Studying the Collapse of Bear Stern’s Hedge Funds

I.

Introduction

Hedge funds have played a significant part in the financial markets in the recent decade. Armed mostly with funds obtained from 99 investors (according to US regulations), hedge funds have been known to use ever increasing amounts of leverage to garner enough funds to overpower the fundamental prices of securities and commodities. Worst still is the involvement of hedge funds in derivatives which Warren Buffett coined as the financial weapons of mass destruction.[1] However, it is not only derivatives like the Collateral Debt Obligation (CDO) that investors must worry about. In today’s highly complex financial market, investors must never forget the basic principles of investment risk and return and must learn of in some cases relearn to respect risk.[2] This research paper is therefore focused on the failure and collapse of two hedge funds under Bear Sterns investment bank whose reputation is now at stake in the midst of the subprime crisis.

II.

Summary

Hedge fund are an alternative investment, that aims at reducing risks and offering investors returns that can offset losses in their traditional investment portfolio. However, the lack of transparency of hedge funds can result in a different outcome altogether. Many individual investors did not seem to mind a lack of transparency by the hedge funds as long as the fund was delivering high returns. The collapse of LTCM Long Term Capital Management clearly shows us the need to further study the reason of hedge fund failures.

Ralph R. Cioffi, the 51-year-old manager of two Bear Stearns hedge funds (High Grade fund and Enhanced fund) was going against the collapsing subprime mortgage crisis. He made a statement to convince its investors that the hedge funds under his management are going to make profit out of the market. Deloitte & Touche, a well-known accounting firm who was the auditor for Bear Stearns’s High Grade fund and Enhanced fund warned the fund’s investors about the poor performance of the funds. This was proven by showing that more than 60% of Bear Stearns’s net worth was tied up in securities, signaling a serious illiquidity that would make the hedge funds fall into trap of severe financial condition.

As the subprime crisis worsens and recovery seems unlikely, credit risk increased and the hedge fund’s portfolio of security became extremely risky. If a firm owns securities that fail to attract buyers during a time of market stress, the fund will have a significant liquidity risk. (Keith H. Black, 2004, p67). This is made true when Bear Stearns was soon unable to sell its securities which turned the funds into a disaster. Furthermore, the two hedge funds were holding some additional lightly traded security. Selling these securities in one of the hedge funds back into the market would drive down their prices sharply and in turn affect the other hedge fund’s net worth.

In 2006, Cioffi’s investment strategy started to increasingly use short term debts to buy lightly traded bonds. Thus, higher borrowings lead to an extremely high gearing ratio, approximately 1:60. In order to pave the way of getting loans at low interest rates, Cioffi had made a critical trade-off by offering big lenders like Barclays (Barclays was the sole equity investor) the right to demand immediate repayment. As the CDOs values dropped sharply and lenders starting to demand repayment, the borrow-and-buy game was over. Contributing to the hedge fund’s downfall is also the fact that the emergency funds of the two Bear Stearns hedge fund were only 1% of their assets.

Due to the correlation between the Enhance Fund and the High-Grade Fund as mentioned above, if anything should happen to the Enhanced Fund, the High-Grade fund will also be affected. This is because both funds were investing in similar underlying securities. Thus, when Barclays demanded repayment of its funds from Bear Stearns, Enhanced Fund started to dump its holdings to pay back Barclays and in turn caused the prices of the securities in High-Grade fund to also fall sharply.

Furthermore, the High Grade funds became more risky as the Cioffi’s management team did not disclose the incident about Enhance leverage fund. Moreover, the funds also grew at a less profitable rate since the Bear hedge funds were using extensive borrowings to invest. To further add to their deceit, the securities in these two hedge funds were valued by Cioffi’s management team without following widely available market values. A hedge fund’s net asset value is its assets minus its liabilities. It is therefore critical to track its profitability based on the valuation of the securities the hedge funds are holding. To make matters worst, the hedge funds were using the “smoothing returns” strategy in their valuation of illiquid assets. Since the prices used are often not up-to-date market prices, the fund’s fair value would be less volatile. Thus, the investors were told that they will receive a steady flow of returns every month.

Other than that, Cioffi’s team was driven by performance fees based on the performance of the funds. Therefore, they were using aggressive investment ways to boost returns for their own interest. As results, these managers remained artificially optimistic although the subprime market was going to collapse. As a last resort, Cioffi wanted to list Public Everquest Financial so as to raise funds from the public to save the two hedge funds. However, this public offering had failed. Now Cioffi faces legal problems as lawyers found that valuation of securities will stimulate the prosecutor’s interest. All this reminds us of the downfall of Barings bank and its rogue trader Nick Leeson.

III.

Stand Alone Risk

Generally, Bear Stearns hedge funds invested in structured-finance products, The Bear Stearns hedge funds, which are the High-Grade fund and the Enhanced fund, begin buying risky pieces of collateralized debt obligations (CDOs), high-yield bonds and etc. We will look into the risk portion in these aggressive investment activities and its danger inherent in the market.

Firstly, the CDOs are an important example of asset-backed securities and normally are backed by a pool of assets (Bingham & Kiesel, 2004, pp.404). The CDOs which the hedge funds invested in are backed by sub-prime and others mortgages. Cioffi was actively trading in the booming CDO market by holding nearly $30billion worth of this type of securities. They were basically taking the investor’s money, leveraging it to the maximum and dumping everything into the CDO market.

Normally, an institutional investor such as Bear Stearns will not only invest in one identified type of asset but it is crucial for us to understand the stand-alone risk in CDO and high-yield bonds before understanding the effect of this type of securities on the overall investment risk associated in his portfolio selection. Stand alone risk is the risk an investor would face it if he or she held only this one asset (Bingham E. 2004, pp.170).

Normally, the lenders would bundle or pool together the bad debts and preferable loans into one basket of loans and sell them to investment banks, which in turn will resell them to their other investors. These mortgage-backed securities will be rated accordingly to their repayment ability and default risk by rating agencies. Before the subprime crisis happened, these securities were actually being rated good gradings, eg AAA marks, because these securities are accompanied by collateral and default risk were at a minimum rate with a booming housing industry. All of a sudden risky consumer loans were reconstituted into something seemingly no more risky than a government Treasury bond. After the housing bubble burst, house prices started falling and the rating agencies were not even quick enough to downgrade the risky investments.

What prompted Cioffi into investing in these securities? CDOs have a probability to generate higher return because of their high risk attached to it. This higher expected return will works as an additional compensation for the higher rate of failures induced in the CDOs market.

References:

Ø Bingham N.H & Kiesel R. (2004), Risk-Neutral Valuation-Pricing and Hedging of Financial Derivatives, second edition, Springer-Verlag London limited.

Ø Brigham, E (2004), Fundamentals of Financial Management, tenth edition, South-Western.

Ø Liaw, K. Thomas (2004), Capital markets, Thomson South-western.

IV.

RISK IN A PORTFOLIO CONTEXT

An ideal portfolio produces returns that have a low correlation to traditional investments, as well as a low standard deviation of returns. This goal is most likely to be achieved when the fund of funds manager carefully diversifies their portfolio. Correlations are very important, as portfolio theory explains that we can invest in high-risk, high-return assets without increasing standard deviation when the correlation between that fund and the portfolio return is low enough to offset the high volatility of the additional investments. (Keith H. Black, 2004, p 314)

Risks are divided into systematic and unsystematic risk. Unsystematic risk is associated with an individual company or industry; it may be diversified away in a large portfolio. (Geoffrey A. Hirt and Stanley B. Block, 2006, p 602) As more assets are added into portfolio, Bear Stearns may be able to fully diversify its unsystematic risk.

Theoretically it is said that a perfectly negative correlation between two stocks can offset the standard deviation and bear no risks. However, in the world of reality, it is impossible to achieve such correlation because there is risk that is unavoidable which called the market risk. Therefore, risk in a portfolio context in practice depends on the correlations among the individual stocks that are hopefully generally positive. However, not all risk can be eliminated and what is left are the risks that cannot be eliminated.

Relating back to the Bear Stearns hedge funds case, the assets in its portfolio is definitely at a high risk as Cioffi engaged the hedge funds in irregular and illiquid securities such as CDOs, lightly traded securities, and so on.

Bear Stearns may be able to make profit and diversify its portfolio unsystematic risk by selecting high risks assets into its portfolio provided the correlation between the assets must be at low or negative correlation or diversify by selecting assets that are of high risks and low risks assets such as Treasury Bills. Unfortunately, Bear Stearns allocated the funds into highly correlated and similar type of stand alone assets that brought about extremely high risks and positively correlated among the assets, making its portfolio risky.

In some cases a fund manager (here, Bear Stearns) may be able to borrow funds in order to purchase even greater amounts of a portfolio than his own funds will allow. The risks in Bear Stearns hedge funds increased tremendously when the fund manager, Ralph R. Cioffi used a type of short-term debt to borrow billions more; yet made a critical trade-off: For lower interest rates, he gave lenders the right to demand immediate repayment. This increases the illiquidity when both of the High-Grade fund and enhanced fund collapsed when investors demand for repayment.

V.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a model of market equilibrium in which the return on a given security is related to the risk premium on that security. In turn the risk premium is related to the covariance of the asset return with the return available on the market portfolio (Maximo V.Eng, et al, 1998, pp.564). CAPM concludes that the investors mix risky assets and less risky assets in their portfolio. Risk-free assets may also be involved in the given market portfolio. The expected return for any portfolio on the line is equal to the risk-free rate plus a risk premium. If investors are to invest in risky assets, they must be compensated for this additional risk with the risk premium. There are 2 important relationships in the CAPM that are Capital Market Line (CML) and the Security Market Line (SML).

CML specifies the equilibrium relationship between expected return and risk for an efficient portfolio.[1] It is only useful for efficient portfolios and can’t be used to assess the equilibrium expected return on a single security. The efficient portfolio means a portfolio that is well diversified in which the highest level of return at the given level of risk or the highest level of risk at the given level of return. All the combination of efficient portfolios is on the CML line. CML is used to determine the optimal expected return.

However, the Bear Stearns High-Grade Structured fund and High Grade Structured Credit Strategies Enhance Fund is not efficient as they failed to apply this theory. This is because the portfolios were mainly consisted of the high-risk securities such as the mortgage-backed securities. These funds aimed at maximizing returns but not to minimize risk by investing in high-risk high return securities.

SML specifies the equilibrium relationship between expected return and systematic risk.[1] SML depicts the tradeoff between risk and expected return for individual securities. It is also applicable to individual securities and portfolios. The security’s risk will be measured based on beta. Beta is a benchmark to determine the individual asset’s riskiness with the market portfolio of all the assets. It measures the systematic risk of the asset that cannot be diversified such as interest rate risks. The market portfolio has a beta of 1.0 which means that for every 1-percent change in market’s return, on average, this security’s returns change 1-percent. If the beta is more than 1.0, it means the assets are more volatile (risky). If the beta is less than 1.0, it means the assets are less volatile (risky. If the value of beta is higher, the risk of individual assets is higher.

VI.

RISK and RETURN

(Two Sides of the Investment Coin)

Investment decisions are determined by various reasons. For most investors, individuals and institutions, one of their primary motives is to earn returns (Prasanna Chandra, 2006, pp.127). The investors would naturally wish that their returns to be as large as possible. In Bear Stearns hedge fund’s case, the management team aggressively invested in the high risk securities as they will be paid according to their hedge funds performance fees. As evidence, Cioffi is going to keep 20% of any profits they generated, plus 2% of the net assets under management. However, they should understand that the returns would bear some risk in which is the possibility of the expected returns being different from the actual returns. Generally, there is positive relationship between risk and return and this trade-off would be the centre for any investment decision.

Basically, there are components which investors must consider in forming their expected rate of return of their investment (Brigham, E. 2004, pp.195). First, it is their required rate of returns, which is the minimum return that an investor expects from an investment. Investors basically will buy and hold the securities if the expected rates of returns are higher than the required rate of returns. The required rate of returns for the Bear Stearns High-Grade Structured fund and High Grade Structured Credit Strategies Enhance Fund must be at least the interest rates of their borrowings.

In order to involve in high-risk investment, investors must be rewarded by a risk premium, which is the additional returns investors expect to obtain for assuming additional risk (Prasanna Chandra, 2006, p.127). The hedge fund managers willingly invested in the exotic and lightly traded bonds as the investments offered higher yields mainly due to the default risk premium. The higher yields of bonds also lead to lower bond prices. Thus, the funds will not only earn a higher yield but also a higher capital gain.

Besides that, the liquidity risk premium is another concern for an investor. If the security is easy to sell at a fair price, then the premium will be lower and vice versa. In the article, one of the motives Cioffi invested in the mortgage-backed securities is that they offered higher liquidity risk premium. This is because houses are not easy to sell at their fair value and liquidity is subject to the market condition. If the funds become increasingly illiquid, then funds are more likely to be failed (Black, 2004, pp.66). Therefore, the two funds collapsed during the subprime crisis.

For the hedge fund’s investors, the hedge funds were supposed to minimise their risks for a given level of returns as they were told to expect a small but steady return every month. However, the returns were not guarantee. In this case, the agency relationship problem arose; the investment strategies caused the investors to invest indirectly in the risky instruments, arrangement with lenders (Barclays), the failure of disclosure, etc. Moreover, they also faced pricing and model risk where these mortgage-backed securities and high yield bonds are often illiquid and difficult to value (Black, 2004, pp.71). The overvaluation of the funds made the investors’ expected rate of returns became irrational. Thus, if the investment risks go beyond manageable level, it will generate substantial losses.

VII.

Recommendations

The Bear Sterns hedge funds were actually involved in murky dealings with investor’s money. They lied to their investors that even if the market is in a bad and unfavorable condition, that they will still make profits and garner returns. As such, we recommend that investors need to have more information about the complex assets that their hedge funds are investing into so as to avoid misleading information by hedge fund managers such as Cioffi’s CDO investments that were of nature extremely high in risk. Thus, investors can make better rational decisions based on the level of risk of the funds. The failure of investors to make rational decisions (especially before the funds collapse) is due to the fact that hedge funds are not required to disclose positions and trading strategies. As a result, no one knew who was holding what, no one trusted counter parties, leading to credit crunch (refer to The EDGE Malaysia, the week of October 29,2007).

In addition, if the two hedge funds are to be supervised by an independent party in their investment structure, misuse of funds will be minimizes.

Despite Cioffi’s considerable expertise in the investment field, Bear Stearns should let him be in full control of both hedge funds in Bear Stearns Asset Management. Cioffi’s overconfidence and his risky investment strategy thus made it certain that it defies and neglect the real purpose of the hedge fund which is to involve in low risk, and low-correlated strategies (Black, 2004, pp.120).

Besides, Cioffi’s team needs to have ethical behaviors towards his responsibility. According to agency theory, it is common for management teams to invest for a personal goal, in this case to obtain high performance fees rather than the maximization of investor’s return. When they are dealing with investor’s money, they should hedge the risk away instead of speculating for higher return. With the excessive leveraging in short-term debts, the hedge funds actually double the risk involved. Moreover, the arrangement with Barclays actually represents a conflict of interest with investors. As a golden rule, Cioffi should safeguard investor’s interests. Moreover, Cioffi must be more conservative, and reserve at least 10% of emergency funds in lieu of the 1% they were actually holding.

In order to manage the risk of the funds, it is important to understand the relationship between the type of trading strategies and the risks and returns in the market environment (Black, 2004, pp.84). Investing heavily in the mortgage market can have large losses during the property market crisis occured. (plz cont. urself in risk mgt : insufficient info.

Diversification is an essential indication to a portfolio selection. In our case, the Bear Sterns hedge funds were not well diversified. At first, Cioffi and many other fund managers thought that investing in mortgage-backed securities provided some sort of diversification through the combination of the prime and subprime loans. Therefore, Cioffi should invest in negative correlated industry such as commodity market.

Most hedge fund activities do not start up to commit fraudulent activities. But losses are incurred; people will try to cover up illegally. The Bear hedge funds exercised overvaluation, and used the ‘smoothing returns’ strategy to mislead investors. As a solution, regulation should play a more important role in hedging activities. The financial system needs better supervision and governance in relating issues arise such as it must set a standard requirement for their disclosures. Valuation methods also must be supervised by government agencies to avoid inconsistent practices.

References

  • Keith H. Black (2004), Managing a Hedge Fund: a complete guide to trading, business strategies, operations, and regulations, The McGraw-Hill.

Reference:

Prasanna Chandra, Investment Analysis and Portfolio Management, 2nd edition, 2006



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