By THE INVESTOPEDIA TEAM Updated April 27, 2021, Reviewed by ROBERT C. KELLY

The headline-grabbing collapse of two Bear Stearns hedge funds in July 2007 offers a look into the world of hedge fund strategies and their associated risks. (…) we'll apply this knowledge to see what caused the implosion of two prominent Bear Stearns hedge funds— the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade

Structured Credit Enhanced Leveraged Fund.

(…) Investment Structure

The strategy employed by the Bear Stearns funds was actually quite simple and would be best classified as being a leveraged credit investment. In fact, it is formulaic in nature and is a common strategy in the hedge fund universe:

1. Step no. 1—Purchase collateralized debt obligations (CDOs) that pay an interest rate over and above the cost of borrowing. In this instance, AAA-rated tranches of subprime mortgage-backed securities (MBS) were used.

2. Step no. 2—Use leverage to buy more CDOs than you can pay for with equity capital alone. Because these CDOs pay an interest rate over and above the hedge fund cost of borrowing, every incremental unit of leverage adds to the total expected return. So, the more leverage you employ, the greater the expected return from the trade.

3. Step no. 3—Use credit default swaps (CDS) as insurance against movements in the credit market. Because the use of leverage increases the portfolio's overall risk exposure, the next step is to purchase insurance on movements in credit markets.

These "insurance" instruments are designed to profit during times when credit concerns cause the bonds to fall in value, effectively hedging away some of the risks.

4. Step no. 4—Watch the money roll in. When you net out the cost of the leverage (or debt) to purchase the 'AAA' rated subprime debt, as well as the cost of the credit insurance, you are left with a positive rate of return, which is often referred to as "positive carry" in hedge fund lingo.

(…)

Can't Hedge All Risk

However, the caveat is that it is impossible to hedge away all risks because it would drive returns too low. Therefore, the trick with this strategy is for markets to behave as expected and, ideally, to remain stable or improve.

Unfortunately, as the problems with subprime debt began to unravel the market became anything but stable. To oversimplify the Bear Stearns situation, the subprime mortgage backed security market behaved well outside of what the portfolio managers expected, which started a chain of events that imploded the fund.

First Inkling of a Crisis

To begin with, the subprime mortgage market by mid-2007 had recently begun to see substantial increases in delinquencies from homeowners, which caused sharp decreases in the market values of these types of bonds [note of the lecturer: the subprime mortgage

backed securities].

Unfortunately, the Bear Stearns portfolio managers failed to expect these sorts of price movements and, therefore, had insufficient credit insurance to protect against these losses. Because they had leveraged their positions substantially, the funds began to experience large losses.

Problems Snowball

The large losses made the creditors [Note of the lecturer: lender to the fund] who were financing this leveraged investment strategy uneasy, as they had taken subprime, mortgage backed bonds as collateral on the loans.

The lenders required Bear Stearns to provide additional cash on their loans because the collateral (subprime bonds) was rapidly falling in value. This is the equivalent of a margin call for an individual investor with a brokerage account. Unfortunately, because the funds had no cash on the sidelines, they needed to sell bonds [note of the lecturer: the subprime mortgage-backed securities] in order to generate cash, which was essentially the beginning

of the end.

Demise of the Funds

Ultimately, it became public knowledge in the hedge fund community that Bear Stearns was in trouble, and competing funds moved to drive the prices of subprime bonds lower to force Bear Stearns' hand.

Simply put, as prices on bonds fell, the fund experienced losses, which cause it to sell more bonds, which lowered the prices of the bonds, which caused them to sell more bonds—it didn't take long before the funds had experienced a complete loss of capital.

Bear Stearns Collapse Timeline

In early 2007, the effects of subprime loans started to become apparent as subprime lenders and homebuilders were suffering under defaults and a severely weakening housing market.

• June 2007—Amid losses in its portfolio, the Bear Stearns High-Grade Structured Credit Fund receives a $1.6 billion bait out from Bear Stearns, which would help it to meet margin calls while it liquidated its positions.

• July 17, 2007—In a letter sent to investors, Bear Stearns Asset Management reported that its Bear Stearns High-Grade Structured Credit Fund had lost more than 90% of its value, while the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had lost virtually all of its investor capital. The larger Structured Credit Fund had around $1 billion, while the Enhanced Leveraged Fund, which was less than a year old, had nearly $600 million in investor capital.

• July 31, 2007—The two funds filed for Chapter 15 bankruptcy. Bear Stearns effectively wound down the funds and liquidated all of its holdings—Several shareholder lawsuits have been filed on the basis of Bear Stearns misleading investors on the extent of its risky holdings

• March 16, 2008—JPMorgan Chase (JPM) announced that it would acquire Bear Stearns in a stock-for-stock exchange that valued the hedge fund at $2 per share.

Read carefully the following article on Bear Stearns hedge funds collapse: 2021 sem 2 Text for C2 THA1.pdf

In addition to the text we provide the following information. Bear Stearns was an investment bank in charge of managing hedge funds. Subprime mortgage backed securities are a form of ABS when the loans securitized are mortgage loans made to bad quality borrowers to buy houses.

Using the information in the text and your own knowledge on hedge funds, answer the following questions:

a) Draw a precise balance sheet of a Bear Stearns hedge fund. Quote the parts of the text that have allowed you to reach that conclusion and make explicit in your explanations any deductions you have made from what was written. Also mention when you have used your existing knowledge.

b) Explain by which mechanism(s) borrowers defaulting on the interest and repayment of the principal of their mortgage loan affect Bear Stearns hedge funds unit, investors. Quote the parts of the text that have allowed you to reach that conclusion and make explicit in your explanations any deductions you have made from what was written. Also mention when you have used your existing knowledge.

Answer rating: 100% (QA)

First Inkling of a Crisis To begin with the subprime mortgage market by mid2007 had recently begun t... View the full answer