The Inside Story on the Breakdown at the SEC

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Illustration by Sean McCabe for TIME; Getty (4); AP; Reuters

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But the SEC was missing the much bigger and more important game. Those lost penalties--which can reach hundreds of millions of dollars--amounted to peanuts compared with the multibillion-dollar stakes in play at investment banks like Bear Stearns and Lehman Brothers. While their brokerage businesses remained under SEC control, their parent corporations--huge holding companies with far-flung interests in hedge funds and other financial services--answered to no one but shareholders. It is a measure of the industry's comfort level with the SEC that investment banks, when faced with the demand that they open their books, lobbied for the commission to conduct the oversight. In 2002, the European Union threatened to impose its own rules on Europe-based affiliates of the big U.S. investment houses. The U.S. firms pleaded for the opportunity to find a regulator at home. To avoid prying European eyes, five banks--Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch and Morgan Stanley--offered to subject their parent companies to SEC oversight. Under Cox's predecessor, William Donaldson, the SEC agreed to create a voluntary supervisory program that didn't extend to the holding companies the debt limits that the commission had once imposed on brokerages owned by the banks. The program had no teeth, but it did permit some government oversight of an otherwise unregulated industry--that is, if SEC supervisors properly performed it.

In theory, it was only a matter of time before hyperleveraging came unraveled. A pair of hedge funds managed by Bear Stearns collapsed in June 2007 as a result of huge losses in subprime mortgages. Despite more bad news--a federal investigation into the hedge-fund collapse, two consecutive quarters of declining profits and a dropping stock price--Bear Stearns' chief executive, James Cayne, announced on Oct. 4 of that year, "Most of our businesses are beginning to rebound." Investors who wanted to reconcile the numbers with the company's conflicting explanation got no help from the SEC. Its voluntary program had given the agency a window into the secretive industry, revealing Bear Stearns' rising concentration of subprime mortgages, its questionable risk management and its yawning ratio of debt to capital, according to a later inspector general's report. But the SEC failed to warn the public and didn't urge the bank to improve most of its practices, the inspector general reported.

Cox insists that he too was in the dark, adding he was never informed of the problems at Bear Stearns and was surprised by the bank's fall. He certainly sounded lost at the time: five days before Bear Stearns collapsed, Cox told reporters, "We have a good deal of comfort about the capital cushions at these firms."