The headline-grabbing collapse of two Bear Stearns hedge funds in July 2007 offered a look into the world of hedge fund strategies and their associate🌱d risks. Strategies begin with understanding h𝔍ow hedge funds work and exploring the risks they take on to produce their returns.

You can apply this knowledge to understand what caused the implosion of two prominent Bear Stearns hedge funds: the Bear Stearns High-Grade Structured Credit Strategies Fund and the Bear Stearns High-Grade Structured C🦩redit Enhanced Leveraged Fund.

A Peek Behind the Hedge

Hedging usually means investing in such a way as to reduce risk. It's generally seen as a conservative, defensive move. This can be confusing because hedge funds are usually anything but conservative. They're known for using 澳洲幸运5官方开奖结果꧑体彩网:complex, aggressive, and risky strategies to produceꦯ big returns for their wealthy bac🔯kers.

Hedge fund strategies are diverse and there's no single description that accurately encompasses this universe of investments. The one commonality among hedge funds is 澳洲幸运5官方开奖结果体彩网:how managers are compensated. It typically involves a 澳洲幸运5官方开奖结果体彩网:management fee of 1-2% of assets and an 澳洲幸运5官方开奖结果体彩网:incentive fee of 20% of all profits. This is in stark contrast to traditional 澳洲幸运5官方开奖结果体彩网:investment managers who don't receive a piece of profits.

These compensation structures can encourage greedy, risk-taking behavior that normally involves leverage to generate sufficient returns to justify the significant management an💎d incentive fees. Both of Bear Stearns' troubled funds fell well within this generalization. It was leverage that primarily prec🃏ipitated their failure.

Investment Structure

The strategy employed by the Bear Stearns funds was quite simple and would be best classified as a leveraged credit investment. It's formulaic and is a common strategy in the hedge fund universe:

1. Step No. 1: Purchase 澳洲幸运5官方开奖结果体彩网:collateralized debt obligations 𒈔(C♕DOs) that pay an interest rate over and above the cost of borrowing. AAA-rated tranches of subprime 澳洲幸运5官方开奖结果体彩网:mortgage-backed securities (MBS) were used in the Bear Stearns case.
2. Step No. 2: Use leverage to buy more CDOs than you can pay for with equity capital alone. These CDOs pay an interest rate over and above the hedge fund cost of borrowing so every incremental unit of leverage adds to the total 澳洲幸运5官方开奖结果体彩网:expected return. The more leverage you employ, the greater the expected return from the trade.
3. Step No. 3: Use 澳洲幸运5官方开奖结果体彩网:credit default swaps (CDS) as insurance against movements in the 澳洲幸运5官方开奖结果体彩网:credit market. The use of leverage increases the portfolio's overall risk exposure so 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. You're left with a positive 澳洲幸运5官方开奖结果体彩网:rate of return that's often referred to as "澳洲幸运5官方开奖结果体彩网:positive carry" in hedge fund lingo when you net out the cost of the leverage (or debt) as well as the cost of the credit insurance to purchase the AAA-rated subprime debt.

This strategy generates consistent, positive returns with very little deviation when credit markets(or the underlying bonds' prices remain relatively stable or even when they behave in line with historically based expectations.

Can't Hedge All Risk

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

Unfortunately, the market became anything but stable as the problems with subprime debt began to unravel. The subprime mortgage-backed security market behaved well outside of what the portfolio managers expected in the Bea🦩r Stearns situationꦬ. This started a chain of events that imploded the fund.

First Inkling of a Crisis

The 澳洲幸运5官方开奖结果体彩网:subprime mortgage market had begun to see substantial increases in delinquencies from homeowners by mid-2007. This caused sharp decreases in the 澳洲幸运5官方开奖结果体彩网:market values of these types of bonds.

Unfortunately, the Bear Stearns portfolio managers failed to expect these sorts of price movements. They therefore had insufficient credit insurance to protect against these losses. They'd substantially leveraged their position so the funds began to experience large losses.

Problems Snowball

The large losses made the 澳洲幸运5官方开奖结果体彩网:creditors who were financing this leveraged investment strategy uneasy because they'd taken subprime mortgage-backed bonds as 澳洲幸运5官方开奖结果体彩网:collateral on the loans.

The lenders required Bear Stearns to provide additional cash on their loans because the subprime bonds collateral was rapidly falling in value. This is the equivalent of a 澳洲幸运5官方开奖结果体彩网:margin call for an individual investor with a br✤okerage account. They had to sell bonds to generate cash because the funds had no cash on the sidelines. This waಌs essentially the beginning of the end.

Demise of the Funds

It ultimately became public knowledge in the hedge fund community that Bear Stearns was in trouble. Competing funds moved to drive the prices of subprime bonds lower to force Bear Stearns' hand.

The fund experienced losses as prices on bonds fell. This caused it to sell more bonds, lowering the prices of the bonds, and this caused it to sell even more bonds. It didn't take long before the funds experienced a complete loss of capital.

Bear Stearns Collapse Timeline

The effects of subprime loans started to become apparent in early 2007 as sub♛prime lenders and homebuilders were suffering under defaults and a severely weakening housing market.

• June 2007: The Bear Stearns High-Grade Structured Credit Fund received a $1.6 billion bait out from Bear Stearns amid losses in its portfolio. This would help it to meet margin calls while it liquidated its positions.
• July 17, 2007: Bear Stearns Asset Management reported in a letter sent to investors that its Bear Stearns High-Grade Structured Credit Fund had lost a large majority of its value. The Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had lost virtually all its investor capital. The larger Structured Credit Fund had just under $1 billion while the Enhanced Leveraged Fund had nearly $600 million in investor capital. The Enhanced Leverage Fund was less than a year old.
• July 31, 2007: The two funds filed for 澳洲幸运5官方开奖结果体彩网:Chapter 15 bankruptcy. Bear Stearns effectively wound down the funds and liquidated all its holdings. Several shareholder lawsuits were filed on the basis that Bear Stearns had misled investors regarding 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.

Mistakes That Were Made

The Bear Stearns 澳洲幸运5官方开奖结果体彩网:fund managers' first mistake was failing to accurately predict how the subprime 澳洲幸运5官方开奖结果体彩网:bond market would behave under extreme circumstances. The funds didn't accurately protect themselves from 澳洲幸运5官方开奖结果体彩网:event risk.

They also failed to have ample 澳洲幸运5官方开奖结果体彩网:liquidity to cover their debt obligations. They wouldn't have had to unravel their positions in a down market if they'd had the liquidity. This may have led to lower returns due to less leverage but it might have prevented the overall collapse. Giving up a modওest portion of potential returns could have saved millions of investor dollars.

It's arguable that the fund managers should have done a better job in their 澳洲幸运5官方开奖结果体彩网:macroeconomic research and realized that subprime mortgage markets could be in for tough times. They could then have made appropriate adjustments to their risk models. Global liquidity growth over the years has been tremendous, resulting not only in low interest rates and 澳洲幸运5官方开奖结果体彩网:credit spreads but also an unprecedented level of 🐎risk-taking on the part of lenders to low-credit-♋quality borrowers.

The U.S. economy had been slowing since 2005 as a result of the peak in the housing markets. Subprime borrowers were particularly susceptible to economic slowdowns so it would have been reasonable to assume that the economy was due for a 澳洲幸运5官方开奖结果体彩网:correction.

The Bottom Line

The overriding flaw for Bear Stearns was the extent of leverage that was employed in the strategy. It was directly driven by the need to justify the enormous fees they charged for their services and to attain the potential payoff of 2🤡0% of ⛦profits. They got greedy and leveraged the portfolio too much.

The market moved against them and their investors lost everything. Some hedge fund managers were accused of not properly disclosing their positions to investors and were charged with fraud by the Securities and Exchange Commission (SEC).

The🉐 lesson to be learned is not to combine leverage and greed.