Case 4
Subprime Heading South at Bear Stearns Asset Management

What am I going to tell Barclays Bank? They won’t be expecting a down month so soon after committing $400 M to our Enhanced Leverage Fund (ELF). Only half of the facility has been disbursed. Do I give them the facts knowing that doing so risks Barclays’ freezing the credit line? Releasing a full story also could send our investors running for the exits. Or, do I say what I need to say to buy time to turn performance around?

MATTHEW TANNIN, A FUND MANAGER for Bear Stearns Asset Management (BASM), sighed as he looked at the preliminary results for February 2007. A key threshold was being crossed. For the first time one of the two Funds managed by Tannin and his boss, Ralph Cioffi, was going to show a loss. Tannin was deeply concerned about how Barclays, the major source of liquidity for that Fund, would react. If Barclays froze its credit line, the resulting crisis could topple the Funds.

Tannin felt constrained by their prior disclosure to investors. Information Memoranda for their Funds described them as “only slightly riskier than a money market fund.”1 The stated aim was to invest in highly rated long-term asset-backed bonds. Most investors assumed these to be auto loan and credit card-backed securities. Yet, Tannin knew that most Fund investments were actually backed by subprime mortgages. These “collateralized mortgage obligations” (CMOs) had interest rates that had allowed the Funds to generate enviable returns for forty consecutive months.

Now the subprime mortgage market was collapsing. Defaults were soaring as housing prices in many markets plummeted. Consequently, prices of subprime mortgage CMOs were falling. Indeed, the capital markets had become so uncertain about the value of the underlying collateral that trading in subprime CMOs had almost ceased. There was no question that CMO prices were headed downward. In response Tannin’s Fund had taken some modest price “haircuts,” and these had produced its February loss.

Tannin and Cioffi became aware of problems in the subprime mortgage market in early 2006. Yet, they remained relentlessly upbeat. Month after month they told investors that their Funds had moved early to hedge risks and to avoid the worst subprime mortgages. Again and again they reiterated the high credit ratings carried by the Funds’ investments. They also de-emphasized the Funds’ total subprime mortgage exposure. In February 2007, Cioffi told Fund investors that while “asset-backed” securities accounted for 81% of total High-Grade Fund (HGF) investments, subprime mortgage securities totaled only 6.1% of the Fund’s holdings.2

The reality was quite different. Subprime CMOs constituted a majority and a growing proportion of both the HGF and Enhanced Leverage Fund’s (ELF) holdings.

Tannin was also distressed by another problem. The Funds had failed to follow control guidelines for trading with Bear Stearns’ broker-dealer. Their repeated failures caused Bear Stearns to suspend trading with the Funds. This cut the Funds off from their most reliable source of liquidity. Bear Stearns was the largest trader of CMOs on Wall Street. Cioffi/Tannin’s Funds would no longer be able to sell CMOs to their most natural counterparty should a liquidity emergency arise.

Partly in response, Cioffi and Tannin sought additional funding from Barclays Bank. Barclays ultimately agreed to a $400 M credit facility for the ELF. Cioffi and Tannin used half of the new cash to bulk up on subprime CMOs whose prices had recently fallen.

By February 2007, however, Barclays was getting worried. Distress in the mortgage market was becoming acute. Despite repeated assurances from Cioffi and Tannin, Barclays decided they needed better insight into the Funds’ performance. The bank formally asked for more information disclosure.3

This demand posed a dilemma for Tannin. He knew that the ELF results for February were likely to be negative. If he simply signaled that result to Barclays, they probably would freeze the credit line. Barclays might also demand more disclosure about the securities held by the ELF. More disclosure might not look so good in light of previous statements de-emphasizing the Funds’ subprime exposure. In a worst case, Barclays might cancel the line and demand repayment. If word of that got around, there was no telling how many other lenders and investors would follow suit.

It was hard to see a way out. Before considering what to write back to Barclays, Tannin decided to review the history of the Funds and their current predicament. Perhaps there was some way to answer Barclays candidly without destabilizing their Funds.

Hedge Funds Develop on Wall Street

Hedge Funds were a recent development on Wall Street. Profound changes impacted both commercial and investment banking during the late 1970s. Core investment bank businesses such as underwriting stocks and bonds, saw underwriting fees plummet. Seeing its traditional franchises in decline, investment banks refocused on mergers & acquisitions, leveraged buyouts, high-yield debt, securitization of financial instruments and proprietary trading. This last activity involved speculative investing using the firm’s own capital.

This new strategy required all investment banks to increase capitalization. Many firms merged and became publicly traded corporations. Most also expanded their trading activities. While bankers stalked corporate takeovers, a new class of aggressive traders pursued speculative gains in currencies, commodities, futures and options.

Eventually some of the more successful traders went out on their own. Raising capital, they promised investors superior returns based upon exploiting market inefficiencies. Capturing such inefficiencies usually carried a risk that markets would move in response, wipe out the discrepancy and turn the investor’s gains to losses. The traders told their investors that they could hedge such risks. Armed with new mathematical tools for modeling risk, traders sought to combine precisely calibrated “long” positions and partially offsetting hedges to capture outsized returns. Thus the Hedge Fund came into being. Attachment 1 provides a generic description of Hedge Funds, the strategies they employ and the pros/cons of investing in them.

Long-Term Capital Management (LTCM) was one such Hedge Fund. Founded by two Nobel Prize winners in economics, LTCM sought to exploit discontinuities in the fixed income market. As an example, LTCM noted that the “on the run” issue 30 Year U.S. Treasury bond (the newest issue) typically traded at a price premium relative to a “seasoned” Treasury bond with 29 years remaining to maturity. Once the “on the run” issue was superseded by a newer issue, it would fall toward price equilibrium with other seasoned 29-year bonds. LTCM’s basic trade involved buying the cheaper 29-year bond, selling the “on the run” issue “short,” and waiting until the latter bond’s price fell as it seasoned. Sometimes this realignment took only 1–2 months. Then LTCM would sell its seasoned bonds, using the cash to cover its “short” position at the new lower price. Although LTCM’s short position might be quite large, fund managers considered the position “hedged” because of the fund’s long position in a security of comparable quality and tenor.

In a cautionary tale, LTCM’s performance went from stunning to disastrous. In 1998, Russia’s sovereign debt default led markets to reprice risk and rein in credit. LTCM’s long positions turned negative; news of its losses caused LTCM’s creditors to demand large amounts of cash collateral. LTCM was forced to liquidate securities at progressively bigger losses, which fed their creditors’ frenzy to exit. Only a multibank rescue effort orchestrated by the N.Y. Federal Reserve Bank headed off the fund’s dissolution.

LTCM’s failure did not discourage others from establishing hedge funds. Quite to the contrary, the natural progression on Wall Street became one of traders proving their bona fides at a “name” firm and then leaving to form their own fund. Many funds racked up enviable track records; major institutional investors put increasing amounts of funds under their management. By the mid-2000s, state pension funds and Ivy League schools routinely placed money with hedge funds.

Bear Stearns Forms its Own Hedge Funds

Bear Stearns was regarded as the scrappy renegade investment bank. Part of this reputation came from its refusal to support the rescue effort of LTCM. But most of it reflected a style born of sharp elbows trading rather than well-tailored banking. Traders traditionally headed the firm, the most noteworthy being “Ace” Greenberg. By 2007, Ace had stepped aside in favor of another rough-knuckled trader, Jimmy Cayne.

Bear Stearns’ nimble trading culture and focus on specific market segments produced results. By 2005, the firm was among the leaders in fixed income securities trading and topped the “League Tables” in asset-backed securities. Wealth under management at BSAM was growing rapidly. These results flowed through to profitability. Attachment 2 summarizes Bear Stearns financial performance for the period 2005–06.

With its deep appreciation for trading talent, Bear Stearns took a unique approach to the hedge fund phenomena. First, they tended to give a wider range of individuals the opportunity to prove themselves as traders. If they succeeded, Bear Stearns would let them form hedge funds within BSAM. The approach had reasonable success in spotting new trading talent and keeping it with the firm.

One beneficiary was Ralph Cioffi. Joining Bear Stearns in 1985, Cioffi quickly established himself as the firm’s preeminent fixed income salesman. His specialty was structured finance products; these included collateralized mortgage obligations and asset-backed securities, which were then coming into vogue. Within a couple of years Cioffi was making $4 M in annual compensation.

Cioffi was promoted to manage fixed income institutional sales; he quickly demonstrated a lack of managerial talent. One colleague, who knew Cioffi well, described his performance this way:

“He had adult ADD … In management, you come in the morning and you’re working on what you worked on yesterday, and you’re trying to hire this guy, or build this business … Ralph didn’t do well with that stuff. He would hire salespeople, and we’d get to the end of the year and find out that he’d cut deals and forgot to write them down … He was just not a really good manager.”4

To rebound from these troubles, Cioffi volunteered an interest in managing a hedge fund. Bear Stearns tried him out managing $10 M of the firm’s own money in a mortgage-backed securities fund. Results were initially positive. Then in October 2003 Bear Stearns gave Cioffi the chance to set up a new fund with outside investor money. Matthew Tannin was brought along to help him. Tannin had nine years’ experience with the firm, seven of which were spent structuring collateralized debt obligations (CDOs). Tannin’s last two years had been spent in CDO research.5

Cioffi called his new vehicle the “High-Grade Structured Credit Fund” or High Grade Fund (HGF) for short. It was, in Wall Street parlance, a “carry fund.” This meant that the fund raised money, invested in securities and held (i.e., carried) them. Outside investors typically delivered only a small percentage of the fund’s capitalization. The rest was borrowed money of short-term duration. Most borrowed money was secured in the overnight “repo” or repurchase market. Cioffi’s fund would borrow money for 1 day, securing the loan using their “carried” securities as collateral. This approach allowed the fund to achieve low borrowing costs by concentrating its financing in the shortest maturity debt. So long as the Fund was earning money, a high ratio of debt-to-investor equity also produced high leveraged returns. Of course, the risk being taken involved the fact that funding from lenders was not locked-in. Should the High Grade Fund’s lenders become spooked, they could demand repayment as soon as the next day.

Cioffi’s strategy involved capturing the interest rate differential between short-term repo market rates and those available on long-term CDOs. Essentially, the HGF would borrow at the shortest end of the yield curve and invest at the long end. As a second source of value, the HGF would exploit what Cioffi judged to be a pricing anomaly. Asset-backed securities, especially those backed by mortgages, could secure high credit ratings from the rating agencies. Yet, such CDOs were often “priced” to carry interest yields that resembled A or BBB rated corporate securities. The HGF was designed to capture this pricing anomaly for its investors.

Cioffi’s strategy was exposed to several risks. First was the risk that interest rates might rise, causing HGF’s long-term holdings to drop in price. In its most acute form, interest rates might rise to the point where HGF funding costs rose above its interest income. Cioffi judged that U.S. monetary policy was pointed toward a period of low short-term rates. Should Federal Reserve policy change, however, he would have to be nimble enough to spot the change early and hedge rising rates. Cioffi’s second risk was that the creditworthiness of CDOs “carried” by HGF might deteriorate. Should this happen, the prices of the Fund’s securities would decline. To hedge this risk, Cioffi promised investors his Fund would buy only AAA or AA rated CDOs.

One last risk element involved the way Wall Street reports financial results. Banks are required to use “Mark-to-Market” (MtM) accounting. This means that securities carried on their balance sheets are repriced to reflect market changes since the prior reporting date. Gains and losses are then reflected in reported net income. Philosophically this approach aims for greater transparency, i.e., allowing investors to see whether the “bets” are in the black or “under water.” It does, however, suggest that income has been gained or lost when in fact the underlying securities have not been sold. It can also involve ticklish and complex valuation issues when particular securities are not widely traded. Trouble can then be signaled to investors based on a few trades or revised assumptions used in valuation models. Whether such signals accurately reflected fundamentals was often debated. Like other hedge funds, HGF would report its results using MtM.

Things started out promisingly for HGF. The Fund showed positive results for 40 straight months and generated a 50% cumulative return.6 In line with other Hedge Funds, BSAM kept 20% of the Fund’s profits plus annual fees equal to 2% of the assets under management. HGF proved a star revenue generator, accounting for 75% of BSAM’s total revenues in 2004–05.7

Mortgage Market Trends and HGF Disclosure

In 1994 approximately 64% of American households owned their home. This figure had been stable for decades. Over the next ten years government policy worked to up this figure. The Clinton administration took an aggressive approach towards mortgage lender discriminatory practices. Under the Community Reinvestment Act (CRA), banks were rated on how much lending they did in low-income areas. Low CRA scores were strongly considered when a bank sought government approvals for mergers or branch openings. The two giant government mortgage agencies, Fannie Mae and Freddie Mac, were encouraged to become involved in securitizing packages of subprime mortgages. The first such securitization, a $385 million subprime loan package, was underwritten by Bear Stearns and First Union in October 1997.8

These government policies were extended during the Bush administration. The 2003 Dream Down Payment Initiative provided money to pay closing costs and down payments for first time low-income buyers.9 Tax policies improved the shielding of capital gains generated by home sales. No attempt was made to rein in subprime activity at Fannie Mae and Freddie Mac, even though there were visible signs that lending standards were deteriorating.

Prior to these initiatives, lenders expected loan applicants to provide a minimum 20% cash down payment, demonstrate the ability to fund their mortgage payment using no more than 30% of monthly salary, and evidence positive personal net worth. The house would be appraised to demonstrate a market value at least 15% higher than the mortgage.

Once the government began encouraging aggressive mortgage lending, these standards dropped—first to a 3% down payment, then zero down payments. Eventually some lenders offered a “103” mortgage, where closing costs were paid by the lender and rolled into the loan amount. The quality of personal financial disclosure also suffered. Borrowers were encouraged to exaggerate their financial condition, or lenders didn’t bother asking. In a not exceptional example, one couple living on disability checks and holding no financial assets saw their $285 k loan application filed by MortgageIT with a report stating they had a monthly $5000 salary, $158 k in liquid assets and a net worth of $153 k. The mortgage was securitized and sold first to GMAC and later to Wells Fargo Home Mortgage.10

Securitization of mortgages strongly encouraged these practices. Loan originators operated with the sense that they would not have to live with the consequences of relaxed standards.

One factor which facilitated the securitization of mortgages was relaxed credit standards at the three rating agencies: Moody’s, Standard & Poor’s, and Fitch. Fixed income investors have long depended on these agencies to do detailed risk assessment. Yet, the agencies are paid for ratings by the debt issuer. This basic conflict of interest had historically been contained by the professionalism of the agencies. However, by the time of the mortgage securitization boom the agencies had become part of public companies. Management cultures changed and standards slipped. Increasingly, the agencies rated mortgage-backed CDOs as AAA or AA without inspecting the underlying loan collateral. Embarrassing evidence of management directing analysts to temper their investigations later surfaced in congressional hearings. At a time when mortgage underwriting standards were deteriorating, bond credit ratings also lost their integrity.

The government’s policies did succeed in raising the level of home ownership. By 2008, ownership had risen to 69% of households. This increased demand helped cause average U.S. housing prices to more than double. Rising prices helped sustain aggressive lending, keeping the origination/securitization pipeline flowing.

By 2006, cracks in the mortgage market had begun to show. Late in 2005, financial services analyst Meredith Whitney published a “flashing red light” report. Whitney focused on deteriorating mortgage credit standards; she noted that a massive number of recent borrowers now had loan-to-value ratios exceeding 90%. Should surging home prices stall, these owners could quickly find themselves “under water.” Whitney documented the stupendous growth of the subprime mortgage segment—it had grown 489% since 1996, from $90 billion to $530 billion, largely on the basis of loans to first-time borrowers. The report’s conclusion was prescient and devastating:

“We believe low equity positions in their homes, high revolving debt balances, and high commodity prices make for the ingredients of a credit implosion … lenders with exposure to this segment [subprime] will experience loss levels of great enough enormity to not only substantially erode profitability but which would impale capital positions … most important, we believe restricted liquidity … could begin a domino effect of corporate insolvencies similar to that witnessed post-1998.”11

This was the background against which Cioffi and Tannin managed the HGF. Their response was to provide reassurance to their investors. The Fund’s investment philosophy was succinctly stated in each monthly performance report:

“The Fund’s investment philosophy is to generate total annual returns through ‘cash and carry’ transactions and capital market arbitrage. Typically 90% of the Fund’s gross assets are invested in AAA or AA structured finance assets.”12

This commitment to invest in top quality securities was buttressed by monthly disclosure of the investment portfolio’s mix. For example, for January 2006 the HGF indicated that 30% of assets were in asset-backed securities (ABS) and another 15.2% in subprime mortgage residential securities.

Such disclosure was at best a half truth. Cioffi and Tannin were less than candid in their description of the assets being held. For example, in July 2006 the HGF monthly statement reported 50.5% ABS and only 6% in subprime mortgage securities. Yet, in a January 2007 investor conference, under direct questioning about the composition of the ABS portfolio, Cioffi admitted that it contained subprime exposure. Later congressional testimony by Kyle Bass, managing partner of Hayman Capital, asserted that HGF’s ABS portfolio was comprised almost entirely of subprime mortgages. Later disclosures by HGF would confirm this view.13

HGF’s initial performance left little cause for complaint. Cumulative returns were reported to be 16.88% in 2004 and 9.46% for 2005.

Financial Control Issues at HGF

Organizationally, Bear Stearns consisted of an investment bank, a broker/dealer who traded securities, and BSAM. From its inception, Cioffi’s HGF did most of its trading with Bear Stearns’ broker/dealer. This made sense because of Cioffi’s relationship with the firm and because Bear Stearns was Wall Street’s leading originator/trader of mortgage-backed securities. Attachment 3 provides an overview of the Bear Stearns organization.

Because Bear Stearns was a related party, procedures were established to guard against conflicts of interest. HGF had to have independent directors on its Board. HGF trades with Bear Stearns also had to be approved by these directors prior to execution. Compliance with these rules was required by the Investment Advisers Act of 1940. In theory, an HGF failure to comply on even one trade could have serious legal consequences for BSAM.

Unfortunately, Cioffi’s managerial weaknesses followed him into managing hedge funds. HGF routinely failed to comply with the rules. For an extended period it failed to appoint independent directors. When these were in place, needed approvals were often obtained after the fact or not at all.

BSAM’s compliance staff became increasingly concerned about HGF’s control failures. In 2003, 18% of HGF’s trades with Bear Stearns were not properly approved. Despite repeated warnings from compliance, HGF’s performance only worsened. By 2006, violations had risen to 76% of trades. Ultimately, BSAM reported that HGF executed 2300 trades with Bear Stearns between 2003 and the end of 2006; of these, 47% were noncompliant.14

Finally, in September 2006 BSAM imposed a moratorium on all trading with HGF. This moratorium cut HGF off from its major source of liquidity. Not only could HGF no longer trade asset-backed securities with Bear Stearns, it no longer could “repo” securities with its sister firm. HGF was thus cut off from the firm which had the most natural incentive to buy a distressed asset or extend financing should HGF encounter difficulties. Finally, it meant that senior Bear Stearns traders, who used to keep an eye on what Cioffi and Tannin were buying, no longer bothered to look. Bear Stearns management became increasingly unaware of whether HGF’s risks were being managed or if its strategies matched what the Fund was telling its investors.15

The moratorium remained in effect indefinitely.

Cioffi and Tannin Respond to Growing Pressures

Cioffi and Tannin understood that loss of access to Bear Stearns seriously diminished the liquidity of their funds. They also knew that pressures were growing in the mortgage market. In an April 2006 call with a potential investor, Tannin noted that the market was especially worried about the current crop of subprime mortgages because of “looser underwriting standards, ‘no-doc’ loans, high loan-to-value ratios, and a large ‘dispersion’ in credit scores.”16

Faced with deteriorating asset quality and reduced liquidity, Cioffi and Tannin embarked upon a new course. This strategy involved launching new funds and attracting new lenders to fund large new securities purchases. Most of the new investments would be subprime mortgage-backed CDOs.

First up was the “Enhanced Leverage Fund.” On August 1, 2006, the HGF was split into two components. Some $560 M in assets, about 37% of the HGF, became the ELF. Cioffi and Tannin promised investors higher returns due to the use of more debt financing. ELF would invest primarily in CDOs, using substantially more leverage while investing in a higher percentage of the least risky securities. The net result would be higher returns with only “limited additional risk.”17

To secure the liquidity needed to pursue the ELF strategy, Tannin approached Barclays Bank for a $400 M credit line. Tannin told the bank that the new Fund would invest in “AA/AAA assets” having “very, very low volatility.” Thus the Fund would:

“concentrate the ultimate exposure in the highest rated (floating rate) kinds of assets [and] generate a prudent return for our investors which allows our portfolio managers and structuring team to concentrate on the areas in the market where there is the greatest liquidity and greatest value.”18

Barclays ultimately granted ELF the credit line. Later in 2006, Cioffi and Tannin formed another new fund, called Rampart, to which they sold $549 M of less liquid CDOs from the two existing funds. This transaction left HGF/ELF collectively with an equity position in Rampart and $149 M in cash. Cioffi and Tannin felt, with some justification, that they had taken meaningful steps to counteract the moratorium on trading with Bear Stearns.

Then, the subprime mortgage market began showing increasing distress, and mortgage-backed CDOs slipped in price. Securities previously priced at par were now selling for 97–98% of par. Cioffi and Tannin used much of their new liquidity to load up their Funds with new securities purchased at what they believed to be bargain prices. By February 2007, subprime mortgage assets represented some 60% of total HGF/ELF holdings.19

February 2007: ELF Performance Turns Negative

A series of hammer blows struck the subprime mortgage market in February 2007.

On February 7, New Century Financial Corporation announced that it was restating earnings for 2006. New Century was a large, publicly traded real estate investment trust and major mortgage lender. The restatement involved home mortgages bought back from borrowers. New Century cancelled its earnings call with analysts and watched its stock fall 37% to a 52 week low. On the same day, HSBC Holdings announced large new loan loss provisions for nonperforming mortgages.

On February 21, NovaStar Financial, another subprime mortgage lender, announced a surprise loss for 4Q 2006. NovaStar also warned that it might not be able to pay its dividend for the foreseeable future. Its stock fell 43%.20

Three days later, Lew Ranieri, a legendary Salomon Brothers mortgage-backed trader, gave a Wall Street Journal interview warning about mortgage-related risks and global markets. Ranieri cited the growing volumes of subprime CDOs being sold to a “much less sophisticated community” in foreign markets. Noting that in 2006 some 40% of the subprime borrowers were not required to produce pay stubs or proof of net worth, Ranieri went on to say:

“We’re not really sure what the guy’s income is and … we’re not sure what the home is worth … So you can understand why some of us become a little nervous.”21

It was against this backdrop that Cioffi and Tannin considered the performance of their Funds for February. Of particular concern was the question of the “marks” to be assigned at month-end to securities held by the Funds. Given all the bad news since February 1, Cioffi and Tannin worried that Fund holdings might need to be marked down considerably. Such markdowns could more than offset the Funds’ interest income, producing a net loss. Attachment 4 provides a brief summary of Bear Stearns procedure for setting monthly price marks.

Matthew Tannin Considers His Response to Barclays Bank

On February 27, 2007, Barclays Bank demanded that Tannin provide them with written monthly performance statements for the ELF. At this point, half of their credit facility for the Fund remained undrawn and available.

As Tannin considered his response, he identified several options:

  • Signal the possibility of an ELF loss in February, but try to persuade Barclays that this result was an aberration. Go on from there to argue that it represented a buying opportunity for the fund.
  • Try to reassure Barclays and buy time to draw down the remaining facility cash. Use the cash to buy additional securities at cheap prices, betting on producing turnaround positive results in March.
  • Try to line up replacement liquidity in case Barclays froze their facility. Perhaps Bear Stearns could be persuaded to lift its trading moratorium.
  • Go into defensive mode. Sell securities to increase cash reserves. Move away from mortgage-backed securities to more traditional asset-backed CDOs.

Tannin thought that these options were not mutually exclusive. Elements of one might be combined with another. For example, they could try to reassure Barclays, draw down the credit facility, but then go into defensive mode. Or, ELF could line up replacement liquidity and still execute a CDO purchase program. The decision depended on whether current market turbulence was localized and temporary, and hence a buying opportunity.

While considering his options, Tannin took stock of the legal framework that governed hedge fund disclosure. Requirements were somewhat murkier than those pertaining to publicly traded securities. Still, Tannin knew that material misstatements could lead to legal actions against the Funds and a possible criminal indictment of fund managers. Attachment 5 discusses the disclosure laws pertinent to hedge funds.

Here Tannin remembered the e-mail he had sent Barclays on February 19. Among other comments, the note had declared:

“You will be happy to know that we are having our best month ever this February … Our hedges are working beautifully. We were up 1.6% in January and are up 2% so far in February.”22

Taking all of this into account, Tannin began to draft his written reply to Barclays Bank.

Attachment 1

Excerpts from David R. Friedland’s ‘About Hedge Funds’23

What is a Hedge Fund?

A hedge fund is a fund that can take both long and short positions, use arbitrage, buy and sell undervalued securities, trade options or bonds, and invest in almost any opportunity in any market where it foresees impressive gains at reduced risk. Hedge fund strategies vary enormously—many hedge against downturns in the markets—especially important today with volatility and anticipation of corrections in overheated stock markets. The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive returns under all market conditions.

It is important to understand the differences between the various hedge fund strategies because all hedge funds are not the same—investment returns, volatility, and risk vary enormously among the different hedge fund strategies. Some strategies which are not correlated to equity markets are able to deliver consistent returns with extremely low risk of loss, while others may be as or more volatile than mutual funds. A successful fund of funds recognizes these differences and blends various strategies and asset classes together to create more stable long-term investment returns than any of the individual funds.

  • Hedge fund strategies vary enormously—many, but not all, hedge against market downturns—especially important today with volatility and anticipation of corrections in overheated stock markets.
  • The primary aim of most hedge funds is to reduce volatility and risk while attempting to preserve capital and deliver positive (absolute) returns under all market conditions.
  • The popular misconception is that all hedge funds are volatile—that they all use global macro strategies and place large directional bets on stocks, currencies, bonds, commodities or gold, while using lots of leverage. In reality, less than 5% of hedge funds are global macro funds. Most hedge funds use derivatives only for hedging or don’t use derivatives at all, and many use no leverage.

Key Characteristics of Hedge Funds

  • Hedge funds utilize a variety of financial instruments to reduce risk, enhance returns and minimize the correlation with equity and bond markets.
  • Many hedge fund strategies tend to hedge against downturns in the markets being traded.
  • Many hedge funds have the ability to deliver non-market correlated returns.
  • Many hedge funds have as an objective consistency of returns and capital preservation rather than magnitude of returns.
  • Most hedge fund managers are highly specialized and trade only within their area of expertise and competitive advantage.
  • Hedge funds benefit by heavily weighting hedge fund managers’ remuneration towards performance incentives, thus attracting the best brains in the investment business. In addition, hedge fund managers usually have their own money invested in their fund.

Benefits of Hedge Funds

  • Many hedge fund strategies have the ability to generate positive returns in both rising and falling equity and bond markets.
  • Including hedge funds in a balanced portfolio can reduce overall portfolio risk and volatility, increase returns, and provide diversification not otherwise available in traditional investing.
  • Huge variety of hedge fund investment styles—many uncor-related with each other—provides investors with a wide choice of strategies to meet their investment objectives.
  • Hedge funds can eliminate the need to correctly time entry and exit from markets.

Hedge Fund Styles

The predictability of future results shows a strong correlation with the volatility of each strategy. Future performance of strategies with high volatility is far less predictable than future performance from strategies experiencing low or moderate volatility.

Aggressive Growth: Invests in equities expected to experience acceleration in growth of earnings per share. Generally high P/E ratios, low or no dividends; often smaller and micro-cap stocks which are expected to experience rapid growth. Tends to be “long-biased.” Expected Volatility: High

Distressed Securities: Buys equity, debt, or trade claims at deep discounts of companies in or facing bankruptcy or reorganization. Profits from the market’s lack of understanding of the true value of the deeply discounted securities and because the majority of institutional investors cannot own below investment grade securities. Expected Volatility: Low – Moderate

Emerging Markets: Invests in equity or debt of emerging (less mature) markets that tend to have higher inflation and volatile growth. Short selling is not permitted in many emerging markets, and, therefore, effective hedging is often not available. Expected Volatility: Very High

Funds of Hedge Funds: Mix and match hedge funds and other pooled investment vehicles. This blending of different strategies and asset classes aims to provide a more stable long-term investment return than any of the individual funds. Volatility depends on the mix and ratio of strategies employed. Expected Volatility: Low – Moderate – High

Macro: Aims to profit from changes in global economies, typically brought about by shifts in government policy that impact interest rates, in turn affecting currency, stock, and bond markets. Uses leverage and derivatives to accentuate the impact of market moves. Expected Volatility: Very High

Market Neutral – Arbitrage: Attempts to hedge out most market risk by taking offsetting positions, often in different securities of the same issuer. For example, can be long convertible bonds and short the underlying issuers equity. These relative value strategies include fixed income arbitrage, mortgage-backed securities, capital structure arbitrage, and closed-end fund arbitrage. Expected Volatility: Low

Market Neutral – Securities Hedging: Invests equally in long and short equity portfolios generally in the same sectors of the market. Market risk is greatly reduced. Usually low or no correlation to the market. Sometimes uses market index futures to hedge out systematic (market) risk. Relative benchmark index usually T-bills. Expected Volatility: Low

Market Timing: Allocates assets among different asset classes depending on the manager’s view of the economic or market outlook. Portfolio emphasis may swing widely between asset classes. Unpredictability of market movements and the difficulty of timing entry and exit from markets add to the volatility of this strategy. Expected Volatility: High

Opportunistic: Investment theme changes from strategy to strategy as opportunities arise to profit from events such as IPOs, sudden price changes often caused by an interim earnings disappointment, hostile bids, and other event-driven opportunities. Expected Volatility: Variable

Multi-Strategy: Investment approach is diversified by employing various strategies simultaneously to realize short- and long-term gains. Other strategies may include systems trading such as trend following and various diversified technical strategies. This style of investing allows the manager to overweight or underweight different strategies to best capitalize on current investment opportunities. Expected Volatility: Variable

Short Selling: Sells securities short in anticipation of being able to rebuy them at a future date at a lower price due to the manager’s assessment of the overvaluation of the securities, or the market, or in anticipation of earnings disappointments often due to accounting irregularities, new competition, change of management, etc. Often used as a hedge to offset long-only portfolios and by those who feel the market is approaching a bearish cycle. High risk. Expected Volatility: Very High

Special Situations: Invests in event-driven situations such as mergers, hostile takeovers, reorganizations, or leveraged buyouts. May involve simultaneous purchase of stock in companies being acquired, and the sale of stock in its acquirer. Results generally not dependent on direction of market. Expected Volatility: Moderate

David R. Friedland is the President of the Hedge Fund Association and President of Magnum U.S. Investments, Inc.

Attachment 2

Bear Stearns Financial Statements Summary for Fiscal Year End November 30, 2006

Income Statement

In millions except earnings per share

  2005 2006
Total revenue 11,551 16,551
Total operating expenses 5,204 6,080
Operating income 6,348 10,471
Interest expense 4,142 7,324
Income before taxes 2,207 3,147
Income tax provision 745 1,093
Net income 1,462 2,054
EPS $11.42 $15.79
EBITDA 6,625 10,821
Balance Sheet    
In millions    
  2005 2006
Cash and cash equivalents 5,859 4,595
Total assets 287,293 350,433
Total liabilities 276,501 338,304
Long-term debt 43,490 54,570
Total stockholders’ equity 10,791 12,129
Cash Flow Statement    
In millions    
  2005 2006
Operating activities (14,438) (19,221)
Investing activities (203) (181)
Financing activities 16,327 18,138
Change in cash flow 1,686 (1,264)

Source: Bear Stearns Companies Inc. 2005, 2006 10-Ks

Attachment 3

Attachment 4

Bear Stearns Procedures for ‘Marking Hedge Fund Securities to Market’

Bear Stearns had a Valuations Committee (VC) responsible for obtaining price “marks” for all securities held at the end of a financial reporting period.

For BSAM hedge funds, at the end of each month the VC would contact each fund’s trading counterparties. Procedures called for the VC to identify and contact as many independent counterparties as possible. Every counterparty would be asked for price marks regarding relevant securities which they had traded with BSAM or which they were otherwise known to be holding. The VC would then average these marks to establish the “mark-to-market” valuation for each security held by a BSAM fund.

These price valuations would then be used to calculate the fund’s Net Asset Value (NAV) as of that month’s end. Changes in NAV versus the prior month would be reflected as the fund’s monthly gain/loss performance.

SEC rules require that if a counterparty supplies a price “mark” late, i.e., after a fund has already reported its monthly result, the fund must still consider the late mark. When considering a late mark, the fund has two options:

  1. Incorporate the mark into its prior calculations, recompute the average valuation and restate performance as appropriate.
  2. Ask whether the mark is correct. However, the fund cannot ask the supplier of the late mark to reconsider its value; it can only ask the other independent counterparties whether the late mark is correct. These counterparties are free to reconsider their own prior value indications in light of the late mark.

Attachment 5

Laws and Regulations Governing Hedge Fund Disclosures to Investors

Hedge funds typically are not publicly traded securities and thus are not subject to certain laws that regulate public financial markets. Hedge funds are subject to the general anti-fraud principles embodied in state laws.

The principal laws governing public markets are the Securities Act of 1933 and the Securities Exchange Act of 1934. Both are federal laws passed in the wake of the 1929 stock market crash. The former lays out the requirements for companies to issue securities to the investing public (and lays out the process for private placements). The latter regulates the securities markets, broker dealers, and establishes the reporting requirements for public companies.

Section 10 of the 1934 Act requires companies to file quarterly and annual reports (10-K, 10-Q, 8-K) and establishes both civil and criminal penalties for making “materially misleading” statements in these reports. This statutory provision forms the basis for SEC Rule 10b-5 which prohibits not only misleading statements but also omissions of “material” information. This rule applies to the purchase or sale of public securities. Typically, public companies find themselves technically in the mode of continuously offering or purchasing their securities; this happens not only as a function of the occasional share or bond offering, but also as a result of employee stock option issuance/redemption, pension/benefit plan activities or share repurchase programs. When public companies find themselves in such mode, the public statements of virtually any officer or director can be considered relevant to an “offering” and subject to scrutiny for “materially misleading” statements or omissions. These stringent provisions do not presently apply to hedge funds.

Hedge funds are subject to the Investment Advisers Act (IAA) of 1940 if they have more than 15 investor clients. In 2006 the SEC adopted Rule 206 (4)-8 clarifying their authority to take enforcement action under this Act. The IAA essentially requires fund managers to provide basic investment strategy and performance information and establishes safeguards against insider dealing and conflicts of interest.

Hedge funds are also subject to the aforementioned SEC Rule 10b-5, but only as regards misrepresentation or failure to disclose material information when they are selling/purchasing securities. Thus, a hedge fund would be subject to SEC action should it make a material misstatement when reporting results in a document offering fund interests for sale, but would not be subject to a 10b-5 action when disclosing monthly or annual performance results to its investors.

The SEC sought to establish enforcement authority over routine hedge fund reporting when it issued Rule 206 (4)-8. The strength of the SEC’s position here is unclear. An earlier SEC rule requiring hedge fund registration and establishing anti-fraud safeguards was overturned by a District of Columbia Circuit Court of Appeals in 2006.

Author’s Note

This case introduces students to hedge funds, one of the major growth sectors on Wall Street. It also shows how acute risk taking, compliance/controls issues, and disclosure questions are never far removed from Wall Street’s periodic disasters.

Ralph Cioffi and Matthew Tannin’s hedge funds are also “carry funds.” This means they borrow short-term money and invest in higher yielding long-term instruments. This structure is inherently risky. It amounts to a bet that short-term rates will remain lower than long rates and that financing can continually be rolled over. Such funds periodically become popular when fund managers perceive that the Federal Reserve will keep rates low. Managers are also attracted to carry funds when spreads between different classes of securities “widen out.” Both factors were at work here.

Students will now confront the problems Cioffi and Tannin faced in March 2007. For one, slipping market prices are causing the funds to lose money for the first time. Most of the declines are in subprime mortgage instruments. Cioffi and Tannin’s second problem involves their having been “less than forthcoming” about the extent of the funds’ subprime holdings. Hedge fund disclosure rules are not as clear as for public companies. Still, the fund managers face credibility issues with their investors and lenders. One lender, Barclays, controls a vital line of credit. Barclays is now pressing for more information. What should Cioffi and Tannin say in response? Finally, the two funds are associated with BASM. In theory, the funds should be able to look to Bear Stearns for emergency support. Unfortunately, they have been “cut off” due to repeated failures to comply with control practices.

The two funds could be facing a quick death. This type of fund is not supposed to lose money. Should investors and lenders conclude it is likely to do so, the investors will “cash out” while lenders will not roll over their loans. Cioffi and Tannin could quickly face redemption demands they don’t have cash to meet. Students, confronting this potential, must try to find a way to reassure investors, persuade Barclays to maintain its credit line, and accomplish these things while “coming clean” about the funds’ subprime exposure. Finding a way to get Bear Stearns back in the game may prove critical.

This case is based on House of Cards, William D. Cohan’s excellent account of the Bear Stearns demise. Bear Stearns was the first banking failure of the financial crisis, falling into J.P. Morgan’s hands for a fire-sale price in March 2008. Cohan thus had a head start on other analysts of the crisis; his book came out in 2009. Subsequent accounts have corroborated his story.

The failure of Bear Stearns’ funds has since been called the financial crisis’ “canary in the mine.” It was the event that alerted investors to subprime’s risks; it also fed mistrust among debtors and creditors. From the Funds’ liquidation in July 2007 to Lehman’s bankruptcy in September 2008, the story unfolds like a slow motion train wreck. This case gives students the opportunity to rewind the story to the previous March and see if a more ethical path to a better outcome was available.

Notes

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