Bear Stearns Bulls Shrug Off SEC Probe

Carefree investors are bidding up Bear Stearns'(BSC Quote - Cramer on BSC - Stock Picks) stock as if the big Wall Street firm has nothing to worry about from regulators looking into the brokerage's role in the mutual fund trading scandal.

Bear's shares are up 10% since the firm said in mid-June that the Securities and Exchange Commission is considering filing civil charges against its big clearing operation. Regulators believe Bear played an important role in processing and financing abusive mutual fund trades for dozens of hedge funds and small brokerages.

Investors couldn't care less. Of all the big brokerage stocks, Bear is the only one trading in the black this year. The stock is up 12%, compared with a 5% decline in the Amex Broker/Dealer Index. Bear's stock gains have helped narrow the historic valuation gap between it and other Wall Street stocks.

Clearly, investors are assuming any action taken by the SEC will be a slap on the wrist and do little damage to the shares. Bulls prefer to focus on the 27% gain in earnings at Bear over the first six months of the year, rather than the occasional bad headline the scandal has wrought.

Indeed, if it's only money the regulators want, investors are probably right in ignoring the scandal. With $708 million in profits during the first six months of this year and $2 billion in cash on its balance sheet, Bear generates more than enough dollars to absorb any fine, even one that some speculate could total nine figures.

But investors might want to pay more attention to the possibility that regulators push for structural changes in Bear's clearing operation, which processes trades for hundreds of small brokerages that lack the back-office muscle.

Most Wall Street analysts who follow Bear consider the clearing and prime brokerage business the firm's crown jewel and most valuable asset. Goldman Sachs brokerage analyst Jim Hoeg calls the prime brokerage business a "dominant" franchise. The overall operation accounts for 13% of Bear's annual revenue and 17% of its pretax profits, or $165 million over the first six months of the year.

Officials with the SEC and Bear wouldn't comment. But a demand by regulators for structural change as part of the settlement is not just conjecture. Bear left the door open to that possibility when it said in June that the firm could be ordered to pay a fine, disgorge profits or face "other remedial sanctions."

In fact, there's precedent for regulators forcing structural changes in the mutual fund investigation. The brokerage arm of Bank of America(BAC Quote - Cramer on BAC - Stock Picks), as part of its settlement pact, agreed to get out of the clearing business. The bank recently sold its clearing business in June for an undisclosed sum to Automated Data Processing(ADP Quote - Cramer on ADP - Stock Picks).

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