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Bear Stearns Hedge Funds

The news only appears to be getting worse for Bear Stearns and investors in its two failed hedge funds, the High-Grade Structured Credit Strategies Enhanced Leverage Fund (the "Enhanced Fund";) and the High-Grade Structured Credit Fund (the "High-Grade Fund").

Last May, when investors tried to get out of the funds after learning that losses far exceeded the amounts that had been reported earlier, Bear Stearns abruptly halted redemptions. In June, Bear Stearns told clients that the High-Grade fund was down 91% and the Enhanced Fund also had suffered a sharp decline. Two months later, in a July letter to investors, Bear Stearns acknowledged that "there is effectively no value left" in the Enhanced Fund and "very little value left" in the High-Grade Fund. Much to their dismay, investors learned that the two funds — which had an estimated aggregate value of $1.5 billion at the end of 2006 — were essentially worthless.

Industry observers blamed the demise of Bear Stearns' once high-flying hedge funds on the subprime mortgage crisis that began last spring. The firm's letter to investors stated that "unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities," contributed to the funds' devastating losses. Another reason for the funds' failure, however, appears to be their large investments in risky mortgages and the collapse of the market for collateralized debt obligations, or CDOs.

Massachusetts securities regulators are now investigating charges that Bear Stearns engaged in improper trading in the funds and, in so doing, caused investors to incur additional losses. The regulators are examining whether Bear Stearns traded mortgage-backed securities for its own account with the two hedge funds without first notifying the funds' independent directors. Federal securities law requires that any investment adviser whose affiliates engage in principal trading with clients must obtain their written consent in advance. Investment companies have long recognized the importance of giving advance disclosure of principal trades so that, from the fund's perspective, it has assurances of fair dealing. If the investigation reveals that Bear Stearns failed to give this proper disclosure and engaged in conflicted trading, the funds may be accused of breaching their fiduciary duty to investors.

Federal prosecutors and the Securities and Exchange Commission are conducting their own investigations of the Enhanced Fund and High-Grade Fund, focusing on the circumstances that led to their implosion.

The intense scrutiny the funds now face may be only the beginning of legal problems for Bear Stearns. A recent Business Week analysis (October 22, 2007) reveals that the funds were "virtually guaranteed to implode if market conditions turned south," as they did earlier this year. The funds not only used enormous amounts of leverage, or borrowed money, they also relied on accounting practices that allowed them to base the value of securities in their portfolios on "fair value," or estimated value, rather than the true market price. Because the value of the assets on which the funds' returns were based was arguably questionable at best, the high returns the funds initially earned were bound to plummet as defaults on subprime mortgage loans increased.

For example, although 25% of the High-Grade Fund's assets were based on "fair value" in 2004, two years later over 70% of its assets — $616 million — were calculated on this basis. For the Enhanced Fund, 63% of its assets in 2006 — $589 million — were "fair valued." Prior to their July bankruptcies, more than 60% percent of the two funds' net worth consisted of complex exotic securities calculated on a "fair value" basis. These securities were so obscure that even veterans in the bond industry had no luck in locating them in market registries. In a note to the Enhanced Fund's 2006 financial statements, Deloitte & Touche, the funds' auditor, warned investors that the majority of the fund's net assets had been estimated by its own managers. Bear Stearns did not release the 2006 audited financials until mid-May 2007, however, only two weeks before the firm suspended redemptions in the Enhanced Fund. Many investors claim that they never received the Deloitte report.

Also according to Business Week, the High-Grade Fund and Enhanced Fund had an unusual arrangement with Barclays Bank, an arrangement that not only ran counter to the interests of other investors, but also gave the giant British bank an enormous amount of control over the funds. In exchange for Barclays providing approximately $275 million in capital to help launch the Enhanced Fund in August 2006, Bear Stearns designated Barclays as the fund's sole equity investor. Other investors in the fund merely held a stake in a complicated derivative contract that mimicked the fund's gains or losses, but conferred no actual ownership rights.

In other words, Barclays had the power to withdraw its ownership interest and potentially shut down the Enhanced Fund. Because the High-Grade Fund invested in similar securities as the Enhanced Fund, had Barclays chosen to pull out of the Enhanced Fund, it would also have endangered the High-Grade Fund. For example, if the Enhanced Fund started selling its holdings to pay back Barclays, prices of securities in the High-Grade Fund would fall. The inevitable cascading effect would almost certainly result in the collapse of both funds. Indeed, that is almost exactly what happened in July of this year. Shortly after Barclays redeemed its ownership stake in the Enhanced Fund, Bear Stearns had little choice but to seek bankruptcy protection for the fund.

The Enhanced Fund's offering memorandum included an oblique mention of the fact that Barclays' interests “might conflict” with those of other shareholders. Most investors, however, were probably either unaware of the arrangement or did not understand its dire implications. Since a more detailed factual disclosure of the Barclays deal may have dissuaded some investors from investing in the fund, Bear Stearns had little incentive to elaborate on the arrangement.

Simply stated, documents uncovered by Business Week reveal that Bear Stearns took investors' money, leveraged it to the hilt and then bought CDOs backed by risky subprime and other mortgages. As yields on the bonds declined, the funds had to buy more and more of them in order to boost their returns. In order to pay for the bonds, the funds had to increase their borrowing. In some cases, fund managers bought $60 worth of securities for every $1 of investors' money. They obtained lower interest rates, but at a high cost: they gave lenders the right to demand immediate repayment. The excessive borrowing also made the funds vulnerable to margin calls from investment banks.

Perhaps most disturbing is the Business Week finding that the fund managers never had an alternative plan to survive a downturn in the mortgage-backed securities market. Instead, even as the subprime meltdown was painfully apparent, fund managers continued to insist that the funds were not overly exposed to risky mortgages but were solid investments.

Equally troubling is the fact that while the offering memoranda for the two funds included the usual boiler-plate statements about how investors could lose their investment, Bear Stearns marketed the funds in such a way that these and other risks were typically minimized. For example, the High-Grade Fund was sold as a "conservative" hedge fund whose portfolio included "high-grade" securities, managed by recognized experts in mortgage-backed securities. In addition to attracting wealthy individuals, pension funds and other non-profit entities as investors, smaller investors — many of whom were retired — seeking a safe yet profitable investment, also invested in the High-Grade Fund. In fact, Bear Stearns directly targeted smaller investors for the High-Grade Fund when it reduced the $1 million required investment to $250,000 during a "window" in 2006. Needless to say, investors in both funds now feel betrayed.

The High-Grade Fund and the Enhanced Fund generated enormous profits for Bear Stearns Asset Management, the Bear Stearns affiliate that managed the funds. Indeed, according to Business Week, the High-Grade Fund accounted for approximately 75% of that affiliate's revenue in 2004 and 2005. Investors, however, were not so fortunate. Losses to investors in the two Bear Stearns funds are estimated to exceed $1.6 billion.


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