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Bear Stearns to Rescue Fund
Investment bank Bear Stearns has decided to loan $3.2bn to rescue one of its own hedge funds that was collapsing after some failures in the subprime mortgage market. This represents the biggest hedge fund bail out since 1998 when $3.6bn was needed to rescue Long-Term Capital Management.
Two hedge funds under Bear Stearns’ management were taken to the brink of collapse from the recently slumping housing market and lending practices that have become sloppy, with money loaned to people with poor credit who struggled to keep up repayments.
This time the crisis was avoided, but if problems in the subprime market continue then hedge funds and pensions funds could be left in trouble, with securities backed only by loans losing their value.
Bear Stearns had to act after the fund suffered losses in the millions when rattled investors started to ask for their money back. They bought out some Wall Street banks who had loaned money to the fund, hoping to avoid a wider sell off. In the meantime the company is in negotiations with banks to rescue another, larger fund with more than $6bn in loans and some apparently even riskier investments. Success in those negotiations is far from certain for the fund started in August 2006.
Comments from market watchers suggested that the problems are not over yet, with other funds expected to have some difficulties.
Bear Stearns share suffered as a result, and the Dow Jones industrial average fell sharply as nervousness kicked in about the sourcing of subprime loans together with rising oil prices.
The problems of the past week are a departure from Bear Stearns’s normal resistance to risking its own capital, but it was left with little choice, as a substantial sell-off of mortgage-related securities at cut prices would have exposed the company to major losses.
As the board met to work out how to manage the problems, many financial analysts wondered how Bear Stearns could reach this point. The original fund – bailed out – the Bear Stearns High-Grade Structured Credit Fund, began in 2005 and had had 41 months of returns of 1-1.5% per month. Investors wanted more, which entailed more aggressive, riskier investments and higher levels of borrowing to boost returns.
A second fund was stared – the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund – with $600m from wealthy clients and $6bn in borrowed money from banks and brokerage firms. The company itself and its executives invested only $40m in both funds.
Unfortunately at the end of 2006 the housing market was reaching its peak and the fall began to lay bare the poor standards for lending in the subprime market. With borrowers falling behind on payments, some large lenders were forced into a position of bankruptcy.
Along with many other funds the Bear Stearns fund had invested in collaterized debt obligations (CDOs) – investments in bonds backed by many loans and other financial instruments. In 2006 mortgage-related CDOs amounted to $316.4bn, up 77% on the year before. In March 2007 the first fund saw its first loss; by April it was down 5% in the year, and the second fund was down 10%. Fund managers tried to protect potential losses in lower-rated securities, but did not do so for higher-rated bonds – but there also fell.
In May Bear Stearns told investors that the second fund was actually down 23%, not 10% as it had thought. Investors were shocked and many contacted Bear Stearns asking for their money, but the company froze all requests for redemption. In June JP Morgan Chase, Citigroup and Merrill Lynch began demanding cash for loans they had made.
Bear Stearns sold $3.6bn in high-grade securities to try and save the fund, and other loans were hastily arranged. Lenders would have to agree not to make margin calls fro twelve months as their exposure was reduced. The banks eventually reached deals with Bear Stearns, who have desperately tried to rescue its fund to protect the company’s reputation. If they had walked away, both investors and lenders would have lost their money; the result would have been the end of the company.