Thursday, July 31, 2008

Bear Stearns - Collapse from Sub Prime Crisis 2007-08

At Bear, trading and handling money for clients has always been the main game. The firm made a steady profit as Wall Street's back office. For a long time that was enough. Particularly under the leadership of the legendary Alan "Ace" Greenberg, Bear's disciplined trading culture made it the "Sparta of Wall Street," in the words of Bernstein analyst Brad Hintz.

Bear grew jealous of the hugely profitable hedge funds run by the likes of Goldman Sachs When Bear decided to get into this riskier action, it did so by channeling other people's money into the funds, and only a little of its own. Due to this, instead of being highly risk-conscious and attentive to detail, the funds missed warning signs in the subprime mortgage market, and top management seemed disengaged.

The hedge funds' troubles started in April 2007, worsened in May, and by mid-June had become a full-blown crisis. Bear's injection of $1.6 billion couldn't save them. By mid-July both were next to worthless. Less than three weeks later, the stock was way down and Bear was selling more than $2 billion in debt, both to shore up its balance sheet and to demonstrate that its assets were still valued.

A former Bear executive summed up the irony: "The culture of being conservative and not betting the house's money -- all that got undermined."

Hedge Fund Story

The first fund, the Bear Stearns High-Grade Structured Credit Fund was started in 2004 and had done well, posting 41 months of positive returns of about 1 percent to 1.5 percent a month.

In August 2006, the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund — the second fund that eventually had huge losses — was started with $600 million in investments, mostly from wealthy individual clients of Bear Stearns, and at least $6 billion in money borrowed from banks and brokerage firms. Bear Stearns and a handful of its top executives invested a mere $40 million in both funds.

The timing could not have been worse.

The Bear Stearns funds, like so many others, had invested in collateralized debt obligations, or CDOs, which invest in bonds backed by hundreds of loans and other financial instruments. Wall Street sells CDOs in slices to investors. Some of those pieces have low yields but they are easily traded and carry less risk; others are more susceptible to defaults and trade infrequently, which makes them difficult to value.

As the sub prime problems surface, at first, the Bear Stearns hedge funds appeared to weather the storm. But in March, the older fund registered its first loss.
By April, the older fund was down by 5 percent for the year, and the newer fund had fallen 10 percent.

Managers tried to protect the fund by hedging potential losses in lower-rated securities they held, but did not do so for higher-rated bonds, which also fell in value.

There was a sharp restatement in April of the second fund. The firm revalued some securities and told investors that the fund was down 23 percent, not 10 percent as it had said earlier.

Shocked investors began contacting Bear Stearns, demanding to pull their money out.

In May, however, more significant problems began to emerge. The Swiss investment bank UBS shut its hedge fund arm, Dillon Read Capital Management, after bad subprime bets led to a $124 million loss.

In May, Bear Stearns froze all redemption requests. This month, at least three Wall Street firms — JPMorgan Chase, Citigroup and Merrill Lynch — began demanding more cash as collateral for the loans they had made.

Fighting to save the funds, Bear Stearns sold $3.6 billion in high-grade securities. Meanwhile, its adviser, Blackstone, scrambled to line up a deal in which Bear Stearns would put up $1.5 billion in new loans and a consortium of banks led by Citigroup and Barclays would put in $500 million.

In return, the lenders would have their exposure to the funds reduced but could not make further margin calls for 12 months.

Some lenders, including Merrill Lynch and Deutsche Bank, balked and moved to sell assets. At one point Wednesday, nearly $2 billion in securities were listed for sale, although some banks, including JPMorgan, eventually canceled scheduled auctions.

By the end of the day, out of the $850 million in securities that Merrill had put up for sale, only a small portion actually sold.

In the wake of the weak auctions, several other lenders, including JPMorgan, Citigroup, Goldman Sachs and Bank of America, reached deals with Bear Stearns. At least some of the deals involved the lenders selling the securities back to Bear Stearns for cash, although the prices were not disclosed.

Ralph R. Cioffi As the market for subprime mortgages was crumbling, the 51-year-old manager of two Bear Stearns (BSC) hedge funds, Ralph R. Cioffi, offered nothing but reassurances to investors. "We're going to make money on this," he promised his wealthy patrons in February 2007. "We don't believe what the markets are saying."

Serious doubts are expressed now on the funds' supposedly strong performance before their July 2007 bankruptcies. More than 60% of their net worth was tied up in exotic securities whose reported value was estimated by Cioffi's own team—something the funds' auditor, Deloitte & Touche, warned investors of in its 2006 report, released in May, 2007.

The Bear funds carried the imprimatur of one of the Street's oldest and most storied firms. The funds marketed themselves with the implicit backing of Bear Stearns and played up the fact that they were run by its experts in mortgage-backed securities. Now investors are left with a troubling question: If they can't count on big, well-established firms to operate hedge funds properly, whom can they count on?

The quick collapse of the inelegantly named Bear Stearns High-Grade Structured Credit Strategies fund and High-Grade Structured Credit Strategies Enhanced Leverage fund conjures memories of Long-Term Capital Management, the multibillion-dollar fund that blew up in 1998. In both cases, the damage helped ignite a worldwide credit crunch that prompted intervention by central bankers.

At the height in 2006, Cioffi was a central character in the booming mortgage CDO market, holding nearly $30 billion worth of securities. "Everybody wanted to do business with him because he was The Buyer," says a portfolio manager who was not authorized by his firm to speak for attribution. Cioffi's easygoing manner made him popular with investors, the bankers who lent his funds money, and the charities he supported.

The funds' voracious buying of lightly traded bonds drove down their yields, meaning Cioffi's team had to buy more and more of them to boost returns. That meant more borrowing. Banks such as Merrill Lynch (MER), Goldman Sachs (GS), Bank of America (BAC), and JPMorgan Chase (JPM) lent the funds at least $14 billion all told. Cioffi also used a type of short-term debt to borrow billions more; in some cases he managed to buy $60 worth of securities for every $1 of investors' money. But he made a critical trade-off: For lower interest rates, he gave lenders the right to demand immediate repayment.

For a while the strategy worked, and the fund became a hit. Cioffi started dabbling in fashionable hedge fund manager accoutrements, weighing a partnership stake in a Gulfstream jet and even getting into the movie business. In 2006, he was executive producer of the indie film Just Like My Son, starring Rosie Perez.

The final blow for the Enhanced fund (one of the hedge funds) came when Barclays told Bear it wanted out, according to the bankruptcy filings. The timing of the redemption notice isn't clear. Barclays declined to comment on the relationship, except to say its losses were minimal.

End game

In March 2008, Bear Stearns, the nation’s fifth largest investment banking firm,
was battered by what its officials described as a sudden liquidity squeeze related to
its large exposure to devalued mortgage-backed securities.

On March 14, the Federal Reserve System announced that it would provide Bear Stearns with an unprecedented short-term loan.

On March 16, a major commercial bank, JP Morgan Chase, agreed to buy Bear Stearns in an exchange of stock shares for about 1.5% of its share price of a year earlier, a price that translated to $2/share. To help facilitate the deal, the Federal Reserve agreed to provide special financing in connection with the transaction for up to $30 billion of Bear Stearns’s less liquid assets.

Bear Stearns and JP Morgan renegotiated the terms of the deal: JP Morgan will purchase 95 million newly issued shares of Bear’s common stock at $10/share in a stock exchange. In response to the changed deal conditions, the Fed altered the terms of its financial involvement: it got JP Morgan to agree to absorb the first $1 billion in losses if the collateral provided by Bear for a loan proves to be worth less than Bear Stearn’s original claims. Instead of its original agreement to absorb up $30 billion, the Fed will now be responsible for up to $29 billion.


$3.2 Billion Move by Bear Stearns to Rescue Fund, 23 June 2007,New York Times,

Report to US Congress - Bear Stearns: Crisis and “Rescue” for a Major Provider
of Mortgage-Related Products. Download from

No comments: