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The Wall Street Journal  E-Mail This Article       Print Article
Bear Stearns Is Faulted on Its Valuations in 2007
by Kara Scannell - October 18, 2008

Bear Stearns Cos. improperly valued certain assets to avoid taking write-offs in 2007 as the credit crunch was beginning to unfold, according to the Securities and Exchange Commission's inspector general.

A report by the inspector general shows that disputes among Wall Street traders about valuations were becoming tense months before troubles at top financial institutions burst into the open.

In a typical case, investigators said, traders at two firms would differ over the value of a hard-to-trade financial instrument -- for example, a bet between the two sides on whether a third party would default. The firms would agree to a "mark," or valuation, somewhere in the middle, but Bear would stick to its original, more aggressive mark on its own financial statements.

Albert Kyle, a finance professor at the University of Maryland who conducted the review for the inspector general, said it was improper for risk managers to allow Bear in effect to adopt two valuations for the same asset.

"In Bear Stearns, the risk management was conducted in such a way that it either made the firm appear to have more capital than they really had" or made it appear to be carrying less risk than it really was, Mr. Kyle said in an interview.

Bear nearly collapsed in March and was acquired by J.P. Morgan Chase & Co., which declined to comment.

The SEC's regulatory staff, which was responsible at the time for overseeing the firm's risk management, rejected the report's contentions. In a written response, the staff told the inspector general that mark disputes "are an unavoidable issue faced by all dealers...and the total disputed numbers at Bear Stearns are much smaller than at other institutions." The impact of any disputes, they said, would have been negligible to the firm's capital level.

The report, issued late last month, doesn't discuss specific valuation disputes and doesn't give figures on how much total money was at stake.

As the housing market began to turn downward last year, financial institutions were beginning to feel the pressure on housing-related assets, but many appeared to let the bad news dribble out slowly. SEC investigators have been looking to see if some firms improperly valued assets. To date, no cases have been brought.

Charles Mulford, an accounting professor at the Georgia Institute of Technology, reviewed the report and said it "raises a lot of questions." Using different valuations for the same asset is "improper accounting," he said. "Whether it rises to the level of fraud is for somebody with jurisdiction to decide."

Accounting rules require firms to value assets at the market price. When there is no market, firms can consider other data to derive a value, leading to some gray areas.

The report said the SEC examiners saw an increase in mark disputes beginning in 2007. That July, the report said, Bear had disagreements over marks with two large dealers that were in excess of $100 million each. Both firms were big trading partners with Bear. One particular dispute triggered many meetings with the SEC and Bear, according to the report, which doesn't say how it was resolved.

On a related matter, the report criticized Bear's accounting of its dealings with an affiliated hedge fund in the summer of 2007. It said Bear agreed to lend the fund $1.6 billion. The loan was backed by collateral valued at between $1.7 billion and $2 billion. The report said those assets were losing value and many became hard to trade.

Bear should have treated those assets as if they were on its own trading book, because it was ultimately responsible for the hedge fund, the report said. The financing arrangement "appeared to have allowed Bear Stearns to delay taking a huge hit to its capital," it said. In June, two managers of the hedge fund were indicted by a federal grand jury on fraud charges for hiding losses from investors. Both men have pleaded not guilty.

By March 12, 2008, Bear's "mark disputes involved even larger amounts," the report said. The following day, J.P. Morgan Chase and the Federal Reserve extended a lifeline to the firm. Two days later, J.P. Morgan agreed to buy Bear Stearns.

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