Dissecting the Bear Stearns Hedge Fund Collapse By THE INVESTCIPEDIA TEAM Updated April 2?, 221 Reviewed by ROBERT C. l'tELL'l'r The headline-grabbing collapse of two Bear Stearns hedge funds in July Ebb? offers a look into the worfd of hedge fund strategies and their associated risks. I...) we'll apply this knowledge to see what caused the implosion of two prominent Bear Steams hedge funds the Bear Steams 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 classied 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. 1Purchase 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 [MES] were used. 2. Step no. 2Use leverage to buy more CDCIs than you can pay for with equity capital alone. Because these CD'Ds 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-. Etep no. SUse credit default swaps {EDS} 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 prot during times when credit concerns cause the bonds to fall in value, effectively hedging away some of the risks. 4. Step no. 4Watch the money roll in. When you net out the cost of the leverage [or debt] to purchase the 'MA' 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. i---i Can't Hedge All Risk However, the caveat is that it is impossible to hedge away all risks because it would drive retums 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 Steams 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 maket by mid-BUD? 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 sewrities]. Unfortunately, the Bear Steams portfolio managers failed to expect these sorts of price movements and, therefore, had insufcient credit insurance to protect against these losses. Because they had leveraged their positions substantially, the funds began to experience large loss-s. Problems Snowball The large losses made the creditors [Note of the lecturen lender to the fund] who were nancing this leveraged investment strategy uneasy, as they had taken subprime, mortgage- ba:cked 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 kncwiedge in the hedge fund ccmrn unityr that Bear Steams was in trouble, and competing funds moved to drive the prices of subprime bonds lower to force Sear Steams\" 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 bondsit didn't take long before the funds had experienced a complete loss of capital. Bear Steams Collapse Timatina In early 200?, the effects of subprime loans started to become apparent as subprime lenders and hornebuilders were suffering under defaults and a severely weakening housing market. In June EMTAmid losses in its portfolio, the Bear Steams High-Grade Stluctured Credit Fund receives a $1.6 billion bait cut from Bear Steams, which would help it to meet margin calls while it liquidated its positions. .- July 11', ZTln a letter sent to investors, Bear Stearns Asset Management reported that its Bear Steams High-Grade Structured Credit Fund had lost more than EDS: of its value, while the Bear Steams 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 $6M million in investor capital. In July 31, EDTThe two funds led for Chapter 15 bankruptcy. Bear Steams effectively wound down the funds and liquidated all of 'rts holdingsSeveral shareholder lawsuits have been led on the basis of Bear Steams misleading investors on the extent of its risky holdings - Harsh 1E, EJPMorgan Chase {JPM} announced that it would acquire Bear Steams in a stock-for-stcck exchange that valued the hedge fund at $2 per shave. C2 - Application of the concepts to a new context 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. (3 marks) 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. (2 marks) c) Describe and explain the actions taken by the creditors/lenders to the Bear Stearns hedge funds. 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. (2 marks) d) Describe and explain the causes of the fire sales by Bear Stearns hedge funds. The text mentions one cause but overlooks a more obvious one. 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. (3 marks) e) Draw how the bailout of its hedge funds by Bear Stearns shows on the hedge fund balance sheet. 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. (2 marks) f) Find in the text some clue that short selling may have been involved. (1 mark)