The Subprime Crisis: A Major Shift in Priorities for the SEC
Caught flatfooted by the meltdown in the subprime mortgage market, the SEC belatedly is investigating whether any wrongdoing occurred. The origin of the subprime crisis is worth revisiting. In a business environment featuring increasing home prices and significant demand for homes, “prime” borrowers with good credit locked in their rates. Mortgage lenders extended credit to “subprime” borrowers with poor credit, who, due to poor underwriting practices, often were allowed to borrow more than they could repay. This practice was facilitated by the issuance of asset-backed securities. Mortgage lenders sold the loans to third parties who packaged them into pools and sold the cash flows to investors in the form of mortgage-backed securities. In turn, these third parties resecuritized the mortgage-backed securities to create collateralized debt obligations or "CDOs."
In 2006, interest rates edged upwards, home appreciation slowed, and subprime borrowers started to default. The third parties that purchased the mortgages sought to exercise their right to return them for new ones or receive a cash refund. Starting in early 2006, thinly capitalized mortgage lenders started to fail, and market participants started to reprice asset-backed securities. Eventually, hedge funds and other investors suffered liquidity problems as demand for the securities declined. In an attempt to increase their cash positions, these funds sold more liquid assets (such as equities) or raised capital. Investor nervousness grew to include asset-backed commercial paper.
In response to the subprime crisis, the SEC has indicated that it will focus on several different areas. First, it will look at the role of credit agencies. Investors were persuaded to buy securities mortgages on the strength of “AAA” ratings. Under the Credit Rating Agency Reform Act of 2006, the SEC obtained authority over major credit rating agencies, which are now required to keep certain records, have written policies and procedures regarding their ratings processes, and manage their conflicts of interest. Second, the SEC will look at the risk management and valuation practices of the five largest securities firms, which until recently included now-defunct Bear Stearns. [1] Given Bear Stearns’ well-known exposure to risky CDO’s and liquidity problems, investigation of these issues could well result in proposals for new legislation or enforcement actions. The SEC’s Division of Enforcment wrote a letter concerning its potential investigation “into conduct and statements by Bear Stearns before the public announcement of the transaction with JP Morgan.” According to the SEC, “the staff declined to provide assurances about future enforcement actions.” [2]
The SEC will likely investigate at least the following potential violations arising from the subprime crisis and the collapse of Bear Stearns. As suggested by the letter, it will look at whether Bear Stearns’ public disclosures prior to its sudden collapse were accurate. It will probably also examine whether anyone at Bear, Stearns engaged in insider trading by selling their stock in advance of its disclosed liquidity problems and announced acquisition by JP Morgan Chase. The SEC will also look at whether any of the firms with substantial subprime exposure engaged in accounting fraud by incorrectly accounting for asset-backed securities in their financial statements, or failing to disclose related internal control deficiencies. Finally, the SEC will review the quality of disclosures to institutional and other investors concerning risks associated with mortgage-backed securities. Investigating subprime-related transactions will consume much of the SEC’s limited resources for the foreseeable future.
[1] “Remarks Before the Los Angeles County Bar Association,” Commissioner Annette Nazareth (Oct. 19, 2007), available at http://www.sec.gov/news/speech/2007/spch101907aln.htm.
[2] “Answers to Frequently Asked Investor Questions Regarding the Bear Stearns Companies, Inc.,” (March 18, 2008), available at http://www.sec.gov/news/press/2008/2008-46.htm.
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