The headline grabbing collapse of two Bear Stearns hedge funds in July 2007 offers fascinating insight into the world of hedge fund strategies and their associated risks.

In this article, we'll first examine how hedge funds work and explore the risky strategies they employ to produce their big returns. Next, 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.

A Peek Behind the Hedge
To begin with, the term "hedge fund" can be a bit confusing. "Hedging" usually means making an investment to specifically reduce risk. It is generally seen as a conservative, defensive move. This is confusing because hedge funds are usually anything but conservative. They are known for using complex, aggressive and risky strategies to produce big returns for their wealthy backers.

In fact, hedge fund strategies are diverse and there is no single description that accurately encompasses this universe of investments. The only commonality among hedge funds is how managers are compensated, which typically involves management fees of 1-2% on assets and incentive fees of 20% of all profits. This is in stark contrast to traditional investment managers, who do not receive a piece of profits. (For more in-depth coverage, check out Introduction To Hedge Funds - Part One and Part Two.)

As you can imagine, these compensation structures encourage greedy, risk-taking behavior that normally involves leverage to generate sufficient returns to justify the enormous management and incentive fees. Both of Bear Stearns' troubled funds fell well within this generalization. In fact, as we'll see, it was leverage that primarily precipitated their failure.

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:
  • Step #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 were used.

  • Step #2: Use leverage to buy more CDOs than you can pay for with capital alone. Because these CDOs pay an interest rate over and above the 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.

  • Step #3: Use credit default swaps 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 called credit default swaps, and are designed to profit during times when credit concerns cause the bonds to fall in value, effectively hedging away some of the risk.

  • Step #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.
In instances when credit markets (or the underling bonds' prices) remain relatively stable, or even when they behave in line with historically based expectations, this strategy generates consistent, positive returns with very little deviation. This is why hedge funds are often referred to as "absolute return" strategies. (For more on leveraged investments, see Leveraged Investment Showdown.)

Can't Hedge All Risk
However, the caveat is that it is impossible to hedge away all risk 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 securities 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 had recently begun to see substantial increases in delinquencies from homeowners, which caused sharp decreases in the market values of these types of bonds. 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 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 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.

Time line - Bear Stearns Hedge Funds Collapse

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. (To learn more, see The Fuel That Fed The Meltdown.)
  • 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.

  • Aftermath - Several shareholder lawsuits have been filed on the basis of Bear Stearns misleading investors on the extent of its risky holdings.

The Mistakes Made
The Bear Stearns fund managers' first mistake was failing to accurately predict how the subprime bond market would behave under extreme circumstances. In effect, the funds did not accurately protect themselves from event risk.

Moreover, they failed to have ample liquidity to cover their debt obligations. If they'd had the liquidity, they wouldn't have had to unravel their positions in a down market. While this may have led to lower returns due to less leverage, it may have prevented the overall collapse. In hindsight, giving up a modest portion of potential returns could have saved millions of investor dollars.

Furthermore, it is arguable that the fund managers should have done a better job in their macroeconomic research and realized that subprime mortgage markets could be in for tough times. They then could have made appropriate adjustments to their risk models. Global liquidity growth over recent years has been tremendous, resulting not only in low interest rates and credit spreads, but also an unprecedented level of risk taking on the part of lenders to low-credit-quality borrowers. (To learn more, see Macroeconomic Analysis.)

Since 2005, the U.S. economy has been slowing as a result of the peak in the housing markets, and subprime borrowers are particularly susceptible to economic slowdowns. Therefore, it would have been reasonable to assume that the economy was due for a correction.

Finally, the overriding flaw for Bear Stearns was the level of leverage employed in the strategy, which was directly driven by the need to justify the utterly enormous fees they charged for their services and to attain the potential payoff of getting 20% of profits. In other words, they got greedy and leveraged the portfolio to much. (For more on how this happens, read Why Leveraged Investments Sink And How They Can Recover.)

Conclusion
The fund managers were wrong. The market moved against them, and their investors lost everything. The lesson to be learned, of course, is not to combine leverage and greed.

For additional tales of woe, check out Massive Hedge Fund Failures.

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)