Key Takeaways
- • Two Bear Stearns hedge funds, the High-Grade Structured Credit Strategies Fund and the High-Grade Structured Credit Enhanced Leveraged Fund, collapsed in July 2007 after leveraged bets on AAA-rated subprime mortgage-backed CDO tranches, hedged with credit default swaps, lost value as subprime delinquencies rose.
- • The Structured Credit Fund held just under $1 billion in investor capital and the Enhanced Leveraged Fund held nearly $600 million; the Enhanced Leveraged Fund was less than a year old and lost virtually all of its investor capital.
- • Bear Stearns extended a $1.6 billion bailout to the Structured Credit Fund in June 2007 to meet margin calls, and both funds filed for Chapter 15 bankruptcy on July 31, 2007.
- • The article attributes the failure to three errors by fund managers: misjudging subprime MBS price behavior, lacking liquidity to meet debt obligations, and overleveraging the portfolios.
- • Shareholder lawsuits alleged Bear Stearns misled investors about the extent of its risky holdings, and the SEC charged some hedge fund managers with fraud for inadequate disclosure.
Summary
According to a Investopedia analysis, the July 2007 collapse of two Bear Stearns hedge funds illustrates the risks of a leveraged credit strategy built on collateralized debt obligations (CDOs) and credit default swaps (CDSs). The funds were the Bear Stearns High-Grade Structured Credit Strategies Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.
The strategy was formulaic. Managers bought CDOs paying yields above their borrowing costs, using AAA-rated tranches of subprime mortgage-backed securities. They applied leverage to buy more CDOs than their equity could fund, and bought CDS protection against credit market movements. The net result, known in hedge fund terminology as "positive carry," produced steady returns so long as credit markets stayed stable or behaved as historical models predicted.
Subprime delinquencies rose substantially by mid-2007, sharply reducing the market values of these bonds. The managers had not anticipated such price movements and held insufficient CDS protection. Heavy leverage magnified the losses. Lenders who had accepted subprime bonds as collateral demanded additional cash as collateral values fell, a process the article compares to a margin call, and the funds had to sell bonds without cash reserves. Public awareness of Bear Stearns' difficulties led competing funds to push subprime bond prices lower, and forced selling further depressed prices.
The timeline the article presents begins in June 2007, when Bear Stearns provided a $1.6 billion bailout to the Structured Credit Fund to meet margin calls during liquidation. On July 17, 2007, Bear Stearns Asset Management told investors that the Structured Credit Fund had lost a large majority of its value and the Enhanced Leveraged Fund had lost virtually all of its capital. On July 31, 2007, both funds filed for Chapter 15 bankruptcy, and Bear Stearns wound them down and liquidated their holdings. Shareholder lawsuits followed, alleging that the bank had misled investors about its risky exposures. The article also notes JPMorgan Chase's March 16, 2008 agreement to acquire Bear Stearns in a stock-for-stock exchange valuing the firm at $2 per share.
The article identifies leverage as the central flaw. It argues that managers should have anticipated subprime stress through macroeconomic research, given that the U.S. economy had been slowing since 2005 with the housing market peak, and that holding more liquidity might have reduced returns but could have prevented the collapse. The article concludes that the fee structure, with 1-2% management fees and 20% incentive fees, encouraged excessive leverage, and that some managers were charged with fraud by the SEC for failing to properly disclose positions to investors.
The strategy was formulaic. Managers bought CDOs paying yields above their borrowing costs, using AAA-rated tranches of subprime mortgage-backed securities. They applied leverage to buy more CDOs than their equity could fund, and bought CDS protection against credit market movements. The net result, known in hedge fund terminology as "positive carry," produced steady returns so long as credit markets stayed stable or behaved as historical models predicted.
Subprime delinquencies rose substantially by mid-2007, sharply reducing the market values of these bonds. The managers had not anticipated such price movements and held insufficient CDS protection. Heavy leverage magnified the losses. Lenders who had accepted subprime bonds as collateral demanded additional cash as collateral values fell, a process the article compares to a margin call, and the funds had to sell bonds without cash reserves. Public awareness of Bear Stearns' difficulties led competing funds to push subprime bond prices lower, and forced selling further depressed prices.
The timeline the article presents begins in June 2007, when Bear Stearns provided a $1.6 billion bailout to the Structured Credit Fund to meet margin calls during liquidation. On July 17, 2007, Bear Stearns Asset Management told investors that the Structured Credit Fund had lost a large majority of its value and the Enhanced Leveraged Fund had lost virtually all of its capital. On July 31, 2007, both funds filed for Chapter 15 bankruptcy, and Bear Stearns wound them down and liquidated their holdings. Shareholder lawsuits followed, alleging that the bank had misled investors about its risky exposures. The article also notes JPMorgan Chase's March 16, 2008 agreement to acquire Bear Stearns in a stock-for-stock exchange valuing the firm at $2 per share.
The article identifies leverage as the central flaw. It argues that managers should have anticipated subprime stress through macroeconomic research, given that the U.S. economy had been slowing since 2005 with the housing market peak, and that holding more liquidity might have reduced returns but could have prevented the collapse. The article concludes that the fee structure, with 1-2% management fees and 20% incentive fees, encouraged excessive leverage, and that some managers were charged with fraud by the SEC for failing to properly disclose positions to investors.
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