Seeking hidden losses, regulators comb books of Wall Street titans

By Randall Smith and Serena Ng
The Wall Street Journal
Friday, August 10, 2007

Securities regulators are checking the books at top Wall Street brokerage firms and banks to make sure they aren't hiding losses in the subprime-mortgage meltdown, said people familiar with the inquiry.

The SEC is looking into whether Wall Street brokers are using consistent methods to calculate the value of subprime-mortgage assets in their own inventory, as well as assets held for customers such as hedge funds, the same people said. The concern: that the firms may not be marking down their inventory as aggressively as assets held by clients.

While the issue is a technical one, and such checks occur routinely, it is sensitive for the markets. That is because, at least through their latest earnings reports, few big Wall Street firms have reported big subprime losses despite the turmoil roiling the markets.

The SEC checks are expected to include the top five Wall Street firms and the securities units of major commercial banks. Among the first firms to be looked at are Goldman Sachs Group Inc. and Merrill Lynch & Co., according to people familiar with the inquiry.

Some analysts and investors have raised questions about whether firms have experienced as-yet-unreported losses in markets such as subprime mortgages and collateralized-debt obligations. The checks may also yield information about whether the hedge funds themselves have reported their results accurately to investors, according to one person knowledgeable about them.

Cross-checking to see whether the firms use the same methods to mark their own positions as they do to mark those of their customers could increase the accuracy and clarity of how the firms report their earnings to investors. Some firms "don't come clean" about such losses in earnings reports, said analyst David Trone of Fox-Pitt, Kelton. "You don't know when people take losses; it's buried."

Marking subprime assets to market is controversial because unlike stocks or bonds listed on an exchange, they can't be readily bought or sold. That makes it hard to establish an accurate price for them. Fund managers have broad discretion in attaching a value to these assets, and often don't reveal many details of their trades.

"No one really knows how to price asset-backed securities and CDOs and that's a real problem in the market now," says Ann Rutledge, principal of R&R Consulting, a structured finance consultancy in New York.

While the markets were choppy in February and March, they settled down in April and May. The turmoil resumed in June. The most damage has occurred in July and August, after the big firms reported their most recent results for quarters that ended in May and June.

The regulators are looking at marking methods used by the Wall Street divisions that make loans to customers such as hedge funds and other money managers. In addition to prime brokerage that provides trading and financing to hedge funds, they also include so-called repo desks, which provide financing to customers secured by assets including the kind of securities that have plummeted in value.

Repo desks manage repurchase agreements, which are essentially short-term loans with collateral such as Treasury bills and bonds, corporate bonds, and other debt securities.

Such repo desks monitor the value of the collateral, most often daily, and if they believe the value has declined, they may ask the customer for more cash or more securities to ensure that, in the event the loan isn't repaid, the collateral can be seized and sold quickly enough to make the lender whole.

Such a scenario unfolded at two subprime-mortgage hedge funds operated by Bear Stearns Cos., which took a hit in June because a decline in the value of mortgage securities in the fund prompted some of the funds' lenders to seize assets and force sales.

In late June the SEC said it had opened about a dozen probes involving CDOs, which are backed by mortgage bonds or other types of debt. Much of the turmoil in the debt markets has been tied to uncertainty involving the pricing and valuation of complex instruments such as CDOs.

The SEC also is looking at the implosion of the Bear hedge funds. SEC Chairman Christopher Cox said at the time the agency was looking into how hedge funds value their assets.

As there isn't an active trading market for some of these types of securities, many hedge funds and mutual funds rely on dealers to provide them with market prices. Those prices are usually estimates or the result of financial models, and can be highly subjective. In recent weeks, these marks have varied widely among different dealers, creating pricing problems for some funds.

The pricing issue is crucial for brokers and banks, some of which hold significant amounts of mortgage or CDO securities on their books. Analysts said it was common in past years for Wall Street underwriters to keep portions of the securities of CDOs or mortgage bond deals they arranged.

The SEC's market-regulation division has been in touch with all big brokerage firms to ensure their risk-management systems are up to speed in light of the quick deterioration in the subprime market. The asset-pricing inquiry is being conducted by the agency's office of compliance, inspections and examinations.

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