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US SEC launches investigation against financial products - extended

The US Securities and Exchange Commission has opened about a dozen investigations involving complex bundled financial products, The Wall Street Journal reported on Wednesday.

SEC Chairman Christopher Cox told lawmakers on Tuesday that the agency's enforcement division has “about 12 investigations” involving collateralized debt obligations, or CDOs, and collateralized loan obligations, or CLOs, said the report. Such bundles of debt or loans, which are sold off in smaller segments, have become very popular in recent years and are core drivers behind the surge in leveraged buyouts. The report quoted people familiar with the matter as saying that the SEC's enforcement division also has opened a preliminary investigation into the issues surrounding the Bear Stearns hedge funds, which invested in complex financial instruments backed by supreme mortgages.

Earlier this year, the SEC enforcement division formed a supreme working group, which is looking at a range of topics from the securitization process to troubled supreme issuers. One area of concern involves the lack of accurate pricing in the CDO market. (

Bear Stearns fallout — the question of pricing of CDOs
“If every CDO (manager) was forced to mark to market their supreme holdings, it would be — well, I can’t think of a strong enough word to describe what it would be,” an unnamed US policymaker tells the FT’s Saskia Scholtes and Gillian Tett. In a detailed FT analysis, the two writers examine a central concern of the moment: that the prices attached to many collateralized debt obligations, designed to provide both juicy investment returns and high credit ratings, have not been tested in the market. Instead, CDOs , have often been valued in investor portfolios or on the books of investment banks according to complex mathematical models and other non-market techniques. Also, fund managers and bankers often have broad discretion as to what kind of model they use — and thus the value attached to their assets.

The crisis at Bear Stearns has left investors, brokers and regulators asking an uncomfortable question: can the pricing models that have provided the foundations for this new financial edifice really be trusted? The valuation problem for CDOs reflects the fact that the frenetic pace of innovation seen in the financial industry this decade has outpaced the development of its infrastructure. New financial products are often illiquid, but they usually occupy a small niche. But the CDO sector has exploded - last year alone, about $1,000 billion in cash and derivative CDOs were issued in Europe and the US, according to the Bank for International Settlements.

Aside from pricing models, holders of CDOs, such as hedge funds, shop for quotations amongst a range of brokers or seek guidance from rating agencies. But as one banker tells the FT: “It is very easy for hedge funds to shop around to find valuations that suit them best and then book their assets at that… Going back to the bank that sold you a CDO and asking for a price is rarely likely to produce an accurate picture.” Similarly, on the credit rating side, such agencies are focused on assessing the chance of default, noting guiding on how market prices might behave. Then there is the issue of incentives. Hedge fund managers, for example, are typically paid a percentage of the profits they book, giving them a vested interest in reporting a high asset valuation. At best, this means that the valuations of CDOs may often lag behind any swings in broader asset classes; at worst, this ambiguity may enable hedge fund managers or investment bankers to keep posting profits — even when markets fall.

Amitabh Arora, head of interest rate strategies at Lehman Brothers, points to a further potential impact from the Bear Stearns upheaval. “The bigger risk now is that it calls into question CDOs as a financing vehicle in the corporate credit market — I think in the next six to 12 months we will see a significant reassessment of CDOs as a financial vehicle not just in the supreme world but the corporate world too.” Some bankers and policymakers argue that this is simply a teething problem that will fade as structured finance becomes more mature. History suggests that most opaque, illiquid markets eventually become more transparent when they grow large enough - but history also shows that large-scale structural dislocations, such as a serious mispricing of assets, are rarely corrected in an orderly manner. (