11~y~ls; '<111.d(2)

ide,o'tiffw!>tanqel>'(e,g,. p; rlJ1ll'scre<t#:r<rtil1gi~ downgrw;kd; ()fi~.~~eplJfed"<te1it.tr<ldes

at high.spreads overTh:as\lrjes)·whenfinnssho~ld~e·'required·wraise additionalcapitaL.

eV¢n ifthefulli othetwiseupj>.ears tohe well capitaliz«!aCPQtdiIig to0SE ptognUn. requiiellleols. .

TIle Divisiob ()ftfudibit ami MarketSpmlcilrsWith this r¢p()rifuleriaatio~eVeJIthougfiwe

heliev¥itisJiasecl ona,futid:lJ;tl1.¢llt~tYfla"Yedl.Uldets1andingofUteSear Steams priiis,

15tPtlE!'th¢t¢s~~'\VerMve,a1reatly ql1dE!~n:¢fforts 'tliatrespop.cltQ tJt¢ J&COlnrrtendttttp11,

Actions: iSfuce&atSteat"riS' f'aiture.\\re have:

jIt Workedwith·theJ3asel Committee on Banking Sl.lpervisionfu amend-capital

adeqtuwyslatidatdsf'orit'ltematioriaUy.a:et1vesopliist'icated·iIistltutlonstoel:eal

ex:pi1cit1¥'YV,1th liq1jiw.ty cis}(.

• SJ,JPpod&i theWor1<oftlleBascfAcc0rd ItllplementatiOnGroi)lJf!11"iIict¢lUejital

cle.fa1.J1triskcapitlrl,"wbich aitIl~to sllpplem~ltValve-atRigk~b4~ed capital to

~tm:>that ''tail riskexpQswes" in fueJr:AAlillgpoo1ca.rti:. adeq1.lately 9apita,~e4.

.D¢v¢lop¢d @d erttered4ttoa:formmMemo(;,l»dtltl1.«?fU.ld~t~lldirtgWitb.ib¢

FederalReserve to improve sharingofinfonnatioll'andprovideamechmrismfor

cooperationinsupervision ofCSEs,

• Jowly with the FederalReserve, discussed withthe seniormanagement at each

CSEflrtililS16rig..tei1l1 fUilditig plans~ iricludfug,plfuiSf6rrilismgriew capital by ~~s$iItgthe equity.8:i:ldlOftg~"t¢ttli debt tll}irke1$.

• Requited puhlicdiSclosut¢.6fcapiW adequ.il.'Cymeasurescomp'utedl.lridettfte

&sel Standmit .

FlawedAssumptiolls and Fitldings:. TMbelievesthattheOIGR'eport'sfmdil1gsare

futidamerita11yflawed1tl.the fo116wingways:

• The oltfReport's exclUstvef'oclls Qli c@itailli rriiSplaced,t\.Sexpla.iried in

(lomm1s$iQIiP1.1blicstatelllelil$ ilJicl1e$1;im,Q~iY~~afS.1¢am$t$faihJ.t¢,wi$d~e 'to a

fUllioi)liqljidity;,uQt papltai, 1.h¢pri1J:la,ry r¢'USgntl1~tJ:.\earfaileclwascoIi~e~ l1Y

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

86

September 25, 2008
APPENDIX VII CONTINUED..

,securedlenders,llIat itwo\ildsuffergreliter losses inthe.fllture.These,'concerns

caUSed se,clti'e(.{ lenders 10 sfPpproYldilig,tmaricing1 evonOilafUlly-':aectlred,hasis1

d~spih.~ili~inttQtSlJ9il1P1ianC,\fwith ~1JPlicabl(( het¢apfuil;r¢quii'~ment$.

.11i~ mG,:R:~p()i1; (1lis.¢<>~festhe naw(¢'():nh~ aas-~LstaiitUu'd.T1l¢ CS:e'tUles;

it1991;por:a~eby ~f~,n<~ge'Ul~~el Starrdarq,,'tlI~ ~apilala'l1~quAAlY J::eg4n~

·,applicable,to interruitiollally"aclive'TIllancial institrilions~includillg,commercial

~=~~~~tl;t~::~'ih~Js~~~~;~j~~ee~ .•~~i=g~~&:~~¢f:::lo. 'Mil in¢qmQl1li¢~ the' lO%I3.aselcapi1~J'a1:i<>Jhre~A()ld' '¢Pll$ti-hlting '~'eU

capitlilize(C"instifution'coosiS1eniwnh the'threshold.used by'banking.

supervisors, Falling belowTO%1riggerscertaio obligatiollsOllthe firm, b\d'

becau~¢ there:jk nocapitatr¢qtllteIJlenti~::n!:it i'i¢.C'essatllya i'violatlori'.!'

- • The OlCf.R:eportqpestionswhether Bear~.s "c~pitalrequirement"amountswere

adequat~;:·;b.urthe ~aHssoo>is'whethertheirttema1tona1m.sehtari<'laid;thatlUI .lntemati6n~hankirtgJmstitutiomr¢1~'Qii;~!sUffit:1efit.

..~~~:-eport'~s ass)'ihiP1ioiiS:fil~ardi~Jevetag¢ bas¢Q,ort'the fi¢kata~l(;l¢ ate

.,: Jhe.~Wl1!Pl~ut()fMr::I5pka.rli.:~Fl~d.~ ~h'l< OrG,a~po,q., is' mappll,c@l¢ It)':tiWi

relevllu't;capiiriLand:liqUiditY:reql.iiremerits;af.,Bear's'holdingccompany" ''TIle

~~~tl:~~~~~::~fron::llt:~~~ompany Baselnc~pilal standards ana

.. Mr. ~iq1@'d,~s ~W®¢ht d<>¢stlo( a,r;:(:l)i'~,ely t¢'fl.fi:gfue le1:t¢~llijd~p¢t{ltiQn9f'

1h~ ~EC'~ CllJTentllet capitalrule:audJ:.~~D,\Jm~()9saIla1yti()ale.t;rOrs'as

result, :Forillstanee~the CSE'broker~dealerswere notsubJecVtoanexplicif

12k,lev.~~g¢'StaridatdbeforetheeSE.. atti'¢lidIJlerits.as:iJflplied'~YMt.

Pil::~tcl. 1beill'tidle saystlu.ltb:f;Ok.e:r~d~eiS.Wer~,tO:mierlyslJbJect··tpi:l,

IeMe~¢ rJlt~Q limit. ()f12xrt¢to.a~ita.l In qQIijpJ.¢irtg lnitUinum ri¢t()apit~l,~an~l

14is lipli.t Wa~'I:I:lD1()Yed hyUi~uet;capit;lit~qtllr:em~n:t$"app1ilJaQ~e"tp ~~rdelilerstibsidiaries of:'CSEs;, (Thislimit.,is;m)the "aggregate indebtedness'"

metho(fforca:!culaiii:'jgbet capital.), R~wevet~ CSE:bt<>'kef:.;d'ealenfwere'not

:~:':~~::;~:::~::~:':J~:~~t:Z:~',::~:r~=~ ': b~tm inlhe rul~ since, 1975;,pnder~r.¢quirem~JJ,~~bl"()ker,;,d~le~ that ca,rry

clJStomer'3.Ccowds maintainmirtirrrum:llet capital equal to no less:than two

percefit:of·'aggte'gate debititenlS"~ notfh:~,~egat¢: li'idebtedn¢ss;st:aiidard'

t¢lerretl1P'lty,',Mr. P:ickarj:l.Ulm 'aitertii).tiv~:l1iethi;~lto,¢(}rtlp'lml'the.nwm\lrtl

ifetc~~tal: .' u1teilletlt1S '.' 'tledh:uall'lhe CSEbr(jket,.de~e~ ailll rt1<5St , ""~ '" (~"., ~P",.·~ ,., .' " '..',.. ",'

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

87

September 25, 2008
APPENDIX VII CONTINUED..

othel'Jarge broker-dealers. Underthe,"aggregate debit items" method for

calclltatmgriet,clijlital~,ajji'Qker..dealet's;abHit), tomcre-ase k\.'erage isIimlt¢d

th'-:QllglJ·th~ :awlitalII?~l)fha~1l~J9':pt9prj:~fu;ry P.Q~iti!:>l)$t4ih¢ttnll",~mrp~gh

theapplic:atiQll ofa levemgestan:4VJ1(roll,1jli¢:ag~g~indebtedness' ' standard. ' , ,

• IIl®illYZin:gBe~~teltrns'~ eff<>rl$~() hl~~as¢its:rela\iver¢lianceort s~9uJ'l;\d

nuher t1~an ~e(:~dfimding.,th~ OIC3'n.ep~rtst'ate~ ~attbis'shift c:atle:4 i~to

question '\vhlillleI':BearhadenoughcApitaltosustainitsbusiiless model}'

Thisstlttem¢nfIoeuses oricapitat .... riotIlqUidity, ;.-a~ theprimaryiSsue

cau..~ing ..~¢at·$CQnftPs~.am.f'l'M beli~v~s}it i$:,t@<.W:m~ntally·irtcqrr~till

¢¢'Ilcllidii1gtltiW $~¢ha¢ti),ritYP9'itlts l(r:in~d¢<l~~: ~p'ital. 4tB¢m'.

•' fw:the.r~ tll~:()l.G' R~P91't:~ta~~thll:t ¢yeI1>tJ)ougb.,aelg.l1a<.ljrtc,:eMed i~

reliance ()n:~ecuredfundmg.itwas "unable to.ribtain?!enougbtosave the finn

ihMarcli Thlsubfuit;s:thatBear-ilc,'erwOlUd:fui,ve;been.abte toobtaUl enougli

funding becausethe:firm"",.a$ ~xpC'nend~g.a';hirt~Otrtittl·l):ank'by

CQtll1t¢:rv~i~'thai ~viae;~q\l(edfQnqiit~ ,.

• itflinl'sdecisioniis tolliefom:roffbndih is based"OJitrian .' fuctornsucl.l a'S. , ' .." , "' ,,,',........ ",.. """ ",,8 ",,,,,,,, ..,,,,, ..,,,,, .. ,, Y " " ,,, " " ,

1enn!di"ersificatio~ colIateraI.'stability oflender" maintaitiingrelations~ps

and cost It-was' widely believedthatsecured.fundmg·was more:smblerand:

ieliabie:tb'an'utiSecure(1fuhditig.A1s,o.th'e C:ost:of'Uri~ecured funding

increased-sUbst.irrtiidl ....... ".,y.$Q,caUfman-caJ}imfittrtionsduriil' ~....,' g..... aiidaftei·the.

Surnm~t:,{)t::20W" I~J'h~$~ Qir~~1@~S:,: iH~ un®~l®iJMle:t1l<l;tm,il.nY:

fmancialeompanies.ihcludingBear. soughtcheapetjrnore :stable-;sourceso'f

fmaridtlg;lnroughj.¢curMfufiding.. ,A1so,,:ih)po(furit'Was the collapse dfthe

semlritizattonhusihess,lhehig&cPstotfliliding WaS.ari.etfePt oftfte:cQHapse

(Ifs¢c.Qotj:z:at:lot\ f~.th¢rthan Its ¢ll.use,

• 'ljIeQRl ~P9I't,incorre9tly,states.,1>ased~,mtl:~yi¢w9finfo.tlua1S'f<Jffnpt~

and intermlf.memoranda;;.tltat TM: didnot'belieNe ithadantandatefo,COll1pef

Bear Steams'to;:rai$eadditional oapitaUfthe fitmrs BaselIIcapiW,ratio was .. ~t '.',ii;., ,.,' l' «0)1 ....erwan :979.,.

'.. AscW explainedittuudiltUi{ c-Otfunents the CSEmles e~slv anci'btoadly'

siat.e:;tliahb'c (J(),mJl1~~tcm~~i~~~~ ,~!ti~li~i' ~tt~m~~$dll~jAet:1h~ "... , 1:J~N1eaJe~ot:'U1,~"~lWt~g c{),wpany)ftl,J..e. Co~~~n :rIP4s.'~ftI(:ce~!?~

and ~ppropriate inthe'pUhlic interestor"fQrlheprd1ectionofinYeslors, See:

Exdi~g~,A¢t,:i(ul~ 15pa:,le(~)('7). 1,'h¢r,e ~;~ls:() ~p¢:Cific condiuoos:ili;..it. Woul(:lfti~g¢t,G9n:iJ;lli$sioti,ii~9Il" :E~ch~)~¢, A¢iRitle l:5~j;.l~(~lH(!)~

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• TM h}lS a1waysbe1ieveda,ndwpres~nted. frQffi tln,~gipningoftheG$E

program tbatitbadbroad,authorityrehited,to financial-responsibilityto

rhfuid;{f¢ thatabtfJkeraealeral1dot its Ultirilil1e.holdillg"eoilipatiyraiSecaphlll

ot8.,ehieve theslfin¢ ¢nd bytedtlci11gthe balanc¢ she¢tasWeillasdite¢tthe

fmn inthe~al¢Qfl!$s¢ts9t c~st.()meta.(:co1.lnts l!$ th,eractsa11dcit:ctuW;f~lCeS

mayw~.ran:t.

't'M,beliey¢stha,tJt mus,eftiIfor the readerto, undei;$1;and cerlMt:tTU11da;tnen1aIfeahltesot:

theDSE flUes, The CSErulesmcorpofare>byreferencethe Basel Standar¢tb.e capitm

adeqluwy.regime"applicable·to intemationallyaetiveifinancial,instituiioos.oih,cluding

commercial ~~Qrt a globalbaSls'.Th(:Cor.iit'iliSSiOilhas sOllghttoappl)rtmsstandatd itl.'a¢ons.eJ:i(,ldiV¢,fi'i~et, JJIJ)m1i9UlarWitb':regwdtQdhll,rges.,fottll¢p~iti()jjsh¢:ld'With ..

1ta(titlgitl~l11:fWhich, are a sig;ll'it1cant~1w'ei()fthrise;hei14 OYei@rkyse~tlfitie.sti®fl.

Specifically, firms have been:requitedto augmentva1ue~at~riskc1ulrgeg.{V:aR,)~, computed

~sitlginternallY-develofed.statisticalnl6dels,,'with~xed·~etcellta~ehaiicuts. Thes,e

adaitlomU hair<mtsare, in fact. amUltipI6' oftheV'alue;,,;ai..riskcharges,atul,so. are more eons~rv~tiy~ . .

Because the Commi~sionrecognizedthatthepritrul.ryrisksto;securities·fi.rms 'are 'those

assQciatedwithfwlclil1g,the CSWpfc'.grafii imposed a liquidity :requ1tementin;additiol1to

the Basel Standard. It, is hnpottanttonotethittthisrequirement, \"lnch"mandatedfj®s

holdi)ignifiCaiitp()olS()fliq\J.idusse~. iSllOtpadottheBusl;ll Stand-wd..

Inlh:ewakeofcrises·atBear Stearns, Northern R.ock;. Countrywide" and amunberof

other mstltiitioris,tlieBasel Cotfuhittee6riBan:ldng SupeNiSii6tt. which developed arid ~r01nulgat¢d,th'¢Easlil St1lhdar~,hasii1itiated anum15etofptPjeem'1tltetidedto Inodify the

:Ba$~t$1!;:l.tldar4toJefl'Sct.th,ele~so11s'()fr'Sc~t~v~11ts,'Dv1's'taff'11~S~C/:~yelyeng~g~dit1,

-tilisef,fOli· atthe bellesto:fQh~inJ:Iat;l~~ TMf)taffcq.;9b~ir QUe Balsel qoIPWit;t~ ~aJ~g

withlheseissues;andpadicipate in another. ""moh are working to strengthen ina munber

ofareastllecapi'ful;Staridai-dS.·appIicabfe'to,mferiiiltionaIlyactiVe 1riStitlJt16nsc. The'Basel

GObunlttee h$~xp@,dedits>Woik. to incllideic()nsideil'~()n()fgt1ida.tl~.andpe~s'

~'Wticitst~ld~nJs1,regardj:ngliqllidity.,ris1c,mat14g~m~ntfQrfl1lMci~ it1$titllnqll.s,..Here

again;TM',staffhas'ooencaetively in\>~olved.S'O \,~hi1e theCommissiotl·staffbelieved that

capi'taland.1iq~liditysiandardsapplicahleto.CSJJ:s.wereconserY~v~1"elative'~~

int¢rt1~onal.noftns.p~()rtothee()llapseof,Bear·St~'l.:theY.Join.,.otl1er5~Iatofflin rec,ogniziiig 1hatfi.JJ.'thets:tt~ngth¥nil;iglm.t1~Jq)anIDngtl1ese:stan~d$ ·tQ··iru::ludI;lJiqujc:llty

i$ ®¢¢$sarYil1tb:e,w~oft~~¢nte¥~s, .... .. .

Reoommtlndati0Ii2:

Tb¢,J)lyislOJ) QfTl'a4!ng mid 'Markets. in 90ns41.ta110ilwithfue l30atd ()fGo\7etn.o1"Softh~

:federaf:&~serve :~J'St~sh<)1.l1q.~a$s~~s pillar; 2. Qft1l~ aas~l UqatnPWQl'k, ,at;l9 .!h.l;l

Consolidated Supervised Entity (CSE)progratnguidelin~sregarding liquidity and make

appropriatechan.ges1tithe CSEprogiful1:s liqUillit}' reql'ureinents. Changes should

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APPENDIX VII CONTINUED..

describe assumptions CSEfinnsshould.berequiredlo ·make about availability ofsecured

lendrnglo umesofstt'ess (tUCll.lditlg secllted lendingfi'OIri the Feoer.al Reserve) aiid shouIdspeIl.o~i.t()irClltilstah¢esirt"v'J:iich. dSEfirtilSshol.udbereqlliredlQ increas¢the.ir

liquidity»eyondlevelsc'llrr~nt1ycoo,tefi1pl~1~a pyCSB PJ'Ogr::un 1iquidityrequirefi1~lts.

'ManagetnentRe,sponse(COl1curorJ'{oll~oncurl;

w~ 'c()licllrwitbthe teQ91f1lh€inda.t10ll.'alia haveelth:etafrea<.1Ytmdert~ehor already

c:()tnpletedwork1hatresp\){ldsi9ihi:<te90mmendatioll.

• \V6rkedWit1l;the:Bas¢1 eoirimitte¢6n BaiiKirig SupetyisiOnlQlmPlemerlttbe

dhaitm®'scallfQ!" aD:1¢n.dedca:pt'talade,qu.apysf®d4rds for internat1():t:\a11y actiYe

.sophisticatedin,stitufi9U$ toCleal..El~li6it1y with·.·Iiqqidity'.dsk

• Join,tly with,t1leFedel"~Reserve~ i:<l:daplislJedl;l(?W,S1rell:;sC:i:<nl!ti9s a$ab~ilvfor

sizirtgliquiditypoolrequiremellts based onthe respollseto shorterLmoreextreme

¢'1intseilmilili~ asiJ8stlttItiattoosofs¢¢twedfitftditlg1mOre SCY¢t¢ I1qttldity

OQtil0,vsfiQmptinfebtg).<etage activities 311<lliqttidit}'dtain$:<lttetO operatious frictJ()~'s1);(:h "l:\~ ill <l~v~iYes$,¢ttlElm~t$ ,®dti.fi1ing ~QlllJ,i<lera1iotj~tel$d'to

marginpostings.

• Jo~t1y ~iththeFe~:r~~ese:ve,~trengtheJ1e~th~ liquidityreq~li~ments for CSE

fl.tl1J.srelative to their unsecur¢d.fUndirt~ needs,;'andcloselY'scitltirtiiedihe

StW~ut¢d.furtdihg~¢tiviti¢sofeachQSEfitm~witha vieW1O·J¢1l~ehingJhe.

avemge:dwatim:Iand b1"9~a~uiJ1~:thediyersity Qf~l1 fi.lU-gi11g~g¢Ui¢1ltS"

like I.tecOD.1lIlenwmOUl.I{e99fi1fi1en4a:tiQu 2istl'lllc4unellta(ly f1awed.~ itlJ~e4 011 the

same analysis. In additioll~aswe informed·the<OIG in.our informal comments. the

arimysisis'iiiacCtIi"8t¢iftth:e fQU<hving:Ways:

• 1l1e0IGR.eport'ssUlwinetit thattheCSEPttigt:amllquiditygijidtiHnes;Wete inadequmelJec~wsf; the tJn)e.horiz9t1foCQ,Ji<jJ.idit.ycrisisJQurtfold.islikely to. be

less tlilU11lle'oll~~Ye'at; peri()q•. atl4~e9uredlenqi,ttg fac:ilitiesarenot automafi9~ly

availableirt times ofstress, presupposesthafthe loss, ofall securedfundirtg was

reason~blyptedlcfubje; 'It als6,ignoIes thedifficu'lty ofprovldilig.adeqiiate

.11quidlt.yf'orthis ev~t .

:. 'f:h,1 h~smted¢t¢4r1y1hat itsl1qm,(iitypo()lreqlli:teme,um. Jj1d.~1hOs¢of91ll¢t

int~ll1ati()lJ.<l1 aWl OQInef3'ti9 regulators·oontemplatittg·si.milar i~s\jles. didh()t

anticipate a complete uuviillingnessoflende:rsto provide tinancfugon quality

assetW(suchas Treasuries of agel'iby secUriti&s).Th1sw6uld ltlcIU:oo the

.av:3illtpilityolcQll'lfi1itted s¢c\lr~dJertdirt~.faci1ities ...

5

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.:Fr(>nl'th~~tandpQint'ofUIJ.Secur~4(Wlding;applying-a'olleyearJiqJ.li~#y

'req\llremeri'tto n~place unsecured funding wasjtselfa logicalapproach.,The

'~~::~t~~~g:g¢:e~:::~:::~il~::~~~~:~:~:~;:::I~~:~~~~~~:S ()fi ~y Ofi~ t():~~lli.l,~Je:n4ing,tb.efift1l·WQ~d-:haye:,ltJiqllid.ityp()o.~izedl()\lll()wif

wreplaQ~ tlle Wl,~!<c~d funding ~:~t m~tw:~d:~ver a. olle-ye<,rrPet:iQd,

• 'Th:e~iO~day cash'flow aruilysiSisa,diff'ereJitmemc thatprovides1he fii:nunofuer

p,et~pective. misi(short4.erm~as1iflo,,'\analS's1S focused 6rii\riiofe aCilte:e'\(cJit.

• ,Also., gtYeh'tbat,:US.{1rid irilematiQiiaj cr¢ditm~k¢tS;1iliy¢:6eeiLttI ,cnstSc{Qr'Qyer a 'ye'ar~1h¢ o~¢~~~¢'8,t'11liSectitedfu.ndin:~1iq~dity:pQQl,r¢qti,itelnent,.temains:'rele.V~ht.

., 'Ibe()iq;l~~VQrl;$sugge$t$ that T:M statfshoj;ddlia;vete¢o~t.U;.::¢dth~t

tern1itl~fi()n~"qfa~ar~s: cQIl11l)it:te4 ~ec~:eyex:green faoilitie~ 'Wet:e,a,pr~di~()r()f

a;\'ntn;;;on~ihe-bank~' However~ during.200Tavailability oflonger-termseoured

,,'fun-amg'1t1cluoirig;eVe'rgreel1 flfuilfties,Was decIkirtgfof.'riloSf,111vestfuerit'bliriks•.

::~~~:~:~:.,~~l~~a;,~~:~:~~o~~~~:~':~;~~as~~~:e,~~;.'a UJ:l<f~t9Q~t~"~,e1if~1~byn{stalt: ,.

• The OlGReporesstatement thatOIG: sfaffcouldnot detennine"vhether'TM,staff

~~~~;:~~:~o::~,;;b:~~~:;~~ln~::~::~i~~rigI~~r~~::le$t A~gttJ;t 2oo1tM.s'Wt pei'iodicany:t¢Cei~ed ilifo@a'fron:'(inthe 'aVailability or ;~tic~it~d ~ver~~ll faciliti~:WFiie;~:lQ'C()m,~1trye.ntoty ~y~~~'repm:~ c,op1pileo

'by Bear Stearns. Also, TlvtstaffeJl:plainedthatifrrweekly and daily discussions

WitllcBeat'S flxetUllcome funding deskaillf'wlili"the Tieasursfnianag~d:~ Belir

mt()nn.~d tM ,staffbif'~fgltifi¢;antlO$$es Qfsu'Cit eyergteettfaCilirles.

Reconmlenda:tioll'3:

tltebi~si.Qii rifTradlffg arid 1\4litket5should ensure'that itadeq:ilatelyincorpora'tes a

fml):'s¢9i\¢¢lltt:8tlQ'ti l;)tS¢¢ii(ftles'infQthe c.Qi'iS9Hda@$i1peii4s:etlEiitlty (GS~

:et()~a{ri.~s~~$~'S$ll):eQt (:)fi~4il'fil,'~ riSK @U1<t$ellJ:e'Q:t~Y$t~J:1\S{e,$;, trtwt@r t()Qft91~,

ll1odels;ek)and~more'aggressivelypromp1iCSE finnsto take appropriate actions to

mitigate suclirisks;·

Weconcufwith,the recommendation, and eiiheralready hadinptace processes, or:have

slnce:tiiidertakene.ff<>iitSthatte8pOJidto the ieCOriimeJidatibri.

•,TheCKE: Pt'QgratDmcoifiQrcitesJi.ftassessm¢nfofafri'jii's c9i1centratio-li'o(

:se®t1tiesiJnt<> the fitm'.sriSk'iiiaifa;gement ptoc:¢sse-s and S~$t¢m:$.

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APPENDIX VII CONTINUED..

'. 'ni~ staffhm'~:inth~;:p~tinstruct~!J CSEs 1<Yre<:41ce,Outsize(Jy ~l' cQIlcpmrated

exposures,relatedto lendingt() specific sovereigns~,parliclllarinstruments on'isk

factors.

lt9w:~vet""th'e,l"e'C()ll1nlen~ti9I)'IllisllPpr~h'ends,··the rt)(e,~fthe q.oll1n1i.~sio(), lt1.'oversl:l,liing: GSEs~ " .

• ' The OIG;R:eport~:s cOllclusiona:tbaseis'atl;lildictl11ent'll{)t-ofthe;QS}3program:~s

assessmeritofrisK ritana:g¢t1iehtsystefuS~;bj)t of Bear's:tllJJ:daritehtalb'ilSu'iess

sffitt~gy.

'ill Anh,e tlm¢pfB'ear's C8Eilppt<)"valandth:¢tea1l.et; 'It\\i'a8 ~pa:te:ntt<)the

Cqmmission and ()$'E)~t~ll$well<l.$ tq:ae~;$,e,qwty ~tl dehti~we~t()rsM4the

market;thafHearsteams business sfrategywasrocused on US~basedfixed

income generally:andmortgages inparticular.

·.th¢ ¢qhiijii$$iQn~$tesponsibi1ityWasn9ttQ djctate~:bU$it1¢ss~$JJ:;~gt~l> tp13¢M

~te.arp$, Rattrer; 'it\v~ t():~viewwl1etb:~tbeexp(>,sQI'e~ t~rtoIll:>yJ3earS~~!>

'were;properly controlled and measured.The'fOcl1s~ofCommission.s:taff:oJlBearrs'

';::;:::~~~e~~~;::;=~~at~:~*~~~=~~~~:~:=~otred

• rQ~ms~1Itli:g¢lhis.:~~liijD,~i\l16ty; ¢9@hi$~iQ~isWt:m9tlit9t¢,d'~e. n:Sk'Pt9file'n[

1h~t1n.nin.th~~gat~an(l <ittlI~; desk lev~111sit1g avaJiety:o!Dleit'i~, and

discussedwith thelmn~sfude.pendllnt risk111all:ag~mentinslances'where linlifS'

were exceede<l. Th:ese'eJl."POsitreS\'~fete;reported bothto Beaf's senior l.ntsli1e~S

HeadS aswell aSlofue ExeCirtiv¢,'Conttnit!¢e re'giiiatly.

ReCODilii:eDdatlctri.4:

The JJi'VlsionQ(Trailiqg arid Mad¢e~~:m cQriSuitatio~:~;lth'tbe ~;rl'doN~9\iemorsiPttlie

;=~~¢~~:yS~~=;i~~~::~=::t:d::~i~::',:~~:~~::~~~~~r;i and under wfuit circwnstance~~to impose leverage ,tat,i~ limitson,the'CSEs. .

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ManagemellfResponse(COllcur orN"oD-<Oncur):

(3iveitjhe,tlutrerrtPUJ:iliC: (jis®S$iQil5: ri~out1he'~nilityo(le\'er~e: ratiQ::! fOt s'"qUritie~:

ndt:fS; W§:l cOiic:ur~ithth~ reg()-!11i~~i)"d~tiotl Mld pelieveit:i$iJ:i'lportaiiteto: \iadr:~ss tJ~s;

issue with fellow regulators;; 'The Recolmnendation, llowever,"rniriimizesthe problems

with:lilip6sirig.iitlii.tstlltoi~gh..leverage ratiOs.

,.Fiilmil':ialiriSt1tu:ti6iis, lU'¢. by1he1f vetyhattiiie)highlyleveragedbtisiifesses. . . - . .

.TheCfu'iUft~si(fjlhas h6tsoUghtl6'1fu[ipse eX'PliCitlev¢!,age,iimit8oiiCSE

holdirtg';ComparuesfOtsevend @lS()tfs.J;'it$t'@~l~ts cafie.asi1~~ 'aSse.ssJ,¢yerage.

fr01)lplJplj,(rfmancial itl'tl)rm~i<>n; $ec~md; a ll(jv/;lrage niti~jsa,"Qrude.;~l\Sure.;;

and implicitly assumes that.every dOllar ofbalance sheetinvolveslhe same risk,

wnetherdiie fuatrefuiury bofu1or anernergirig.marJret equity;.Fllrthei, leverag¢ te.s1Sd91iot;a.~ all c+\ptllt~ the~p:ot¢htia.ie~()sllteS:'ot~detiva.tiYe pr<Xl®ts:tIiat

:~@!i~;olrp.i4~~~ she~;,:F~l1)~:~I_e,y~ge'limit,:~re~~~ 'a,p;in:c~riti.veJi#~ 19' ~JIlOv~ pxpQsures,ofrbal~nce'.S1t~:et, tl]f()ugll i~tru,m~ts:l'lU1ging.fri:lmover·the~

counterderivatives:lothe SIV'structuresthatproved highly"problematicfor,oilier

:fmancialIiisrltutions (IiQfliiV¢'st:rfreiit blUi.k<i) In.tJieiastyeat. .

• WillIe it lWetage iiniitmay be effectlve:for.ari~i1istitmiQniliat dQ¢s't1dt deal ill,

'd¢rlvativ-e:' ':'odtlC1S. hight'com "lex instiMiohs;oaneasil". :evt¢,e: an levera 'e Jkit~p,q~Qfl~ir·WjtlJ:~~~l@~(r~On~~q~len~Pfkc~~ing~:ec:f1f1l1~S exposure'to complex;instrmnenfs.

i,ie¢qnun;enda:tf(i).$:

'tlieD,iyision '('if:twJi:ng atX4 Ntaike~'(l'M)'*91,@ e:n~llte:tlul,f: (1) th¢ cOl1s\?liMte<l, S\lp~med Entity l(,1$fj)fiMs.have $peQifiq prj~er:i<J;f<>l' ~viewihganCJ appro"~J,lgt:llpdel$'

usedfor:pricing,an&riSk management;I2),thereview and approYlllprocess conducted by

=~~=:~=:~:t~::\~~;:j::n:==:~;;oo~::~=:~~~:n:~~~h M.d ,iji))~ly m:alm~t;;~,(4)~PQSe,~l1its~nx:i$)cW9tlg ~y!irmsttt,l@:ilS where TJ'v:f' '.

detennines-1lllitriskmanagetnent.is notadequate; "

'J.'N[¢l)~cpl'$c·with'fu~ gollls ()fN~Q11jJ,l1¢n4atism,$; @4't11~ ¢$~p.t:t}mm; d()e8:¢~s~ tlta.l

these stfu1dards'MesaUsned. ' .

"'However.. ilie OlG'Report doesi,not recogniZeThe'Pfogresscachieved1hrough'the,

i'eYie:\ov prQi:!¢ss. 'While theaio:R6porl cQrreetly-Ji6testhatthe staffrafsed"

'conceroswithEearStelttns ~glilitihgits cover~g¢ ~aild,staffiijgijfifS'MQdel

~eview:Ft:mcti~n;jhElQIG :RepQif,;~$ n,ptrefl~!<i t),le rell!#tihg !iu,Q!i!;lq~t

progress. Iilfac't;:the.:finn didrespond'io staff concerns, 'and'created,and

implementedaclion plansto addressthem.

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APPENDIX VII CONTINUED..

•• .F()r e2(ampll;1.~n SeptemDer 290(5 ,B~<lrWt:~cl twgpi;lcliplrted ffi()delcoIlholf)tWf·

personsforMBSandcaShprodllcts andThree completed model reviews were

l,res:ciited at thistime. The MBS alld CasliilWelil,Qry models WereieViewed

betWeepseptem'b¢!.20Q6 and r>ecell'thet 200t.

.Witli resI5¢qftQ thetisKtllti1ril.:\S th~tth¢nrfl1w~edinmMag,ing its lIl~r}(ehri:'lk;t()

m<>t1g~gepr()d~ts.lh~oJGRep<>rt q<>11t~ key ()tnig!;i()11$.;~t1({41®rreC!

conClusions.

• The fmnJnfacf made significantprogress inimprovin,g>itsVaRinftastructure

subSeqtlenttQ:c~r>tQ\ra1hitespoiise toCbmmissioo'StaffCQhceriis.. Fore*ample~<

lhelltm toilowedthtojjgh on r¢'coirttn¢lidati<5l1s1<5eMancecoiittoloYer theV~

system,I1l.pUisto Va:Rm()~¢l$w~ fegW~lyy;pd~teclf61l()wit~g~ppnc@i<>t1

approval . .

• Sincethe.beginriing ofthe:SEC o'versightofBearasaOSE. Bear regularly

ifupl'Oved.ai1d,-eJij)anded its:,diltli's6Uices. Tii some':iriStiili.OOs v\rliei? damsourOOs

Were H~'t1he in$trl.linents",reretrtllnat~u1atF()i~xatl)#i~.riiort~age·

.deriv;ltiyes, which~:El@4jstin.cttti;)m QD~ and~$ CPRposf4ot)!;. w~r#,c@

inlmllterilij I;1xp()sw~with,oIlly (Je:miQimi!;imp..9f ()nl3y~'~ prdfit~!llo~:>.

• The OIGreport: assutnptionsand conclusionregardillg13eai"s modelreview

stail'itlgiareiliaCCUrilfu. Specificall¥.\\'l1ile.certail1tnQdelr¢Viewers.letlBear.in

2006 and thehe~d()ttnodelv~idationre$i~ecl in early2007, Thi••·.SWfdiscllSsed

.s'tlUfJilgatid:th~m9del vgfrqationpr,ocesswithifutl head of13¢{li's M~,del Rf;'J;1~w

C<»:nrni~ee; 11lem()qelcOlltrol fUt)ctiOll for m()J,igJtgtlSw~ :>hffte4JotheprodIJcJ

line riskmanagers while anew,Head,·of Model'Validation;washiredin Sept,2007~

.MOdMc6ritrolwocko't11fioit&ages ,vas unaffected duffllg the interim periOd.

ke~"lQl:enda:timf6:

The Divisi(.)fi of T1'a~J1g Md Ml»'kcl$sh'Ould llel11~res}(eptic~()fCoJl,solid~ed

Supervised Entity firms risk models andworkwithregulatetlfirmsclo help them develop

additiooa1 stress scefuU'ios that tiia¥.ormay iibthaWnolhavebeencfuit¢)hplmed as:part'

ofthe Pttidei1tWt¢gul~li()tfpr()¢esS.

TIV[COiicltts:t1iat s~ptlcis·tiiisWa1Ta1ited,vhen revie\·trng fJiintiSkmQclels.hut Wt)'

b,¢li¢;vethAtae¢9tl1D:l.eiiqatiQi16is' has¢q'()nitX99iripl¢'f¢ infOrrii~(jfi.

• ~arSt¢~$' us¢ ()r$~ellarj()~wysis wt.lS~()llsisj~ll,t withiJ:laM$p:yp~~ti¢e's:

vi$lallyth¢ ~nijreb~nJ.cipgI)eeto.t:fltiJedto ~tiqipm:~ the l11agt:1i1;ud~ anel. scope of

the housing decline thatis still.ongoing. -

• TN! staffdid in faetcliscussl'epeatedly'\\,ithBeilttiskofttcers the·firm"sAlt-A

~dopti()t1.A.RMS ppsit.OfiS•.••ihil4d1ti<mJo<sQllptime.

SEC's Oversight of Bear Stearns arid Related Entities: The CSE Program

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September 25, 2008
APPENDIX VII CONTINUED..

• Therefore"theOIGreport conclusio11S;which are based 011 the OIG ea'Fert's

review Ofitilemal TMmelnorahdiltliatdid riotriientlon fonvaid4obkiligrisk

·scellaii()s,s~h i\Sa,¢(')mplete,:tneltd()wn,of'mQrtgage'matketliqui<lit;y,ate'based

()l,1 incPll1plete.iilf()t'ln.a#®;

Recommeridati0ri:7:

i'he Diyisipn of''tl''8.ding and Markets {l'Nt)sh:ouldbe inv()IVeillitt'ortrtutatirtgactkni

PW)$ for ava,rjety<>h~$~Qr di~~t~$~~1a.rig$,evel1itthepl~.~.huPt'l11al,itlclqdjn~

plans for everystressscellariolhat1he Consolidated SupervisedEntity{CSE)finns use ill

riskmanagemen.tj;- as well as plans for scenariosthat'Thil believes might happen bllt are

b()t.iri~()tP()tatedi.fit() CSEflfuis'riSk management.

~nn~~mJlfitR¢spO:ll,!ie(f]OJl,rtir()l'Thf()n.-(:C)n:¢ur):

We c6riCllr' With the rec6iiimeridatioi\ bUtbelieveiliat Itreflects\vliatTM arid Bear.had.

:a1t¢ad¥'1¢comtiHslied..

• C@*r.ary toth~ OlGItep()rt.~t.at,emen.t$i6e.ar 4idi;l1I3Ql'por~~jl1toi~$J'i$k

scenarios'thoserisks.discnsseclin meeting-swi'th TMstaff~snchasahousinW'

'l¢q l'¢t¢s.£;ion,~efi;:trio.

RecQmmeudition8:

Tn¢DiVisioo OfTriid1rrg and NlaJ'l(eti>sli6uldtakestepstoensuretllatriiaJ'l( disputes di:)

fi9tP~Vide·'~1.oCcas.ioh fot OOfi!ioli4ate<t S,upetYiseq••Efitliyfi@sf9 ill.f1atefh~:¢oIiI1Jit.1.¢l1

c~pit~oft,v.q (mus py~singJnconsi~lltmarks. ..

W¢coD.¢).trWitllfhe t~coilfirt~ficla.t1ofias'Wtitte~6Mf'We 6~lieVe itrtff.lectsa, ]lli~~I)CleJ:S1:an4illg ofthe marking prQcess and14~ o'Versig1lfcapabiliti~sqf:wpery~qrs.

-fM@imo\vledgescertairi, persistent miti'k.di~pl.rtes1iidiCa:te •.iliiq~iid asse(:Karid. ya1l~()nissue~ jhatTM sboq}ct inquire ifito.:fIow~'V¢r.ifil;ldiat.itlgifiostoJ:atlof

an)' in,diyidl,alftrnl's di$a~~l;ln1s o:vermw:ks:~lc(qSS all i~ qomdel'Parti~s i$:nqt

feasible, A:dditionally~ many ofthe disputed margin ca11srelatedtoproducts,guch

as cus!orilizedstftilitUied ci'edifde~Vativeswhete pilceldthsparencyis an iSsue

jiild·vatUlti()il.S iij1'ilMksIS concetvl.tt5I¢;

'.·:i'h¢6IG.~p()ttdQesil()tptOYide::theptop¢ic6titext,vheli discusslngc~li $100 :nlitliQI1]n.a,rk4isp,ui¢~]3ear hail wittlc()lU1terpar#¢$.a:e~rl1~dnt~tMtl 25,000

ttades'Yith1PM.an~~givetlthel1ature.. ofthe'count~rparty,ahig~ty~rated financial

iilstitution;" the capital Impactulider Basel II wouldbedeiiiitlimis,

10

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APPENDIX VII CONTINUED..

• Therefofet TIvIhelieves thatthe OIGrepori assumptiOn that-finnsare

conahorati~glo create c~pltal \vas:ri6t propetlystibStllhtiated.

-lii-e OlGreppt't'c'onfbjilic!s hiatkilig vetsus::pric¢ ?;ietifi¢atiailpro¢ess¢s;'id

ih'V~$tmeJjt baliks~ and d9~s,Mt ¢9tisil:1:¢.raJltli¢inf(jiti1afipnPrOvidedtp'OI(Jby

TNt ~,&~it1$. pti~'verifi:~ti:onWP'c.e§$~s~ .

BaCkW<:iifud,,6ii rndustty Practice';.

first, w¢: sllotild P.piIlfouttJi~ijjargiri di$p~¢es at¢ iltiav i;)iclabl¢ipat1.1i;)\.daily·\.vheiiiiulrJ.@s

bepgroe te~sJiqJ;~~ at: illiq~i& 1'hi~J13 :anis,sue'thllf' all q~"le~~' fa9ilrgjoQay aQ:i$ tlle

to1a1.:disputedmimbers atBearsteams.·were·much smallerthan at other·institutions,.

Wit·lit.¢specttoth¢ OfGr:eportasSem(Yll ab(jirt,:osii~guadets' hilltks:t~tP.torrt\afi(f loss, 'it

is UrtivefSat.iAdl~'t!Y Pt~cii¢~(@la¢lldofSedb:y varipu~4¢$¢ripti()ns'ofbe.~t·:Pt@ij.¢¢~'!l\rch

a.sthe omt!P;():(~Q)f()rtJ:adersto lll!U'lcfipn hlVe~t()J"y for pt1tp()~S ()fboql,ci~qrecor.&>.

It isthen>that anincJependenlcofitrolgrollp has;:theroleofvalidating;orsubstimtiating'

t.h

'.' ."'. .., :.!~- .~' .•.' · "d'.. ··"···,· :;1'.·,·t.....•.. ' :;;;::t; "".,. ,. v, , ,. " .. ose marMi VlaJUlln ~en9enpnceveu c~lonvrocess.

ReCODlDlelldation9::

Th¢:biYisloh attFadlng and Nfarkets,sill)ul<i eri'Co'ufug¢theCQiis~:>11(Jate4 Superv1~¢d

~~Y~.·~;~:~~:t~i&~~~:t~~;1r:;r9.~:th~fJ::::b~i::::;:~:~~er, allows riSkTa<itors;to be applied consistentlyto;jndividua1;desKs, ..

1\'laiiag~ment.ReSp6ii:seXC6umj;':ot;No:n-toncur):

• The ()IG.ex:perLsupportsthis·conclusi011~Y'·notingthatBear·stradingydesKs

e\.ii.t'itated·pro:flts iirid risksittdividually and SO;8ssl1l'nes Va;Rw3.soiiot'iinpie.nerited

fmnwide.

···:~::::4e~::;;·~~~~9C~~~~~~=~~:~~g.~~~V~ :howe.ver; was .iinplemetited;f'irm~wlde.

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September 25, 2008
APPENDIX VII CONTINUED..

ReoommeudatiOJl'10:

TheDiv.isioo. 6f'l'ra&.ng and :h4arkemshould ensiltethatthe Coo.solldatedSupetvised E1It:itYlakeap.Pt()pd~''Ya1J.JatioIl <ieducuoU$ for illiquid, hatd,~w-VaJ.t~e;$l,setwatld

appt9pria~ .(l.apit~4.~411cti,on!l· •.ror.~~sed.·repQs, .e"sp~cially·~~~se4'r~pps·'·"yh~:re ill~qlli4

s~curities are postedas"collateraL .

WCOJl9tlJ:s,vfithth'? reconunendatioJl andeijhera~adY hadjnpl~<;e prQ<;i:l~ses~ OrJ1ave

since undertaken efforls thatrespondfo the recommendation. However,webelievethe

fttiditigS l.liidetlyii~ Rec6t'funeridilu6tl 10 ~." uns'4pported;

TI1e:reppd·,assert$::PM sh9UldhaYe¢QIl$itJe:redel\'paildingthe list QI:asseis 'thai:re<tttlte(il

full dedllctJ.()Jlfto.Wcapit:at. FJ:Qwever. theR.et>ortdid not.presenle\>jd.e!lce~ rM di4

notfollowBaselmordid.nof applysufficientlyconservativecapitaL'freatmentinlightof

the.relative illiqiiidltyofassets. The fu:iMysisfu suppoifthiSi.assettioiilsfucofu,plete of

withQut basiS.

As em1ained ininfonnal commentsto.the;()IG. TM:appliedBaselUcoll'ecllyanddid

employ conservative capital treatmenhvhere appropriate.

• Specifloal1)f,withfespecttoilI1quid assets, Basel Udoes notreqlllrefull

<lEl<lncu9i19:f'ltit>$t illiq(lid a$~#$,th:l11yo±':Whic~attr.a'Cl¢api1~t:¢ht)tgesof$%;

1:r\1 pjd.t~gujr¢ ~dl@p1,l¢fiprt:f:Qf¢¢rt:ajn iUig'Uid ~s¢'tS,)~~lchJ~:mpl'tgage

.resio1:m1.s.. .

• Forassetsheldinthe'tradiilgbook,:Beartooksignificantmark.;do\\'11sin

rilQrtgage-relatedassets whi6hfesl)1tedin atedl.1ctioft ,ofTier leapital, aSlt

sholiid.

• With tespecfW1h.ertWottisclescnt>tion of'J3¢ar'sloarttQthe j3sAM: HighG1'ade

hed'ge.fl1Ud,~s J:M expl~:ne"4i.njnf,o:®al 'P9tm~ents,tliEll()4t:l'W4s

overcollaternlized,andBasel U did notrequire Beartoreduceitscapitalby the

fullamounfoftheloan.

• Spedflcally,'I'M e}.'Plaiftedtotl1e:OIGthalBearptoVidedtherij>la.ceinent

SEl¢'llt¢dfUnditlg:t.O,:a$.A~tfilh<ls C'ufi:'etltmadcs, thilt.is netp:t;Wtite-do~ •. ;md

'Wjth,1@ir~l~fs.~art()()li.;capital ¢hargesf()ftlWteS:ultmg's~¢l1t¢4¢1q'lo$ptes~'

fare:x~e;;:de4 ~s¢lll teqtJireJ:1i~nl$. a.ndeff~ctiyelYt:re.at~p· the plj:)i:ti()n~~ ifthe~e

:hadbeenheld on Bear Steams' baIance shee't.

• ':Whenllie BSA1Vff'Uftds railedt6fuake ~iheallsir.bJl.lly,'theassetsWereirideoo

taken ontO &atStea'ttl$' h6pkit

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APPENDIX VII CONTINUED..

Reoommcildatim:ll1~

theDMsi91l.()fTr~dillgand Matke1:S(TM), i1iQ()ll.smiauo.riWiththe ChaltfiJ.!;\Il.'s()ffi¢¢.

~tiOlll<llli$P!1~StjS~101~rMce wi'ti:ttbeBo.ar<l ot'J>ireet9rs Mel sell.i~.. mNll1.g!'lme,t1t,oI'e~ch:

ConsolidatedSupeniised EniliY,(CSE)fimlID befterundersfandwhethertheactions of'

CSKfifui staffaiecOf1SistciilWith the desires Qfthe BOardOIDirect6rs'aridseluof

Il'l.anagell'l.ell.t, "Th1sirifQrtl)iitIoll.'WQUldehable Thllo'bet:tei'assessth¢eff'e¢t;iveMssQfth¢

fmlls'risk:tharutgetll(:mt s:y:s'Ulms.

ManagementResponse(ConcnrorNoncconcur):

t].i~()Il.¢UtSwfththls~c()Il.iIl.:iell.datiQniUld we have alteadyhadill.pJ~'PrOcesses.:or

hwesi:li¢¢'Utid9!'biketl¢ff'Qrts.1.hlitt¢spoild'to the tec9IrtIrtendauo.ri. ' ,

• tM acla,lQ~v:ledS~i1mtSE.C$eUi9r offiC'i~ls$h()ut((~lga:getheC$E.,pOard$o.I

'directors periodically to review riskmanagement"jssues <and,assessr1sktolerance'

,oidiscuss paiticmfu> issues.

:R~~mmen41lt1~J2:

The Division ofTrading and Mal'k.efirsholildrequirecompliance with thee>.1stingrule

thatreql.lites eXternal aUditorsfo retileWthe CotlSolidated SuperVised EntitY:11.rmS·riSk:

maii:agenwnt,coitttolsystems>otseelC¢6iiiJjjisstonal'ptovaIiIf.a,ccptdaiiCeWith the

AdttlltdsmtlY9 p.t,oc¢dtJt¢s A¢tl IQdhis de"i,tiatiQfi:fffill.:ltheC~.rii tUle~steqQjteln¢nt

ManagemenfResponse.(Concnr'·orNoncconcur):

TM,:Wid¢tstlltldsilie.f.¢c()tnmelidatioll.:••,~a'·Willpt$e1ittothE\,,¢o.lrtrtliSSiOfi"Whetllet'lo

~ql1it:e POttlpU@:cewiththe e¥iis~m:gmle Ottopt9p!.n:e:ruleatfieU<lt1l'e1'ilsthatWQWd.

penl1J1tl;le itIten.1a1allditorto #()rmthisreview,

HQ\lievet.webeHevethaHlie firidlng is lheom¢t. We tmsedthe'fo!foWirig isstn;ls ,vith

~sp¢ct tothiSfifidi:hg:'Md.recon.ifil~d;rti6tl:

-rMhas.specifi¢allth9tityio iSStlee~efillm®sfr(jm:the:rt¢t ¢apital t~i1¢or\vbich

15c3-1gis all!lPPet1~x;S~~ 17 GFR 2(1(),30-3(a)(7)(ii). 1'h:!' :flwetiQns'ofthe

Director;ofTrading and MaIke!s mcluderesponding iono"action requests from

CSEs. See lTCFR20Q,19fu

-'I'M sttQi1g1Ydls~gt¢¢s\Ylthtli¢ statemehtthattheteare·seriousQ.~ti011SabQtit

the, ),riScJOrtl(j£i(sd¢ci~i(j.ri; ,'IheRule pennitl.!the ex(:emaI ~cliUQbe lla$¢d.®

1·TheAdtniriislrative,ProceduresAcf(5:tf.S.C.§500eL'M.q,,)setsforththebasieprocedural.requirert'lellts,

foragetroy<rulemaking. It~enerally',requires(1}publicationofanoficeofprQJ?0sednilemakit1ginthe

Fede.ratR(.!gist(.!r,C2)9PPommityforP\:lblicl~cipationinnl1<llllakingbYS\11JnlisSionQfwrittm

cOri1ri.1~,!"lnd(3)P9bnc~i@s.rltf.ihalnl1~!Bi4wOri1panyiligstiiterneiit of1Ja,;ii>:wJ:dpJJJixtSe not,le$:i

@i:l..:3fJ ~:ysb¢ft>~t@!UWseffectiye(J~. ' , , '

13

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APPENDIX VII CONTINUED..

'~agreedup0tlprooedllfes"behveen'thefinnaIlditse~rna1auditor..i\ftermuch

negotiation bet\veentlleDivisionofTradfugand Markets,theCSEs andlhe

ex:t¢lllalauditofS.th¢ ¢;xt.erna1®dittlrsW(jl.lldfiot,agr.e¢to ~rfornLtllon::tban a

"ch¢cteth:eJx>x"revi¢vv ofth~:risk 1naltag~t11¢fitp011ttolsyStet:fis forlear()f

liability, .111us, itwas apparentthatthe "agreeduponprocedures"wotildbe of

ininitnaLbenefit

• Iri.coritriis't,TMbeIieved that aSubstantive re'Viewofproce'diiies byiritetJlal audit,

which in¢llliled.a.detertnifiati6tlJ)fWhethetthe.pf<>cedUfesused·l)y1h~.·finnwere

s:utli;cien.tfQrtheJlllrp()Sesjllt~l(fe9,. Woutd'be afl10~ e:ffeetiv¢Cl1ePk:ol1j:be·

firms' riskmanagementprocess. As a resUlt, theintemal audits undertaken Qythe

finn were greater in soope and substance than wouldhavebeen.petfonnedby'the

·¢xtetful1a\lait6ri>undetth~ragr®d upoo PtQ~dure$ ..,fhemtefliaJ. audit·

d¢I1annietlt'S.fl:;view ()fiQf(.lOlairi&kmana~eJilefit (J()il(r,(ll15 also W01;uiIbe

COtla1JC,te4tl1tO\!gh(mtth¢)'i:@'l'ath:ettl1tf!.t~.~ .~ oJ)¢~ ~y~@ AUtt#Ptl?q~ss. Th,e

independence,.sta.ff'lllglevels, and audit·scopes ofthe"'intemalaudifdepartments

·werefeviewedhyDeIE and the DiviSion of'I'fading.fuid1\i

larketsaspartorthe

~P1iCatiOjlproCeS$.

.'t'heteP()l't·~~Stateni¢lltJ1tat·1he~~m.aI iUlditOf"sworkisrri,ofe strj¢tl~regu1at~d

a,~ th.ePGA,0:B :(egtllil;1ese~~1'11<ll11lJdit()rs" is mi~1¢ading4~JPthe la.ckof

substantive auditing standards for reviewing·af'irm's.'risk.manageme,nt;control

systems. Italso1s.notolear'that1he PCAOB has in place a processfor reviewing

·such auditing work.

Recommemlation13:

ThE:DIvisIon of'I'iadl.ng and MMlcetSshoitld ellSUretllat reviews 01' aflftn'sConttngetlCY

:F'\ltidiligPlan;mcludean asse,ssmerlt6t'a COllSolidat¢d SupervisedEntltyftrrit's Int¢friaJ. . ~d.¢xteIDal·q.ommunicatiQfistrategi¢$.

ManagemenlResponse(Concur orNon-concnr):

'fhe. Ph1s1<>11 cjf'fOO&hg and .NtafketS'dQesnotconCtlt with t1risfec()mmendatioll.

.,Asit:N!'mformed QIGitie$1iet~errt$.iliete i&;:i:in r¢q\ilteilie:rttirttlte·CSE

t'Ql,esilia.tc:.S~MveMii:1~at ote~~¢Q1l1Ol~cati()1l' poli~', ,L.ikewise,

1h.erearel1xFSEC rtilesrequiringnon;,;CSEbroker;,;dealersto main.tatn such

¢01nmunictdl()li,pojicies~arid·we.are tmiW$¢ ofanysttchiequiremehtf6rany·

otherSBCfegidateoerrtities, .A1thou.gbTMnoled. thatBear~;St¢arn.sliaaa

c:qitillil.lD.ic:ati0t111.str~t¢~Withili,it'.;C9ntm~¢JiPy;F1;mdirtg Pl~. ih«¢ Was h() Thl·. "~@S~15lIl~nt" 9fi1lats~~~gy. ~'15t~dby()rQ~'

• What OIGhasfailedtoappreciate iStllatthe CSEsare parl ofpublic holding

·.comPanies•.thatha'~,s~t1uriti~sregistere~ withtlleSEC andlistedall~.frading;on ·0:.8'. securities exchanges. As puvliccompames.theCSEs are· sl115jecttQ m)lriad

14

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APPENDIX VII CONTINUED..

SECdisclos~'erequirements.including R~gulaiionS~XandRe~afionFD.

C9tporiltedisdosutes sJ.lPh;it> those covered inBearSteams'sCFI)

conltll.tlniclltionsnateID' llI'~sul>jeQt.to thQS\: dlsQ19sut\: ~qJ.lil$tll.errhl, an4the

S~G'sI)ivisi()1lS0n;()rpota:ti()n.Fjn:an.C~MdEWorC>etl1ellti1:cfu'.alyeWOJ;ce:

compliance with 'these reqpit'emellfs. Accordingly" itwouldbeinappropriatefor

T1VI"toopill..eori, oi"otlienVise,iiiflueiice, thecoIpot'.il.te coril..niilriicatioriS·"0f1lie~e

ptibIiccotll.patiies.

Reoommendation14:

'I11e.Divlsiou ()fTrildirig ana MarRetssholild develop a forfual inuomaredpioceSS!oWck

tnaj;etia1; issues iClerttffi¢<tby the monitoring lltafl'toetlsurethirt1l):ey ate adequately

resolved. AtapllIlilllUlrt,the 1t-$kingsyste1ll,sho1.llq pt'oyi4e ilreJollc)\ving:infonntttlcm:

The S()urt;e <?ffuetsflJ;(e; .

Wheniheissue wasidentified;

• Whoid'entilledtlte.issue;

-The curreflt stlltt:ls.ofthe i$SUe(litg"new developments); • \Vhel1thejsSl1~ w:a:stesQlved; Md "

Ifo"YtheJssJ.le w:~resolYed.

Ho\vever,tbe anaJ.)lSis undeilyingtherecommendafiondoes nolshow evidence fuatfue

aSEprQgram failed to adequately tes6IY6tssu¢s,otill.at trtaterl~:tiSsues'Wer¢not

1ll01Utoted. "

• J{ather,the 9IGreportrell.Ch~s,itscQnclllsioll thllt'thept;ogramdQefi nQ't~deqt»Itely

tr'af.J:k i~sl].esfx"o1fl its l;lJ'itiQis1fl()fthe I:ecordkeePing()ft1JQ~e issues;, WliHewe

recognizefuat an automated audiftrailis desirable; its.absence is nofprooHhatissues

aJ:etlQt &deq1.1atelY tracked?metely fuattecormtigoffuos¢ iSSJ.leSCol.J!d be itnprowd

RcoonnnendauOll15:

1'h¢DJVislonofTradii~g and :k1al'ketssh9UJ.d:(l)l'eassessalltl1eprior Office of

CQIlipijltflc¢JllspeCUQJigltfldExlUnimdiQfiS(OCIrD issl.Jest()¢tlSut'e 1hlllh9si'grtificat1t"

is'fi~S !l.f~~s!)lyedegiy~njll.el>eli~f'tbMQGre followed l1p)}m1a.(2)f()l1ow~p (lp;aU

significant iSsues. "" "".

15

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'Management Response (Collcur orN'on-eoncur):

We t1Iiile~tmil1thetecQli'ltnendatiolt,ltut believe thatt1lese issues are eitherniootodQllg;

sin,ce addt-~ss?d;

..Nl~()"er,aswee:({plailJ.ed inoqtinfOtnial C9@1ietlts. the tecQli1Dlend-iltJ.ol!is

predicated,onall'mcorrectullderstandingoftbedivisionofrespollsibilities?pas't

andprestmt. betW.een the DNisioil ofTrading mid MarbtS and QCIE. "The report

criticizes TM: slattthat '~~stlmed'; Issqes Wet¢ the i¢Spol1sibility QrOCIE, Wlre~8sit(faet fot eightee.n 1l1()l1thsS1JPseq1Je111 to tlreBe~Stearns;flppliq~tion

eX8miflation;theissneswereifi fact.OCIE!,s responsibilities. ' ".

• IlladditiOll, as we.infoffiled.QIGhl'ourinf'onnaLcommenis;TIif monitored the

tlta1:eiiallssuest().assure that:tlteyWerej'esolved. TMalldOCIE agreedthat,Qlle

issue mi,intiol'l.¢djtflh¢ report, the iSsue regat:(.ling workpap¢ttet¢l)ti6iia(Eear

$teams, WaS1l1a1elUlL The Ill1i1 W3$tetllliI'edthteSP<>11dirtWtitinglCl tNll1e(Ote

arePQ1l1t1lAA-~tiQnWll$lnade 1lJ.l.ltthe<Jonlnlissi()uaclqpon thi::applicatioll. atld

firm in fact agreedlo retainworkpapers. Subsequent oversight by TIvLpersonnel

·telledoil,M¢e'sstoth$e \votkpaperS.lU1dso veri:tiedthatcOtreotl.V¢a6tionbadin

fal:it Q¢qtitte<l. With teg~t()th¢ SecOl'l.<:l lsa~ riientione.d in th¢ i¢PClt't, as We

e~tllil1ed lt191Jr: it1f'o~l~():rnt11ents.:th.<tte is.119pas'isforme state1l1eiltaPP9t'

materiality oftheVaRmodeUssue. TheCOIG eA-pertdidnoidireclly reviewthe

ffiodels,relaieddocuments.andiliedIrm'sbooks and records. Without a

thocougiireViewandteasonable,basisforthesta1etneJlt its'iliateriaJity'fln&'rigis'

QOilcllJSQry. Api>~nAi.'{In inc:1icat~Ql¢lll1.y thatrteimyt Ol.GuortheeAl'ert .

C()11(fucte<t an in~¢pei1Cleilt.aI~lysis()fl3ear'~r:isl<:@tla.ge:l11eilt$y~tetn:

TIl~Di.visiQlIgf Trad111g and. :fy1#l<.¢1$sho1J14l;:n,s~t1.tllttl!eycoroplete'allphas¢l> ()f~

ftrm~sinspectionprocess heforerecommendingthaUhe Securities and Exchange

ComtriissioilallQ"ianyaddition.aICotlsolidatedSiipend:sed Eiltityfrifusilieal.lth6ntyto

tise'the a~l'rta:tivecapitalil'l.eth6d.

• Ast'heJ)iYisioilstaffexplalwdiri itlformal¢omments.t1ieCQri:lliUssihriWas

qlearly itrl'()tJll¢<1ofmeexilrtiin~iQilrJ1i4it;l~:an~th¢irstatuswl1~th~yapproved the CSEapplicatl()ns, . "

16

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:- In~9diti@. 1h~ OIQ'report'soharacteriz~l)n o(1qe appliC~IHonproc:e.ssas"'le~s

meaningful ~''is inaccurate. The Commission waswellwithinitsmrthorityto

3pprovesuch applications, give:ri:th.ey'were:riotified-()fOCIE'sfindings, '6fm's'

·;r~s~:~t~~:~~~e~:~~:~~~::~~~~;~~$~h~~~~;~=~;=:: i~s\l~Scand.,~;;o.l\q;ioll' .....

_The OIGreporffi\ilsto 'appreci3:te~thafCSEexamjmitionswerean'ongoing

process. As piltN5fits ri6rinalbUslhess operatibriS,aCSE COllstaillly re~lewed~its

tiSk mahageinefit'systemslo tiSsureifimth'd8:¢'sY$t¢tiiSadeq'inrte'ly de~dt \Vith

IfI~tk¢tPl~¢qhangl;s.(j9ti~¢ql,l¢nt1y,the sfuffcontihwdly: olQIritQredd'i,OO'$:clsk

tllaJ:lageinenrsys~ero~ toideJltifYoh~ges a CS;ElIlad.~ti.o its risk l11aJ:l~geWeIlt

systems and to;determine whether'those :changys'%IPfopriafely addressed,ihe

perceived issijeS 3:11dtnatthey\veteadeqlialely,,irilpleriieilted.Foritisrahee,if

niatl¢~lila¢¢ changes,~a,tl~ed at) in9l':eas.¢~l)«OS-Ei~baCkt¢sti1igexception$;tlle (~SEoould ......., amei1(fifirlIlodelsto ', ,.. '¢ap.... tuteoadilltional ·

dtltaw,· ':'lrttSulatleff6rtfu ' " ~ec~as~ su,g4: ~~,?eptiQm>; 111..$lJ.¢.hca~e:s1he: ~aff;wqm4r<::vie"YaJ:ld<~Pproye:1P9se­

"changes tolhe:CSE's:models.

···~~~~!::·~fi~j(:~::~:;;:~::::~:'~~:t:l~:,~~~~~~:~~s ·coh$oli<tafedbMis:. '6iv~ii;f.hjs::tiifI¢lm¢ '~d,theJ¢vel:ofmatena)i't)njr1h¢: is.S:\J~s

.jnvolve<t,,'{'M:4i.d m~t:J>eI,i~ve'it,nel?e~s~ t()i:>,ygit'f'ort\ie,j'"Qrmaltrit@nlititaliQfa

'writtim'deficiency letter orthereceiRt'of"a writterrresponsebefore recommending

the Coihttiissioii approYethe,otdeii

• F,ma1i~~,1:htrOIG repott"s sWementthat.'TI\{failed1ufolloWUP Qjjlssues raised by OCIE;:iJ~jrjiig:its.:insp~ctioIi<ofaec¢ is:inl;:ott~¢t.AsJ¢1i."pl.utie(hQ; OlG.$~ffifi

't;K;r;"s iJU'Qni1at~()mil)e~~,',J,1;l ~,~~4 r~~9lv~d m;~i~t iSS9.¢S i'd~jjne41ly.

OCIKandthe;repoifnasn-of:Cited allyfaetual basisfOr"fitlding 'otherwise; .

~ee<mml¢fidad(jirt7.·:.

ne-.·Divi~iprtsgfG.()q>·~ratiQl1·.·FiIiatli,')!-l;(CF):at,l~···l'~i;lillg aJ:l(1 M<tJ'1(e~(JM)~h9til4:~e

concrete steps to improve1heir'collahorationeffortsandshould de'tenniitewhe'ther TM's

lllfOhnatioii on theColUloIidated.superviSed Entity (CSE)'t'iiifu;couldbeused.1)Y:'CFfu

lt~revieWofth:¢ :CSE tifin~.

Tlvl:corictirSwlth·thiS recommendatton, alld,\vHlwotkwilli CFt6 assessilie·d'egreero

whlchaddtti9i1a1 i1it~ott and inton~9il'\yo\lld h~ lJSeml. .

'. :U:oWevet, iW;fhe.istalfexplijiti:~ujn-ib{fuform:ali,19m:ttients. TM~affJ,rtet - repl;)at,e41y ",vitJi':Cf~,s*,aff\twing 2QQ7'aJJ:d~OQ~i9disCJJ~s 1heiSsu~s*edinth~

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report around public disclosure ofcapitalinformation. Noacknowledgementof

thOseeff'Ortsis mademthe formal driift"report.

Recommendation.18:

l1teDlvision. OfTtiidirig Met };ifMketS{TM).andtlte Officeof'Coril.pIiarice Inspections

ahdExamihatlolis (OCIE)sboiJIc.l de\ielop acoilabol'atiOh aweenient{e.g., disc\1Ssiiig

ihfcjfIIl.mi(n.1 snw:ing)thai tl:liUrMifiS, ·a. :ctea(delilieiti!otlQftesPQD$ibilljie.sb¢t\i\!¢ehThl

~et.OGIE \vithrel>peet···t9th~'C(mso1idated $l.~peryilfedElliity·p~gram. 'I1J.~ysllq\ild

irifonn·theChaiiman~s Office of.any·ilisagreement(s) sothatthe'issne(s) can be resolved,

11\'ri;)OI1C1.1r~with·thi.s rec()ll1ll).entlatiotJ,M!l\villwqrk""itl)0Q1Kartl:lthe'Chainnro:l's

office to detennille howcollaborationshould·befurtherfonnalized.

"Asw,einformedorfinoUf·infonnaI ~Olllments,ho\Vever~ a~ldwhatisnot

desetibedirtthe OIGrepott,;iSthat'Th1 ana DelEissuedjQirtt gtlidailce toalfstirlf

(egardin~ihedivi.siQDo[respohSiQilities@d the sharin.gQfitIfMfi#titlli'with

xespei;)ttotb~ C$E.f]Jlll,s·QtlMar9h 19. 2Q07.s49rtJ~' aiterihe'COJJlI1lissipn

transferred inspectiollsresponsibilityftomOOIE'ioTM; TN! has compliedwith

all piovisionsoftliatg..lidfu1c.e.

Jl~f:~n:l»l~11tl,atitQlt9:

The;Division ofTrading and Markefsandthe Offioe>.ofRisk Assessmenlshoulddevelop

,ariagreemerit,()11t1iningtheiir01eSarid:ieSP6t:is1bill:ties~,tiS..wel1as methOds fQthuonriatlori

~llM1tig;$l1¢h :as¢ofi~Dicatitlgproj¢¢tteg:ult.s. .Th~etWQ~Ciffi¢es ihQldd itifqrlilth¢

Qha@l}lti·sQfl)ce.of any d~a.gt:ee1l1el:li~g):>otlIl:lrtheiSslwt$):canhereflolve.tk

Management-Response (Collcuror NOll"£oncur}:

T1V!p,OficlJtS\vtththis r¢¢omm<m<WiQ~ andwnrWQrkWiihQRA.•~dthe efuirtn,ah's

o:fil<::eto det¢nuh1.e hoW :con~01'atiollshouldbefurihertpnu~ize&

• Wen()~~hQW~ver" t1latT~'s1"elatignshipwith ORA iss1rofig; ~evidenceclby

colIaborauonon anumber;ofissues ranging<from creditratingagencies:io

anaiyiiSofBearStetiriiS" failure.' . .'

• Formalizing an agreementbetWeenti,vo offices :Witillifthe CoJ:'.lifrilssidfi WOtlldbe

tehtfi.vely1lJlilS\latiD. qOrttxast tq'CMclutiing af~'['Jl'iat M(1)with.a,n ext¢tti~f

ageIlPys»ch~slhe Eel;leI<l1~~sen'e. .-

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RecommendationZO:

tll.e-'DlVision otCorporatioll Finanoe sb:o(lld: (J)dbvelQI,itrtetrialguide1irtes,fo:f

tevi¢wuIg filiIlg~.in: <t.tilil¢lYrtlAtlIl:er.and C:Mtr<lCkmr4·'itioJ'lit9t,Col:Itpliap:qe ;\¥ltb.the&¢

i1).~n:ta;1 ~iJiqeli1re.~.· " .

N'fanagemellfResponse:(ConcnrorNon"ConCUl7J;

Recommendation:!1:

'fhlfDivisionofC6rppiatl'oft' Fiiiance (CF)sh6u1d (1) establiShapoH.cy outffiUng ",'hen

f"liillS at(;: ¢xp~te.("'t6:s1.1hS13ht1veIyt(;:~l'ond'to issti¢siaised in b:F;,~¢onunent i¢tt¢rs,and

(2) ttackanqijioIlit9c ¢QUlpHano¢ witlltliiifp9Il<:y.

,1\lanagement:R'esponsei(Concur···oriNon:.,concur)~.

Recommendafion:12;

~th~~~~'~:~~~~~:~i~~~::~~~r:~e~r~v~~:;:~=~~:~d. the..OfficeofCbmplianceJnspecl:ions,andExaminations,. TIle TaskForce sllouJtlP,eifonn

an analysis,ofl~edirms'withcustomeraccount'5·that hold significantamoUlrts·of

:~=~:;~~:n~~V=~~=i~l~·~:ii;~~:=ic~:;~s~n:~~~~~¢~~S;ih~ tlle$'ecl:lriijes aq(f' ~~¢~g¢,c-Qnt!nis$i~(C~A1tnjll$i~~l)\Slt().ll1:~:$UP.~t:\~(~~~~~ ~1®s; ~Il

a,conso'1idatedbasi~,:it sh()uldmake~[.recommenOation to.the·:Commissionthat involves

seeliliig'the ri¢cessary:statutoty fuithonty to,o:vers.e~ tliese,ftriilS'ona-,06.risolia'8tedbtiSls.

1\{3n~~I1l¢ntRe$P9 ..~.:(COJltlt",··o... :N~)l'(~on¢Ut);

l1vrC()119urs:vIi1}itlti~ r~c()Il11ne.ndati()n. .'

• \VejlQt¢~ hpWev¢t'. thatthis iss].l¢W$pi9.yi9]'J~lY oonsiA¢£'¢4wh¢1l bfipl~m¢nting'

1he m1¢,s; (()(' $U~¢J;yi$.edlt1'll'e~ent a~lp41g'(3()WP~~s (Sn~fI~~); .

• In'Exc.hMge A~ kel¢as¢ 49S:3:1~ th¢Cpnmussionfi5®itthat its s4P~rvi$i91f:()f:M

ifiy¢~n1entb~~k;.'J1()lditl:g'CQmpafwalla SJBI1C wolI1't}pe 'i1¢C~llam' art'4

appropri'ateonly when the IBFIeis affiliate.a withabroker~dealer thafhasa

'!s\ibstantialpresence!~:fu:the&ecurifiesb\lSmess: The'requiremeriHhata fwm·have

A <~slibstatitlal presence" was 'to identity b.t9Ket-<ieaIers and ·their. holding

cQrnparrles- wb:~~ liil1li:~cowdh<.iYe.·, {lijia~ti~lly adV¢tse Impact Qll ,oth¢t ;s'e~llf.iji~sro~ke~;'pArtf~lp~~,;thtl~1e:(hlgit)S$!,st~mfuti~}(:' .

• trrtdet1h~ SlEne. iiJles~ami)fig'otb~f .iAi)'IgS, e\>idenc¢that :ili1' u'i\ie.stilieiit hank

.b()l(1j.l1g'<?bmp~y. :o.wn~~t: l<qptr.dlsa·~ml;,et-de:~ertb'atm~ntp,'ms ~$J'()qmiJl~i?J:l: in

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APPENDIX VII CONTINUED..

tentative net c.apitat would be srifficielltio ,demonstrate· 'asuootantial presence; in

th¢ sectiritiesbtisiri~s. Oil¢:flrm: hasappiied'tobostlp¢tVlsed il'SaStBItC.

It¢¢()n:uuend:a:tlbJi)$;

The' Divis'i9n QfT~d,ii;tg AA~ }'b,rk~ •.'ill CPlJ,SVltAAioQ,WiUl ~~ Q(uw:n;uui's;ofliqe. ~19\jlcJ·

detennine what additional changes n:eedto~belnade'tothe Consolidated Supervised .

Entlty{CSEj piogratn llillgJit ofthe'.collapseofBMr Steams and:ehangtiig.ecoiloDuC ~hVito,ntl'i¢tlt;

M~n~gentel1t.R:~P9,,~,(pO"91rorNQIl;,cQn~)~

We understandlheirecommendation,.andarenow actively :working withtheChainnan's

offlcefucoriSider'wiwfdWiges are appropriat¢in::llghtoftecent develOptheritS, In

additiQli,theOhititlitan:jiasnmdeat1tUl1bet ot'tequeststot le~Mative¢hangesthat MuM

(eqWr~ :fu:rth~r:moditlq.ati~lSo(theCSEiproW;,t.t'll';

Recommenda:titiri:24:

:~~~~:i~:~~~;~:~~::~~:~:~:~~:~=~·e=n:u\:~:i·~d' program~sfunctiongoing,f()nvard.TIvr shorild'alsoest.ablish milesionesfor,completing~

eachphase',of'an inspeclionandimplement aprocedure:to ensurethat the IriilestOnes are

mel.

Man~~~l'~()n~'{Gon~l"~,r1N:oll~~Ii~~):'

TM:eon¢iirS'wl1J.l'this rec()i1'ifuendatto~ and we have alriiadyfuidertal<:en efforts~that fuliy respOiiclto'It. .

..W~iliavepQ~ed"a:p:ositiQilfot:~\irAss1stant D1t¢etot fCSE InspectiQt1$}'ltfN¢w

York. '~~,w~tl ~·stitf.jQb$' ()tih,? q$E"il,l~pe-~j().lsU.Mf$m bQth,N~\TIo·tork ~4

WtiShin:glon.· ,

_ltls worthnotillg~,however.that this recommendaiiol1 arises lllpartfrom a

misJ,>,erce.pti6riofthe CSEiiispect16ns'progtfun.

tit .A,s\ve 'Uif9Ifue4:thtf6IGin.o\itilif&rijate)jmmeri.&~1l1ree iriSpeC;tiQriSbave':j)een

con.d:tltrted. andtwQ ul$peqtiot1J:¢po$ haN¢ prpg(¢s~edi()f1iefmaI s:htg¢$ofr~v.i'c;:w

in1h~ ]:~rn$)nt1)~,~in~e W$PQlll>i\il.ll:fy wa~d;r~feqe<1frowOOIE~~lfu;th~ 9

months sfuce"'niI'!sinspecti'oDs'unitbeeame operational.

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financial market conditionsthathaveprevailed through nmchofthis year have

affecfedthepac¢ of:tllisWork. alldlllu¢helse.

lt~¢{)ttml.el1Jlatlon2'5:

The Division ofTrading and Marke~iil1 consultation withthe OtliceofCompliance

ltlspectio:l1s aridExatiunatl.ons arid .theCol111ilissio:l1~s·Ethics office? shoUld develop an

ethics matltlal.

Man~eJ:fimtRes}){)It~(P9n~r·{)rN{)n~~It~IU'):

TMconcursw;iththis recomnrendation, and We have a}rea.dY1:iiidetfii:k:.en etl'oi1sthat fully

r¢sp9iidlO1lie:re¢olntiieri,datioli. .

• As.·we ·1nfollil¢dtheQI(Tirt~urinfo:rnial¢oliirii¢ntS.tlie:fitiairtg is based li~(jri

f#tw~dl.Jlldet:St')lldiilgofth~:91J~ntsitl~i()tl,.In..p~!Clllar; ollMarcl1 .•1,2pO?;the

Division Director ofTM. direcled the Division staffto·followOOIEfsEthics

Gliideliiies Witli·twQ.riii:l1ofVariatio:l1s.

• ·Fotshl1pllcityfssak.e,TM riiaiikgeliieritreCetltly con¢ludedthatstaff4lhoitld

fc,l1()WthiaiOQlE@id¢lirt,¢s. An eluail bas baensentlO1he statrpi'oyidmgthat c41rifi,catI9l'L ....

RetonUn.eJldatlQrt26:

the,Division. o(1'ifi,dlllg atlet M~ei$sh()lild C()tl~ltl~ iO$getc ollhvaysfoinc:@Me its

communicatioll,coorwnation.,..andinfoflnation sharing,with the EederalReserve and

other FederoLRegwators.

TMconcurs withthe recommendll:tion.andwe have already undertaken efIortsthatfuUy

:t¢sporid1othei~coil1ihetldationSiliceiliception. TM hascollaboraredW:1th alarge

lllIDi1?e:r of'otllet :re~l.ltators ill the C01lt¢A't()fthe¢SEPt0W'am~incitutitigth¢ F¢d¢ral

R.es¢;hieiaoarq,th¢ Ney~' YorkFeaet~tl{e'g¢tYe:Ban1C, .1he F1jlb,1heStht¢ oft1;'tah,ariq

ot:h.e.rs.Eff9$ c(:jntinuet9 e~pand1h~ ra1:lgeof'b9thbilat(:r<4flJldtnulijlmer<lL~cl.iviijy:;.

21

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APPENDIX VII CONTINUED..

MEMORANDUM

TO:

FROM:

SUBJECT:

DATE:

David Kotz

Jill Lennox

Office of Inspector General

Lori Richards, Director

Office of Compliance Inspections and Examinations

OIG Draft Report 446 -A: "SEC's Oversight ofBear

Stearns and Related Entities: The Consolidated

Supervised Entity Program"

September 24, 2008

The Office of Inspector General provided a draft of its report, OIG Report 446 -A

"SEC's Oversight ofBear Stearns and Related Entities: The Consolidated Supervised

Entity Program" and has requested that we provide a written response indicating

whether or not we concur with each recommendation that refers to the Office of

Compliance Inspections and Examinations. This memo outlines our response.

There are three recommendations in the Report that are directed to the Office of

Compliance Inspections and Examinations (OCIE) (Recommendations 18, 22, and

25), and one recommendation that references the Office (Recommendation 15). Our

response to each is discussed below.

Recommendation 18:

The Division of Trading and Markets (TM) and the Office of

Compliance Inspections and Examinations (OCIE) should develop a

collaboration agreement (e.g., discussing information sharing) that

maintains a clear delineation of responsibilities between TM and

OCIE with respect to the Consolidated Supervised Entity program.

They should inform the Chairman's Office of any disagreement(s) so

that the issue(s) can be resolved.

OCIE concurs with Recommendation 18. We believe that a collaboration agreement

that maintains a clear delineation of responsibilities between TM and OCIE with

respect to the Consolidated Supervised Entity (CSE) program would improve the

effectiveness of the oversight by both offices. While the two offices issued a

memorandum on March 19, 2007 to all staff involved in CSE oversight that

described the allocation of responsibilities and the reallocation of CSE examination

oversight from OCIE to TM, a more detailed agreement could enhance the

information sharing and corroboration between the two offices.

Recommendation 22:

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APPENDIX VII CONTINUED..

Chairman Cox should create a task force led by the Office of Risk

Assessment (ORA) with staff from the Divisions of Trading and

Markets, and Investment Management, and the Office of Compliance

Inspections and Examinations. The Task Force should perform an

analysis of large firms with customer accounts that hold significant

amounts of customer funds and have unregulated entities, to

determine the costs and benefits of supervising these firms on a

consolidated basis. Ifthe Task Force ultimately believes that the

Securities and Exchange Commission (Commission) should supervise

these firms on a consolidated basis, it should make a recommendation

to the Comr.nission that involves seeking the necessary statutory

authority to oversee these firms on a consolidated basis.

OCIE concurs with Recommendation 22. A joint TM, OCIE and 1M task force led by

the Office of Risk Assessment to determine the costs and benefits ofsupervising

firms with significant customer assets and unregulated affiliates could be very

valuable in producing evidence supporting the need for consolidated oversight. At

the current time, the SEC is generally limited in its oversight authority of financial

firms to registered broker-dealers, investment advisers, and transfer agents; the

Consolidated Supervised Entity oversight is a voluntary program. In the current

environment, where firms are highly diversified and deal in very complex products

and businesses, with much of this activity in unregulated material affiliates,

consideration of additional statutory authority would be valuable.

Recommendation 25:

The Division of Trading and Markets, in consultation with the Office

of Compliance Inspections and Examinations and the Commission's

Ethics office, should develop an ethics manual.

OCIE concurs with Recommendation 25. OCIE has implemented strong written

ethics procedures for the OCIE examination force, with requirements and

prohibitions that are more stringent than the SEC procedures that apply to all SEC

staff. Examiners are entrusted with special responsibilities that require the utmost

integrity, avoidance of even a remote appearance of a conflict ofinterest, and the

highest level of professional conduct. Because SEC exam staff are evaluating

compliance with the law and effectiveness of risk management controls, their

credibility, judgment, and independence must be above reproach. For this reason,

OCIE believes that the stringent ethics procedures that apply to OCIE examination

staffshould apply consistently to all SEC staffthat perform examinations, and

would work with TM to develop an ethics manual for the CSE program.

While Recommendation 15 does not require any action by OCIE, it does reference

the Office and therefore we add the comment below.

Recommendation 15:

The Division of Trading and Markets should: (1) reassess all the prior

Office of Compliance Inspections and Examinations (OCIE) issues to

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APPENDIX VII CONTINUED..

ensure that no significant issues are unresolved (given the beliefthat OeIE

followed up); and (2) follow up on all significant issues.

We note that the OClE examination process generally involves requesting and

receiving documents, reviewing and evaluating those documents and conducting an

onsite review, determining if any deficiencies or weaknesses exist, conducting an

exit interview with the firm, producing an examination report and detajIing

deficiencies in a deficiency letter sent to the firm examined. The OClE staff request

that the firm provide a detailed written response to the deficiency letter that

describes any corrective action. OClE evaluates the response and determines

whether the firm has responded appropriately. For significant findings that do not

appear to be appropriately resolved, OClE works with the firm on resolution. All

responses to findings that required action by the firm are then followed up in the

next examination. The most recent CSE examination of Bear Stearns that was

conducted by OClE resulted in an examination report issued by OClE in December

2005, and Bear Stearns provided its response in January 2006. The results were

provided to TM. TM subsequently assumed responsibility for the overall CSE

examination program in March 2007, and OClE ceased CSE examination activities

as of that date (OClE"examiners continue to be solely responsible for examinations

of broker-dealer firms that are part of CSEs).

***

As an additional matter, on page 37 of the report you indicate that in 2007 the

Government Accountability Office commented on our method of tracking

recommendations regarding Self-Regulatory Organization ("SRO") inspections.

Please note that following receipt of that comment, OClE developed a formal

tracking system for recommendations in SRO inspections, and deployed the system

for use in SRO inspections in early 2008.

Finally, you requested that OClE indicate whether there is non-public OClE

information in the report. Any non-general examination-related information would

be considered non-public. Examples of this are found on pages 20, 37, and 39 of the

report.

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UNITED STATES

SECURITIES AND EXCHAN(;E COM.MISSION

WASHINGTON, .D.C. 20549

D:1V1810N ·OF

:ORPORATIO.N PINANCII:

September 24, 2008

H. DavidKotz

Inspector Geneqil

u.s. SecuntiesandExphange Commission

lOOF Street, NE

Washington, DC 20,549

Dear.Mr. Kotz:

ThaiJk you for the oPPOrtunity to respond to lhe recommendatiol1$relatingto the

Division otCOrpQ~tionFiIianceinyoux: AUgtJSt 18, 2008 draftreport SEC'$ ()versight of

Bear Stearns andRelatedEntities: The Consolidated SupervisedEntity Program (Audit

Report NoA46-A).

In 2007;Cotporation Finance selected Bear Stearn&' 2006.Form 10-I<, for review.

On Septeinbet27, 2001, two months prior to its intemalguidellne for issuance ofa

comment l~tter to a company selected for review, Corporation Finance issued its

pomment:letter to Bear Stearns. Thatletter included a focus On sUbprirne mortgage

l11att~, Soon after ~ceiving this letter, and wellbefoteBearSteams' collapsemMarch

2008, Bear Stearns began addingimprovemehts to its disclosures about subprimt?

mortgage securities in its publicly available filings. Those additional dIsclosures appear

in:

ItsForl11 nH~filedon October 10,2007 (details on net inventory markdowns

relatedW losses in residentialmortgages and leveraged finance areas);

Its F0tJjl8-Kfiled on November 15,2007 (updated information on coUateraJized

debtobligatioIis and subprimerelatede~p9sures);

Its Form 8..Kfiledon~ember 21. 2007 (fourth quarter fmancial.results,

including a detailed exhibitofCDO and subprime tnortgage asset exposures); and

Its.Form to-Kfiled on January 29. 200g (schedule ofsubprime exposure),

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VII CONTINUED..

H. David Kotz

Illspector General

U.S. Securities alid Exchange Commission

Page 2 .

Di"i~ion ofCOI"pClration 'Finan~e concerns:aboutAudit'Report tmdings·onBear

Stearns filing review

In Finding 8 ofyour auditreport, you recommend whatcould be sweeping

changes to CorporationFinance'sfull disclOSUre prograntbaseduponconclusions you

draw from a single Corporation Finance review - the review ofBear Stearns' 2006 Form

!O-K. Youinciudeconclusions regarding that review in Finding 8 withwhich 1cannot

agree.the two mostsignificantofwhich are:

1. That COrP()]J;l,tl,()n F'inance's"untimely review deprived investors ofmaterial

infonnation that they could have used torp.ak:e well-informed investment

decisions/, and

2. That CotporationFirn{nce'sreview ofBear St~arnswas ''w1tirile.ly.''

TheDivision ofCorpordtionFihtlnCe reView ofBei:trSteamsresulted in

improved and timely dfsclosure!orJnvestors

Asto the first ofthese conclusions, .you indicate that~\Belir Steams' response

letter(coupled withCF'.s COlllPlentletter) cQnwneq.·rp.atepalinforml,luon that investors

co1l1dhave used to make well·informed investnlent decisions." Youalso concllldethat

''the information (e.g., Bear Stearns' expoSUte to sUbprime IllQrtgage secuntie.s) could

have potentiallybeenbenefieiaIto dispel 'tuDlQrsihatled to Beat Stearns'collapse."

WIllIe you go on to identifyinfotIllation in: that letter and state that AlbertS, Kyle, the

oro expert, believes that this'information wouln'have been "helpful" to investors. you do

notnote the$ignificant redacttonsofinformanon. I do not understand the basisfor your

or ProfessorKyle'sconclusiol1S.

First, as 1indicate above•.Bear Stearns began making additional puhli~d,i$closures

concerlling,jtssttbprime exposuresin itspubliofilillgs soon after it received oUr

Septembet27, 2007 comment letter. In addition, the information thatwas inBear

Stearns' response to our commentletter, which we later posted OIl oUr website, Was

heavi1y~ct~ Wlderthe,coll1.1@Jltia1ity p,rovisiol1S ofRuIe83, I note that inwell over

100 places in the, letter, BearStearns redacted slgpificantinformation. 1 I have difficulty

agreeing with Professor Kylethatthis heavilYr¢dacted letter) whicb wou1d not have

I RedaetedJnformation included: variouS memcs util~tO detei'IhilleF1CO score$ arid designatiQn pf

loans as sllbprime;Joan to value ratios; subprimeproductlonin2005 and 2006; trend data fodoan-to-'value

ratios and full-document loans durihg 2007; percentage ofloans with fulldocumentation; size ofdata

sample upon: Which risk models are based;. table ofmarginJequirements by collateraltype; fairyalue of

stibptime loans at various dates; mit value and baIimce ofnon~perfonningsubptimeJoans;fair value of

rened interestS ill sllbprime securitizations; reduction·ofsubprime exposure fromhedgirtg; fair valileof

se~yrltizationtrusts; amountofsubprime.loans servi¢e<4 amounts securitized through SPEs; amounts

proVided tomance subprime collatetalto counterparties; fair value ofothenubprime telatedinStruments;

revenues derived fromsutiprime actiVity for all periods presented; litigation reserves.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

111

September 25, 2008
APPENDIX VII CONTINUED..

B. Oavid Kotz

Inspector General

U.S. Securities and Exchange Commission

Page 3

become available under our posting pQlicy until at least45 days after we cQmpleted our

review and afterBear Steams had made additional subprittle disclosures(which inclUded

actual nUttleric data and dollarafnouuts), would have been "helpful" to investors or

would have provided material infonnatioll that Bear·Steams had not already provided in

the public reports it fIled with us. The redacted letter, however, is publicly available and

Ittrge investors and-otherreaders ofthis report to review the BearStearns response letter,

and reach their own concillsions about the importance ofthe additional infonnation

appearing in the redacted letter, plllticularlyinlight ofpublic disclosures in the FOtIns 8-

.K, 10-Qand lO-K lreference above}

The Division ofCorporation Finance review wastimely

As to the second c.onclusionwith which I cannot agree,. you concludMhat "OF's

filing review of:BearStearns' 2006 to-I<: was not timely." This lsnot correctand the

implication ofyour cc>nc1usioll isthat We shcmld review Forms 10-I<. immediately upon

filing and that a failure to do So meansthat we are "untimely." As ba~k.ground, we have

a sel~tivereview prqgram,guided by Section 408 ofthe Sarbanes-Oxley Act of2002,

through whichwe review all public companies ona regular and systematic basis, at least

once ina rolling three-year period. Following thisstatut()ry direction, we select for

review between 35% and 40% ofpublic C<'>mpantes each year..... which results ill

approximately 4,000 to 4,500 company reviews. We do not have a requirement to review

each company each year and there areIllany C<'>mpan.ies thatWe do notselectfor review

in any givenyear. Although mostFonns 10-K are filed ill February and March, we

conduct our reviews ofthose companies we select for review thropgho"llttheyear.

As you corre~tly point out, our longstanding internal gqideline isthat we should

issue ourihitial C<'>mments t()a ~ompanYwe selectfor review before the.end ofthe

company'sfiscal year. By folloWlngthis guidelille, We give the companies 'we selectfor

review time to reflect ourCOIllIllellts,ifappropriate, ill the disclosure in their next Form

10-K. As yop'state in YOllt repol't, we metthisinternal gqiclelinein our review ofBear

Stearns' 2006Fonn lo-I(, filed. on February 13,2007, byprovidillgco:mmentson

September 27, 2007- Qvertwomonthsptidr to the end ()fBear Stearns' fiscal year OIl

November.30,2007. Thus, I.cannot agree With yourstateIlleIltthat tlieamoulltoftime

we spentto review :Bear Stearns, filing is "simply'unacceptable.,,3

2 http;l!wWw.sec.gov/Arcllives/edgatJdatal777001l0000914J21 08(}00089/filenameI.txt

3 III fact, in 2Q()6, theIIlspectorGene1"ll1 (AuclitAOl)reco1lllJlend¢cl that Corpbration Fitiance consider ways

tOIlla.l1~eworkloadpeakstesulting frOIll the bunehitigorFonn 10-K fif inFebmaryand March. This

recommenQationretlected the Inspector General's acknowledgement of .. ... .. .culties we face inmeeting

ourSarbanes..()Xleymandared and inrernalreviewguidelines. The implication ofthis Inspector General

tec()1lllJlendatioj) in 2006 Wasacmlllly that Weshould.collsidethmgthenmgthe tiIl')efi'aIlle for our filing

tevieWS,llQtcoj).densing itClosetto the February and March filing peak. .

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VII CONTINUED..

H. David Kotz

Inspector General

U.S. Securities andExchange Commission

Page 4

As an aside, I should pointout that our comment letters to the other four CSE

finns, all ofwhich we select~ for review in 2007, were·sent out weUbefore their fiscal

year ends inNovember and December. We isslled comments to Lehinan BrothersHoldings Inc. on August 1,2007; to MorganStanley on August 30,2007; to Goldman

Sachs Group, Inc. onSeptember 2.0,.2007; to Merrill Lynch&- Co., Inc. on September 25,

2007; and to Bearstearns Companies,Inc. on September 27, 2007.

Curfentandpetiodicreports are theappropriilte disclosure mechanism

Separate from any discussionofthese two conclusions, Ithought it would be

useful to provide some backgrpundon our review process Mditsrole inproIDptinggood

public company disclosure. Our commentletters and company responses are not the

mechanismJordisclosure ofmaterial Information to investors envisioned by ourfull

disclosure program. The goal ofdisclosure ofmaterial information to investors, which is

paramoUIltin oureffol'tS, is achieved m our program by seeking improvements to a

company's public disclosUresin its periodicandcurrentreports. ThoserepoItsare

readily available to all investorS. These changes:ind1sclosure are subject to the full

liability provisions ofthe federal securitieslaws applicable to infonnation.appearingm

these reports and, when they are included ina perlQd.icrepo1't, tlle•sEifegwrrds provided by

the Sarbanes-OXley ,Act Qf2002 apply, including senior officer certifications.and the

disclosureconttolsand procedure.sproceSS.

The public posting ofcomment letters andtesponsesis only a recent development

in ourfull disclosure program and is intended toinctease the transparency ofourreview

process and to Inake this·cotrespondence available to all interested persons atnocost.

'We believe that comp@ies like to look at tlle comment letters we send to their

competitorsto See what comments they might expect, as weUas togleancoIDpetitive

information. To address ¢ompany concerns about public disseminationof¢ompetitively

hanttful infonnationintheir commentresponse letters, wepennitcompanies to redact

such infonnationpursllahttoa Rule 83 confidential treatment request. Companies

frCQ.uently take advantage ofthis provision, as Bear Stearns did inits response letter in

the review ofits 2006 10-K.

Wemtentionally wait until atleast 45 days after we complete a filing review

before we post correspondence. Ourseparation ofthe. e'Xchange ofviews reflected in this

correspondence :from the disclosure PUblic companies provide in their :filingsis

intentional = we seek to promote a :freegive,.;and-take in the review process andto avoid

having concltiSionsdra.wn from our questions before acoIhpany has an opportunity to

respond. FrequentlY,acompany'sexplanation or analysis ofan :issuewill satisfactorily

resolve an issuewiihoutMY chliIlgesto previously filed. or filture disclosure. When a

CQmpany imprQves.itsdisclosure, it makes those improvements;inits widely available

periodic and. current diScloSure docil.Itients. which iswh¢te investors expect to .flnd

materiald1sclosures. To my krtoMedge,investorsdo not useteview correspondence,

whiCh may be heavily redacted, and vvhichwedo notpost Ullti145 clays after we

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

113

September 25, 2008
APPENDIX VII CONTINUED..

H. David Kotz

Inspector General

U.S. Securities and ExchangeComrtrission

Page 5

complete our review, as a source ofdisclosure. To revamp our program to make this

pack-and~·;forthcorresponQence with a company a, disclosure vehicle to investors would

reql.tire significant, and Ibelieve unwarranted, changes to our program, which would

significantlytWde!mine its ·e:ffectivene~ for jlwestQts. .

TheDivision ofCorporationF'inance seekstimely responsesto its comments

You also discuss Corporation FinaIlce's general practiceofreque'sting, butnot

requiring, thatcompaniesrespond to comments within ten business days. Whileitis true

that we rarely insist that a company respon4iJIthat nmeframe, it is. importanttg note that

in many cases, companies do respond during that time period. You recolIl1l1end that we

establish apolicyo~tliriing·when weexpectCQmpanies to substantively respond to issues

we raise in our comment letters andmonitotcompliance with this policy.

Our disclosure review program is built on the ,common goal we share'with

companies ~to enhancediSClosureandiniproVe compliance with the disclosure

requirementS ofthefedetal secliritieslaws. Although the limited COnsequehceS ofnot

responding to our comment:s can be quite significanr-for example, a company is

~quir~ togis.close materi~sta:ff CQritmentsthat have been outstandillg forsixmonths in

its Form rO~K anqlor CorporationFinance may rerera I;I,on~omp1iantCompany or one

with faulty dis~los:ure to the Division ofEnfofcementfor further inyestig~ion- th~y 'are

rarely"l:he outcome ofastafIfiling review. While you recommend thatwe change our . . .

'pOlicy in this area, ou:rexpetience isthat most'companies do respond'to us, in some form,

within the tenbusiness'dayS ,it1whichwe seek a response. Our experience is also tha4

similar to the Bear Steamsreview described above, a companymay respondto staff

COlIl1l1entsinits public disclosure documents. Although we believe.that extending the ten

busin.ess day r¢quest..for-re~ongetimeperiod will be cOl.l1lterproductive to our ongoing

effortsto enha!1cepublic 'diSclosure, wewill consider your recommen~tionan4 how it

would impact our program.

Diyjsion ofCorp,oration Finan~e's l"olewithrespechothe CSE prowam

The Commissioii~sC.sEprogram is the focus ofyotJrrep6rt. You explain in the

Executive S1itIi:Iii81y that your objectives in this audit '<Were to evaluate the Cortuilission.'s

eBE program, empha,sizingtheCommissionis oversight ofBear Stearns, and to

detennine whether'improv¢ments are needed in the Commission';s mon,itoiing ofCSE

firms and its administration ofibeCSEprogram." You also summarize the work of

Albert S. Kyle, the. expert you obtained to.assistyou With your audit, and indicate that

ProfessorKyle's focus was on "the DivisionofTrading andMarkets' oversigbtofthe

,CSE :finns, W1tlla particularfocus on Bear Steams;" .

The Division'ofCOl'{iorationFinahce is not·directly involved with theCSE

program and, asJ understand youtteport, neitherthe DiVision ofCorporation Finan~,

noritg full disclosure programgenerally, wasthe f\Jcus ofyour auditorofProfessor

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

114

September 25, 2008
APPENDIX VII CONTINUED..

H. David Kotz

InspectorGeneral

U.s. Securities and Exchange Commission

Page 6

Kyle's work. However, in connection with your audit ofthe CSE program, you did

review Corporation Finance's review ofBear Stearns' 2006 Form lO..K, filed in Feb11lary

2007, and, based .on thatsingle review,yoll haverecomrnended what could be sweeping

changesto CorporationFinance'sfulldisclosUteprogtam. In oUt full disclosUte

program,.we reviewthe filings ofmore tha:n4,OOO companies each year. 1believe it is

inappropriate for you to have reached conclusions, and. to have made recommendations,

about our program based upon your examination ofour review ofjust one company's filings.·· .

1believe, based on the scope oryouraudit work, that you.r comments and

recomrnendationsto Corporation Finance would have more appropriatelyfocused on our

full disclosure progratnasit relates to the CSEprogtam. To the extentyour

recornttlenclationsdo focus on Corporation Finance's interaetionwith theCSEprogram,I

agree fully thatwe shotildexaminethe interaction between outreviews orthe CSE flrtns

and Trading and Markets' administrationofthe CSEprogram. For example, we will

consider whether we shou1dreviewCSEfirms promptly after theymake their annual

Exchange.A.ctfilitIgs and issue comments,gany, wi'thin a specific timeper1o<l.We will

discuss ourthoughts on this with Trading and Markets. In addition,inl"inding 7, you

recommend that we shouldtake concrete stepsto.in1prove our collaboration efforts with

Trading and Markets and that we·showd detetnlinewhetherthe information Trading and

MarketsreceivesfromtheCSEfinn.s. would be helpful inotir reviews ofthe filings these

companiesl11a.ke..As you.i1ote, we werenotable to respond to yOU! questions durin~the

audit aboutthe potential usefulness ofthisinformation since we did not know wb4t it

was. Furthermore, as we previously conveyed to you, we are concerned about basing our

comments to a company, which we will make public, on non..public information that a

company provides to another Division or Office for diffetentpu.rposes. That being said~

we will take.stepsto wotkclosely withTtadingandMarketsto pursue this.

I appreciate your givingIlle the opportunityto p.(es~ntmyyiews on your report

and. I very much appreciate your commitment tQpresent thisletter as an attachm.entto it.

Doing so will allowteaders todTawtheit own. conclusions, and·isconsistentwith the

transparentfulldisclosUte review process I and the staffoftheDivision ofCorporation

Finance are proud to administer.

Sincerely,

.LW.~

J.· .•...•.

,

·...Lw. ltootorWlrl~

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

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September 25, 2008
APPENDIX VIII

Office of Inspector General Response to

Chairman Cox and Management Comments

The Office of Inspector General (OIG) has received responses to its audit report

entitled "SEC's Oversight of Bear Stearns and Related Entities: TheConsolidated Supervised Entity Program" from Chairman Christopher Cox, the

Division of Trading and Markets (TM), the Office of Compliance Inspections and

Examinations (OGlE), the Division of Corporation Finance (CF), and the Office of

Risk Assessment (ORA).

In total, the Commission's responsible management officials have concurred with

21 out of the 26 recommendations contained in the report.

Response to the Chairman's Comments

We are particularly pleased that the Chairman has commented that he believes

that the 26 specific recommendations are well-considered and worthy of support.

We also appreciate his comment that the report provides an invaluable and fresh

perspective for the agency to carefully review and consider.

Response to the Comments of the Division of Trading and Markets (TM)

The OIG is pleased that TM concurred with 20 out of the 23 recommendations

addressed to them in the OIG audit report. The OIG, however, is, quite

disappointed in many of the assertions made in TM's "Management's

Commentary."

The OIG made supreme efforts throughout the entire audit process to engage

and consult with TM on every aspect of the audit report. Over the five months of

fieldwork, OIG auditors had weekly and sometimes daily conversations with TM

management, including senior officials, on all issues relating to the audit work. In

many cases, TM management did not provide full responses to questions posed

and issues raised by the OIG.

It is important to point out that specifically because the OIG recognized that this

audit involved numerous issues of a technical and complex nature, the OIG

retained a renowned and highly-regarded expert on many aspects -of the capital

markets, and market microstructure in particular, to assist the OIG's efforts. The

expert worked closely with the OIG's auditors, providing technical expertise and

guidance. The expert also spent countless hours reviewing detailed notes and

memoranda that TM staff had prepared during the time periods pertinent to the

audit and conversed in detail with TM management and staff.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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September 25, 2008
APPENDIX VIII CONTINUED..

Even after having numerous conversations with TM staff throughout the audit

field work, immediately prior to finalizing the draft report, the OIG convened a

meeting with the Director of TM and several senior management officials to

discuss the findings and recommendations in the report. TM officials stated that

they were unable to provide any substantive responses without viewing the

report in writing in its entirety.

Shortly after this meeting, the OIG also provided TM officials with an initial

working draft of the report, complete with findings and recommendations, for

their comment. TM management provided in response a red-lined version of the

report and an additional memorandum containing substantive comments. OIG

staff painstakingly reviewed both TM's redlined version of the report and its

memorandum. Thereafter, the OIG incorporated many of TM's suggestions,

including making major revisions to one finding, and removing another finding

altogether. The OIG then provided TM with a second draft for comment and

invited another round of substantive responses. The OIG also posed two

separate sets of questions to TM officials regarding some of tb.e assertions they

had made in response to the working draft of the report. TM failed to provide

any response to these two sets of questions.

Instead of responding to the OIG's questions or providing additional substantive

suggestions regarding the OIG report, TM decided to issue its "Management's

Commentary," which claims the report is flawed and inaccurate, and asserts that

TM was not provided with a fair and meaningful opportunity to address the

issues raised in the report. It is worth noting that notwithstanding the rhetoric

contained in "Management's Commentary," TM concurred with nearly of the

report's recommendations. Moreover, while the commentary asserts that the

report in fundamentally flawed in all aspects, it provides only a few examples of

actual statements being inaccurate, all of whom are relatively minor, even if true,

and have no impact on overall findings and conclusions of the report.

We sincerely hope that the tone adopted in TM's "Management's Commentary"

is not indicative of TM's unwillingness to take the OIG report and its findings

seriously and responsibly as these matters are of utmost importance to the

Commission and the country, particularly as lawmakers consider the

administration's proposed unprecedented bailout of the nations' financial

markets.

Response to the Comments of the Office of Compliance Inspections and

Examinations (OCIE)

The OIG is pleased that OCIE has concurred with all 3 recommendations

addressed to it, and commented favorably on an additional recommendation.

Specifically, OCIE concurred that the development of a collaboration agreement

that maintains a clear delineation of responsibilities between TM and OCIE

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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September 25, 2008
APPENDIX VIII CONTINUED..

would improve the effectiveness of the oversight by both offices and that a joint

TM, OCIE and Division of Investment Management task force led by the ORA to

determine the costs and benefits of supervising firms with significant customer

assets and unregulated affiliates could be very valuable in producing evidence

supporting the need for consolidated oversight. OCIE also concurred with the

recommendation that TM develop an ethics manual, agreeing that stringent

ethics procedures should apply consistently to all SEC staff that perf9rm

examinations, and indicated that it would work with TM to develop an ethics

manual for the CSE program.

Response to the Comments of the Division of Corporation Finance (CF)

The DIG is disappointed that CF concurred with only 1 of the 3

recommendations addressed to it. The DIG also disagrees with several of the

comments contained in the management response submitted by CF.

First, CF indicates that the DIG recommends what could be "sJVeeping changes"

to its program. The DIG's finding concluded that CF has not established

guidelines for the timeliness of second level filing reviews. We recommended

that CF establish such guidelines and thereafter monitor compliance with the

established guidelines. We do not view these improvements to be "sweeping

changes" but rather reasonable and necessary management practices.

Second, CF points out that its current view of timeliness, as it pertains to the

entire filing review process, is dictated by the requirements of Section 408 of the

Sarbanes-Oxley Act (SOX) of 2002, as well its internal guideline of issuing

comments before a company's next fiscal year-end. While these factors may

guide the timeliness of filing reviews (and the issuance of comment letters) as a

general rule, CF ignores the need to address high-risk filings in an expeditious

manner. As evidenced by developments in recent years, a company's stock

price can have a dramatic downward swing in a very short period of time. Under

the particular circumstances involving Bear Stearns, we simply disagree that

CF's review of its 2006 10-K was "timely."

Third, CF questions what value to investors an earlier release of its comment

letter on Bear Stearn's 2006 10-K and the company's response would have had

because those documents were heavily redacted when publicly disclosed.

During our audit, we considered whether the information would still have been

useful, even though it was redacted, and we concluded it would have been quite

useful. Further, the DIG expert opined on the redacted version ana found the

information to be beneficial.

Fourth, CF notes that under Section 408 of SOX, it is not required to review

every company each year, and there are many companies that are not reviewed

at all in a given year. While this may be true, CF is overlooking a critical aspect

of Section 408, which contemplates that CF will consider the risks associated

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

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September 25, 2008
APPENDIX VIII CONTINUED..

with filings when scheduling its filing reviews. Bear Stearns' 2006 1O-K filing was

high-risk, in our opinion, given the company's high exposure to subprime

mortgages and, accordingly, should have been reviewed in a more timely

manner.

Fifth and finally, CF maintains that investors do not use review correspondence,

which may be heavily redacted, as a source of information on which Jo base

investment decisions. In addition, CF explains the practice of publicly disclosing

the comment letters and the associated responses as a relatively new

development intended to increase the transparency of the review process and to

make correspondence available to all interested person at no cost. However,

according to SEC Insight (now known as Disclosure Insight), an independent and

private investment research firm, CF's comment letters and responses can be

quite beneficial to investors. In fact, it was stated by SEC Insight as follows:

The comment letter proposal [to make the comment

letters public] provides one important means for _

investors to level the playing field with registrants

[companies] by enhancing their ability to do what

investors do best in transparent markets; that is,

assess and discount risks. [Emphasis added].

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

September 25, 2008

119
APPENDIX IX

Gross Leverage Ratios

Figure 1. CSE Firms- Gross Leverage Ratios

Gross Leverage Ratio: August 2006 - February 2008

34

32

30

28

26

24

22

20

s;)CO s;)CO S' S' s;)'O

~", ~\:)' ~' ~", ~", ~\:)' rf,>' ~q. :Qr/t q,<::\ _t.t..~ ~q. :Qr/t q,<::\ ~..:§!$ 0~ '$;I''::> ~. ~v.CJj 0~ '$;I''::>

l ~~ ~0 l ~~ ~0

Date of Quarter Closing

-+-- Bear Stearns Company

- Goldman Sachs

Lehman Brothers

-*- Morgan Stanley

--1IE- Merrill Lynch

Source: This data was provided by TM. They obtained the information from public filings (i.e., 10-K) and

Bloomberg. We verified each firm's year-end gross leverage ratio amount, but did not verify its quarterly

ratios.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program

Report No. 446-A

120

September 25, 2008
APPENDIX X

Criteria

Basel II Standards.

Final Rule: Alternative Capital Requirements for Broker-Dealers_That Are

Part Of Consolidated Supervised Entities" (Release No. 34-49830).201 In

2004, the Commission adopted rule amendments under the Securities and

Exchange Act of 1934 (which created the CSE program) that allowed firms (the

broker-dealers) to apply for an exemption from the net capital rule and instead

use the alternative capital method.

TM's Policies and Procedures describing its administration of the CSE

program.

Publicly Disclosed Information about the CSE Program.20~ The Commission

has posted the following documents on its website about the CSE program:

• Program Overview & Assessment Criteria;

• Program Description; and

• SEC Holding Company Supervision With Respect To Capital Standards

And Liquidity Planning.

201 Source: Final Rule: Alternative Net Capital Requirements for Broker-Dealers That Are Part of

Consolidated Supervised Entities (69 Fed Reg. 34.428). Commission. 21 June 2004.

<http://www.sec.gov/rules/finaI/34-49830.htm>.

202 Source: SEC [Commission] Holding Company Supervision Program Description. Commission. 5 June

2008. <http://www.sec.gov/divisions/marketreg/hcsupervision.htm>.

SEC's Oversight of Bear Stearns and Related Entities: The CSE Program September 25, 2008

Report No. 446-A

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Audit Request and Ideas

The Office of Inspector General welcomes your input. If you would like to

request an audit in the future or have an audit idea, please contact us at:

u.s. Securities and Exchange Commission

Office of Inspector General

Attn: Assistant Inspector General, Audits (Audit Request/Idea)

100 F. Street N.E.

Washington D.C. 20549-2736

Tel. #: 202-551-6061

Fax #: 202-772-9265

Email: oig@sec.gov