Bear Streans And The Seeds Of Its Dimise Case Solution

1. What was the investment strategy of Bear’s two hedge funds, the High Grade Structured Credit Strategies Master Fund (“High Grade”) and the High-Grade Credit Strategies Enhanced Master Fund (“Enhanced”)?

The formula behind ‘High grade’ hedge fund was quite simple and witty in nature. Capital raised by investors was used to buy collateralized debt obligations (CDOs) backed by subprime, mortgage-backed securities with high credit ranking AAA. Excess leverage on the investment was then used to buy more CDOs that could not have been bought by private capital. CDOs offered high interest rate compared to the cost of the capital and hence, every additional unit of leverage augmented to the expected return of the fund. To hedge the high risk associated with the investment, Credit Default Swaps (CDSs) were purchased as they were likely to pay off when credit market speculations resulted in reduced bond prices. Introduced in 2006, ‘Enhanced hedge’ fund was different in that it had a higher proportion of investment in those so called ‘low-risk’ securities. Therefore, they were marketed as a mean for earning high profits with a slightly high risk.

2. What was the carried interest rate of the funds in 2003-2007?

* The rate of return on Hedge funds was about 25% more than the corporate bond of similar rating

** Carried interest rate= return on hedge funds -debt on CDS

3. Why did the investment strategy succeed in its earlier periods? What courses contributed to the collapse of two hedge funds in 2007?

There were several reasons that made hedge funds a profitable option in early years. The funds were marketed as low risk and high return investment options and included securities that were given high credit rankings and, being managed by experts in the respective discipline. It attracted numerous wealthy investors especially in the period of year 2003 and 2004, when interest rate touched low values due to the central bank’s policy and investors were looking for some alternative lucrative investment options. As a result, vast increases were observed in mortgage refinancing, new mortgages and hence, drastic increase in housing prices. This phenomenon made these types of hedge funds safer and yielding high return. The consequence was nothing but more and more investments into this arena. However, the boom was quite short-lived. Problems began for both types of hedge funds when the market confidence began to shatter in late 2006. Banks lent exuberantly without setting any strict standards because they knew that these debts would be passed to other institutions soon, and they bore a few risks themselves. Such an approach resulted in excessive lending that was pretty unsafe and the chances of the repayments were minimal. Consequently, firms had to bear huge losses, and their earnings were compromised in an attempt to cover bad loans. Speculation of increasingly undocumented loans in the portfolios caused the prices of CDOs to fall immensely at the start of 2007. Initially, investment in ABX index absorbed the effect of fall of prices for the hedge funds, but things changed when ABX index also stabilized and offered no money to the company. Meanwhile, the company showed a decrease in its equity whereas, its investment in CDOs rose drastically in an attempt to address the issue. This trend made the company short on cash and liquidity and investors’ confidence began to decline. Investors attempted for redemptions of their investments and lenders wanted to repossess their collateral on their loans. All of these incidents forced Cioffi to file for bankruptcy for these funds.

4. In light of the collapsed hedge funds, how serious were the Bear Stern’s problems? What steps did management take to address the problem?

All incidents had hit the image of Bears Stearns quite badly. The credit crisis was still present in the market, and it was extremely difficult for the company to restore its old status. The liquidity was a major problem and, in an attempt to dampen the issue it increased the maturity of some of its financing by shifting to new long-term borrowing agreements. It was quite clear in the mind of management that it was completely inevitable to boast the confidence of investors of the company. In an effort in this regard, they held few presentation explaining the investors about the potential of the firm and how it managed to recover from most of its problems. They asserted that the reduction in interest rate by the federal government will help to eradicate the credit crisis. Company also laid-off about 300 employees to reduce its costs. However, the efforts seemed to fail as the company still held a huge investment of about $50 billion in mortgage-based securities. Moreover, the credibility of the management team also got compromised when certain stories regarding the lack of seriousness on their part were printed in the media.

5. Do you agree with Alan Schwartz that there was nothing Bear Stearns could have done differently to address the problems created by the collapse of two hedge funds? What other steps might have been taken by Bear’s Management in your opinion?

According to the company representative Schwartz, there was nothing much that could have been done to deal with the crisis company got attacked with in the year 2007. It was true that the crisis was quite immediate and depressing; a different attitude of the company might have helped to manage things in a better manner. One of possible strategy could have been a better team effort rather than just laying-off some of its old head who were more aware of the basic structure of the company. I believe that laying-off workers and management in a rush deteriorated the confidence of investors and clients further and, the alternative leadership failed to provide any radical steps for restoration. Company should also have tried to take all of its management along that was not the case especially, after the scandal of Cayne’s irresponsible approach to tackle the problem. Similarly, no breakthrough policy had been announced regarding the long-term debt and liquidity crisis when the news regarding the liquidity issues was proving lethal for the company. Rather, management chose for forging tactics like the announcement that no big positions are being held in long-term debts when the public already knew that the company owned about $50 billion in the mortgage related securities.