Bear Stearns Bulls Shrug Off SEC Probe

Just days before the SEC filed civil fraud charges against J.B. Oxford(JBOH), the small Los Angeles brokerage announced it was selling its small clearing subsidiary. Regulators contend the J.B. Oxford clearing unit facilitated hundreds of illegal and abusive mutual fund trades.

Of course, the clearing arms of BofA and J.B. Oxford were small potatoes compared with Bear's, which ranks as one of Wall Street's largest. Also, Bear's clearing division entails much more than simply processing stock and mutual fund trades. It's home to the firm's prime brokerage operation, which provides financing and other services to many hedge funds.

A source says one of the allegations regulators are looking into is whether Bear clearing executives matched up hedge funds interested in market-timing and late trading of mutual funds with small brokers willing to handle those trades. Market-timing and late trading are the two trading abuses regulators have focused on in the yearlong mutual fund inquiry.

In light of the division's importance to both Bear and the securities industry, it's difficult to imagine regulators pushing Bear to sell the entire business. But there's the possibility regulators could demand that Bear sell part of the clearing business, or impose new operating restrictions that reduce its future profitability.

The uncertain outcome of the regulatory investigation is one reason Egan-Jones, an independent debt rating service, is holding off on upgrading its rating for Bear's corporate debt. The ratings agency, in its most recent report, says the firm's "financials suggest an upgrade," but it wants to see what the regulators do first. Egan-Jones has an A-plus rating on most of Bear's debt.

Any significant regulatory mandate that crimps the division's profits could have a negative impact on the stock's valuation. Currently, Bear trades at a price that's nine times this year's earnings, just a step or two behind its Wall Street rivals. Lehman Brothers(LEH) trades at a price/earnings ratio of 10, while Goldman Sachs(GS) has a P/E of 11. Leading the way are Merrill Lynch(MER) and Morgan Stanley(MWD), both of which trade at P/Es of 12.

Historically, the valuation gap between Bear and its peers has been wider because the firm's business model is not as diversified. In trading and investment banking, Bear is still mainly known as a bond shop. Its work in equities and merger advisory work falls far behind its competitors.

With the bond market beginning to cool down, so are the expectations for Bear's earnings. In the third quarter, Bear is expected to earn $2 a share, down 13% from a year ago, according to analysts surveyed by Thomson First Call. The firm is expected to announce earnings on Sept. 20. Earnings are expected to continue their slide in the just-begun fourth quarter.

But those lowered expectations don't yet factor in the potential impact of a regulatory deal on Bear's earnings. With so many of the big brokerages trading at similar valuations, the regulatory risks surrounding Bear might make it a stock to avoid right now.

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