In particular, according to the report, SEC staffers knew about Bear Stearns' high level of leverage and its heavy bets on the mortgage market, but failed to take action. The report also says the SEC allowed Bear Stearns to use internal auditors to manage its risk, even though SEC rules require outside auditors.
SEC delays in reviewing Bear Stearns' 2007 annual report deprived investors of critical information that may have helped head off the run on the bank that ultimately spread to other institutions, the report says.
Senator Chuck Grassley, R-Iowa, had requested the audit in April, following Bear Stearns' collapse. In a statement, Grassley calls the report "another indictment of failed leadership."
"Officials responsible for monitoring the safety and soundness of our nation's largest investment banks ignored red flags and risky behavior," Grassley said.
The SEC had launched an investigation of Bear Stearns' mortgage-backed securities business in 2005, even informing the company of its intention to bring civil charges. But the investigation was later dropped with no charges filed.
Bear Stearns and the nation's other large investment banks, Merrill Lynch , Lehman Brothers , Morgan Stanley and Goldman Sachs , were regulated under the SEC's Consolidated Supervised Entity Program, which was set up in 2004 specifically to cover those fast-growing institutions.
Today, Bear Stearns and Merrill Lynch have been taken over by JPMorgan Chase and Bank of America respectively. Lehman has filed for bankruptcy protection, and Morgan Stanley and Goldman Sachs have converted into bank holding companies, regulated by the Federal Reserve.
Following the Inspector General's report, SEC Chairman Christopher Cox announced the agency is scrapping the Consolidated Supervised Entity program.
"The last six months have made it abundantly clear that voluntary regulation does not work," Cox said in a statement.
Cox says the Inspector General's report echoes concerns he has expressed to Congress about the lack of clear legal authority for the SEC or any other agency to regulate investment banks.
More From CNBC.com