A government report concludes that staff at the Securities and Exchange Commission improperly let failed investment bank Bear Stearns slide in an investigation of debt securities sold by the investment bank, and may have thwarted federal prosecutors' efforts to expose widespread problems there.

Jin Lee / ASSOCIATED PRESS

Bear Stearns was the first major investment bank to fall victim to the credit crunch earlier this year—in part due to writedowns in the values of its debt securities.

In the report, obtained by CNBC, SEC Inspector General David Kotz says the agency inexplicably dropped the case in 2007, even after Bear Stearns had offered to pay a monetary settlement.

The report says the director of the SEC's Miami office, David Nelson, had an "ongoing personal relationship" with the Bear Stearns attorney in the case. In dropping the case, Nelson allegedly told his friend, "Christmas is coming early this year," adding Bear Stearns "can keep their money."

The report does not draw a direct connection between the two individuals' 20-year relationship and the decision to drop the case, but the Inspector General writes, "even the appearance of a conflict is disturbing and could potentially damage the reputation of the Commission."

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See: The Collapse of Bear Stearns

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But perhaps more crucial, the report suggests that dropping the case may have caused authorities to miss bigger problems that led to the bank's demise. The U.S. Attorney's office in Manhattan was investigating similar charges against Bear Stearns and had asked to be kept apprised of the SEC investigation, the report says. By abruptly dropping the case, Kotz writes, "A significant opportunity to…uncover evidence of a systematic problem at Bear Stearns was also lost through neglect."

The SEC's case involved collateralized debt obligations sold by Bear Stearns' Latin American group beginning in early 1999. The SEC was investigating whether Bear Stearns and the company that purchased the securities, W. Holdings, misrepresented their value.

In 2005, the SEC issued a Wells notice to Bear Stearns—the standard notification that it planned to file charges. Early last year, according to the report, the two sides agreed to a tentative settlement for $500,000. Then, according to the report, Nelson suddenly decided to drop the case. Other staffers were "stunned" by the decision, according to the report.

The report finds "a failure on the part of (Miami Regional Office) management to administer its statutory obligations," and calls for disciplinary action against Nelson.

In a written response to Commissioners, the SEC's Enforcement Division defends its handling of the case and calls the Inspector General's report "misleading." The response claims the report "relies on speculation and innuendo to support its harsh conclusions."

In a statement, the SEC points out that the initial investigation did not involve mortgage-backed or subprime securities. The Commission does not address the recommendation to punish Nelson, saying it does not comment on personnel matters.

Iowa Sen. Chuck Grassley, the ranking Republican on the Senate Finance Committee, had requested the Inspector General's investigation in April. In a statement, Grassley says the report "certainly demonstrates the culture of deference at the SEC in dealing with the big players on Wall Street."

Bear Stearns was one of the early casualties of the credit crisis. In March, after suffering a precipitous drop in its share price, the firm was taken over by JPMorgan Chase

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