Ten years ago today, JPMorgan Chase & Co. (NYSE: JPM) announced that it would acquire Bear Stearns in a stock-for-stock exchange that valued the bank at $2 per share. The previous July, two Bear Stearns hedge funds filed for bankruptcy. Losses for investors of Bear Stearns High-Grade Structured Credit Strategies Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund were finally estimated at close to $1.8 billion.
How did such a huge amount get wiped out, and what transpired that eventually triggered the downfall of the entire investment bank?
A Star Performer
In October 2003, Bear Stearns Asset Management announced the launch of Bear Stearns High-Grade Structured Credit Strategies Fund (High-Grade Fund) with an objective to "seek high current income and capital appreciation relative to LIBOR primarily through leveraged investments in investment-grade structured finance securities with an emphasis on triple-A and double-A rated structured finance securities."
To gain leverage, the fund borrowed against its underlying assets. A transaction described in a subsequent lawsuit by Bank of America was for a security labeled as a CDO squared, which was a debt instrument with the initial collateral comprised of underlying assets of the two hedge funds.
BusinessWeek reported that banks like Merrill Lynch, Goldman Sachs, Bank of America and JP Morgan Chase lent at least $14 billion, and that worked very well for both the fund and its managers Ralph Cioffi and Matt Tannin.
As the rewards piled up, Cioffi it is said began taking greater risks by seeking out high yielding but less credible investments. A February 2007 email by Tannin that was cited in a lawsuit shows his concerns about his colleague’s risk appetite– “Unbelievable. He is unable to restrain himself."
Fueled by the success of the High Grade Fund, nearly three years on, the asset management fund decided on another offering. The Bear Stearns High-Grade Structured Credit Strategies Enhanced Leveraged Fund (Enhanced Fund) was launched in August 2006.
Some capital was transferred from the older “Unleveraged Fund” in its own financial statement to the newer “Leveraged Fund.” The newer fund allowed for higher levels of leverage compared to the older one.
But this created a new problem: even though the mandate of the funds was to invest 90% of the corpus into AAA and AA rated securities, the remaining 10 percent were very risky investments that went unnoticed in the portfolio. And the allocation levels started slipping.
By the funds’ own admission as of May 2007, “the percentage of underlying collateral in our investment grade structures collateralized by 'sub-prime' mortgages is approximately 60%.”
Signs of Trouble
By the end of that year, the subprime mortgage market had begun to unravel and investors had started asking questions. Even within among the managers of the funds some concerns were raised but, Cioffi shrugged it off.
The fund managers held multiple investor calls to try to allay the growing fears of the investors and to assure them of the health of the funds. Investor calls were held in January and in April and in the latter, Cioffi claimed that if the CDO prices remained where they were, the High Grade fund would generate an 8% return while the Enhanced Leverage fund would return 6%.
These troubles deepened over the coming weeks, but instead of coming clean, the fund managers reached out to institutional investors seeking more loans.
As the housing market continued its downward spiral creditors to the funds became nervous about the value of the underlying assets. They sought additional cash as collateral, in a way that would for an individual investor be akin to a margin call.
Meanwhile, the funds themselves were in the red. Less than six months old, the Enhanced Leverage fund was already giving negative returns while the older fund’s record 40-month positive return streak was also broken.
Down and Out
However, privately Cioffi began losing confidence. In a March 15, 2007 email to a colleague he all but admitted defeat-
“I'm fearful of these markets. Matt said it's either a melt down or the greatest buying opportunity ever, I'm leaning more towards the former. As we discussed it may not be a melt down for the general economy but in our world it will be. Wall Street will be hammered with law suits dealers will lose millions and the cdo business will not be the same for years.”
In about a week, Cioffi asked to redeem $2 million of his personal investment from the Enhanced Leverage fund. But that did not stop the fund managers from trying to raise funds from investors touting their own money in the funds. An SEC complaint alleges that they raised nearly $23 million in new subscriptions for the May 1 subscription date.
Soon enough that stopped working as investors sought their money back.
The funds had made a lot of money in strategies that were risky but more importantly not very liquid, and that made it very difficult to ascertain the actual value of the assets held by the funds. The funds would employ a fair value method of arriving at the valuation, and that also took into account the marks given by other broker dealers based on the transactions taking place in the underlying assets.
According to the auditor’s note in financial statements for the funds ending December 2006, the value of 70.19% of the securities held by the High Grade fund (worth $616 million) and 63.1% of the securities held by the Enhanced Leveraged fund were estimated by the fair value method in the “absence of readily ascertainable market values.”
The auditor also warned that these values could differ from any value that could be determined if a market for these securities existed.
The problem was, in the last few weeks even as the managers tried to sell assets to meet some of that redemption pressure, there was hardly a market for the securities. Further, once the word of troubles at the funds got out, no buyers emerged.
In the end, it just wasn’t enough.
According to documents filed with the Financial Crisis Inquiry Commission, at the end of March 2006 the High Grade fund had $924 million in investor while the Enhanced Leverage fund had $638 million. The long positions however, stood at $9.6 billion and $11.15 billion respectively, according to the New York Times.
The performance wasn’t anything to write home about either. For May 2006, the High Grade fund returned -3.6% while the Enhanced Leverage fund returned -13.2%. These numbers were better than the -5.08% and -18.9% respectively recorded for April.
Faced with redemption orders worth $550 million, $187 in the High Grade fund and $363 in the Enhanced Leverage fund Bear Stearns suspended redemptions from the two funds on June 7, 2006.
On Jun 20, Reuters reported that Merrill Lynch had seized $800 million worth of assets of the fund in order to sell them and recover its dues.
Six days later, Bear Stearns committed to $1.6 billion credit line to bail out the funds but realized soon enough that there was little left to salvage.
“The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund as of June 30, 2007. In light of these returns, we intend to seek an orderly wind-down of the Funds over time, said Bear Stearns Chairman and CEO James Cayne in a letter to clients on July 17.
The end was far from orderly though, as many litigations arose out of the collapse of these funds starting with those around their bankruptcy filing, to SEC’s civil and criminal charges against the fund managers. Both Cioffi and Tannin were acquitted in the criminal case while the civil suit was settled. Bear Stearns was also sued by many investors as well as its lenders for misrepresenting the funds’ performance.
The stock of the parent company also took a hit from all the negative news that emanated from the hedge fund failure, though it wasn’t the only reason why the investment bank that was trading at close to $170/share at the start of 2007 was ultimately sold at $2 per share to JP Morgan in 2008.