What forces contributed to the collapse of the two hedge funds? What explains the rapidity of the decline in the hedge funds’ performance? Were the reasons unique to Bear S

UV1064 Oct. 22, 2008

This case was prepared by Susan Chaplinsky, Professor of Business Administration. It was written as a basis for class discussion rather than to illustrate effective or ineffective handling of an administrative situation. Copyright  2008 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to [email protected]. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation.

BEAR STEARNS AND THE SEEDS OF ITS DEMISE

“I just simply have not been able to come up with anything, even with the benefit of hindsight, that would have made a difference.”

—Alan D. Schwartz1

John Corso hung up the phone on January 15, 2008. He had been talking with Michael Minikes, a senior executive at Bear Stearns (Bear). This was Minikes’s second call in a matter of weeks. The first call had come in late December, shortly after Bear had disclosed a $1.9 billion write-off of bad loans. This time, Minikes had wanted to discuss Alan Schwartz’s promotion to CEO following James E. “Jimmy” Cayne’s resignation the previous week. Minikes reassured him that the firm was in good hands and was expecting better results this quarter. Corso understood the subtext of the call. During the past year, Bear had experienced a series of wounds—some self-inflicted and some not—and rumors persisted about the firm’s ability to survive the current credit crisis because of its large exposure to mortgage-backed securities. Corso was the manager of an $800 million hedge fund that held its brokerage account at Bear.2 Though he himself had little exposure to the mortgage market, his long–short fund kept sizable cash balances at the firm. Corso had a longstanding relationship with Cayne and Bear going back many years. When certain regulatory issues had been raised about his fund in 2001, Bear had stood by him. Loyalty and admiration for Bear’s grittiness had kept him a client so far. But with mounting pressures on the firm, he wondered if now might not be the time to move his business from Bear. History of Bear Stearns The Bear Stearns Companies Inc. was a publicly listed holding company that, through its subsidiaries, was principally engaged in investment banking, sales and trading, and asset

1 Senate Banking Committee, Testimony by Alan D. Schwartz, April 3, 2008. 2 As of November 30, 2007, Bear held approximately $86 billion in customer margin and $88 billion in

customer short balances in its prime brokerage business.

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management. In 2007, it was the fifth-largest U.S. investment bank with nearly $400 billion in assets and more than 14,000 employees worldwide. That represented astonishing growth, relative to the $500,000 in capital that Joseph Bear, Robert Stearns, and Harold Mayer had founded the firm with in 1923. The young Bear Stearns prospered in the fast-paced markets of the Roaring Twenties—it began trading in government securities and soon became a leader in this area. Throughout its history, Bear developed a culture of risk-taking that grew out of its trading operations. Over the years, Bear’s top management rose from the trading floor. In 1933, Salim L. “Cy” Lewis, a former runner for Salomon Brothers, was hired to direct Bear’s new institutional bond trading department. Lewis, who later became chairman, built Bear into a large, influential firm. Alan “Ace” Greenberg, who succeeded Lewis as chairman, started as a clerk at the firm in 1949, at age 21. He moved up rapidly within the company; by 1953, he was running the risk arbitrage desk, and by 1957, he was trading for the firm. When he became chairman in 1978, Greenberg had earned a reputation as one of the shrewdest traders on Wall Street.3

More than anyone, Greenberg defined and shaped the persona of Bear through the traders

he hired. He shunned the “frat boys” from the best families and schools that other top Wall Street firms stocked up on in favor of the “bridge and tunnel” crowd.

The Bear, as old-timers still called it, cared about one thing and one thing only: making money. Brooklyn, Queens, or Poughkeepsie; City College, Hofstra, or Ohio State; Jew or Gentile—it didn’t matter where you came from; if you could make money on the trading floor, Bear Stearns was the place for you.4

Bear was where Kohlberg met Kravis and Roberts and where Sandy Weill started after graduating college. Greenberg coined a name for his hires: PSDs, for poor, smart, and a deep desire to get rich.

Greenberg’s protégé, Jimmy Cayne, took over as Bear’s CEO in 1993, while Greenberg

retained the title of chairman. In contrast to Greenberg, whose executive style was known to be impulsive, Cayne took a more cautious approach and avoided big risks. Together, Cayne and Greenberg were thought to make a powerful and well-balanced team. Yet Cayne remained the quintessential PSD. He was a cigar-chomping kid from Chicago’s South Side, who in his early years sold scrap metal for his father-in-law. After a divorce, he found himself driving a taxi while pursuing his beloved pastime, playing bridge. It was at a bridge table where Greenberg met Cayne and famously told him, “If you can sell scrap metal, you can sell bonds.”5 Cayne found his calling on the trading floor, moving huge amounts of New York City municipal bonds during the city’s financial crisis of the 1970s. He became the embodiment of Bear, a go-it-alone maverick, impervious to what Wall Street thought—so long as Bear made money.

3 “Bear Stearns Companies, Inc.,” FundingUniverse.com, http://www.fundinguniverse.com/company-histories/

Bear-Stearns-Companies-Inc-Company-History.html (accessed September 29, 2008). 4 Bryan Burrough, “Bringing Down Bear Stearns,” Vanity Fair (August 2008). 5 Burrough.

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The last member of Bear’s management team, Alan Schwartz, was the exception. Schwartz was a member of Duke’s varsity baseball team and a top student. After an injury to his arm, he turned from baseball to investment banking and joined Bear’s research department in 1976. His background was not in trading, but in corporate finance, especially in acquisitions of media and entertainment companies. He became head of investment banking in 1985 and then copresident in 2001. Unlike his rough-around-the-edges predecessors, Schwartz was described as a “smooth operator.” When advising Michael Eisner on Disney’s acquisition of Capital Cities/ABC, Inc., in 1996, he told him, “Stay cool. Stay calm. Don’t overreact.”6 Bear Stearns’s Asset Management: Hedge Funds

During the booming 1990s, when most of Wall Street grew rich trading stocks, Cayne

kept Bear focused primarily on bonds and trading. Eventually Bear, like most on Wall Street, branched into asset management. Bear Stearns Asset Management (BSAM) provided asset management services to institutional clients and high-net-worth individuals across all major asset classes including money markets, fixed income, currencies, and equities. BSAM also provided investment services to the company’s proprietary and third-party hedge funds. Unlike some firms, Bear promoted its own traders rather than outsiders to run BSAM’s funds, and each fund specialized in a specific type of security rather than a diversified mix of securities.

In 2003, Bear tapped Ralph Cioffi to run one of its new hedge funds, the High-Grade Structured Credit Strategies Master Fund (“High-Grade”). Until the events of 2007, Cioffi was a Bear star. He graduated in 1978 with a business degree from Vermont’s Saint Michael’s College and joined the firm in 1985 as a bond salesman. By 1989, he was head of the Fixed Income sales group. At that point, he considered leaving to launch his own hedge fund, but the firm convinced him to stay and lead the firm’s charge into structured finance.7

The fund may have touted its sophisticated investment strategies, but in truth its strategy

was simple and formulaic in nature: Step 1: The High-Grade fund raised capital from investors and used it to buy collateralized debt obligations (CDOs) which were backed by AAA-rated subprime, mortgage-backed securities (MBSs).

Step 2: Through the use of leverage, the fund bought more CDOs than it could have with its own capital. Because CDOs paid an interest rate higher than the cost of borrowing, every incremental unit of leverage added to the fund’s total expected return.

Step 3: The fund purchased credit default swaps (CDSs) as insurance against movements in the credit market because the use of leverage increased the fund’s

6 “You Can Just Call Alan D. Schwartz ‘Mr. Smooth,’” New York Magazine online Daily Intel, January 9, 2008,

http://nymag.com/daily/intel/2008/01/you_can_just_call_alan_d_schwa.html (accessed September 29, 2008). 7 Matthew Goldstein and David Henry, “Bear Stearns’ Bad Bet,” BusinessWeek (October 11, 2007).

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overall risk. CDSs were expected to pay off when credit concerns caused the bonds’ value to fall, effectively hedging some of the risk of falling collateral values. Due to the high rates of return possible on AAA-rated subprime MBSs, after deducting

the cost of the debt to purchase the subprime MBSs and the cost of credit insurance, the fund was left with a positive rate of return, or “positive carry” as it was termed in the hedge fund industry.8

The High-Grade fund was marketed to investors as a “conservative” investment because

its portfolio included low-risk, high-rated securities, and it was managed by experts in mortgage- backed securities. It attracted wealthy individuals, pension funds, and other entities that sought a safe yet profitable investment. These investors were motivated, especially in 2003 and 2004, by a search for yield due to historically low interest rates (Exhibit 1). In the aftermath of September 11, 2001, the U.S. Federal Reserve had moved aggressively to cut interest rates to stave off a recession. During 2003, interest rates declined to 1%, implying near-zero or negative real rates of interest. This low interest rate environment spurred increases in mortgage refinancing, new mortgages, and substantial increases in house prices. With house prices increasing, mortgage- backed securities seemingly offered both safety and yield.

For most of its existence, the High-Grade fund was profitable, posting positive gains in

every month and a cumulative return of nearly 50% through January 2007. But as the housing market began to cool in 2006, its returns began to even out. In August 2006, Cioffi opened a second fund called the High-Grade Structured Credit Strategies Enhanced Master Fund (“Enhanced”). Investors were told that the Enhanced fund would generate greater profits than the High-Grade fund, but have only limited additional risk, in part because the fund would invest an even higher proportion of its assets in low-risk securities. The increased profits would result from greater use of leverage. The Roots of the Problem9

Over the past decade, the traditional business of banks—loan making—had undergone a major transformation. Banks that had once granted mortgages and loans and kept them on their books, in recent years, moved to an “originate and distribute” model in which banks granted mortgages and loans, repackaged them, and sold them to other financial investors. Investment banks had also transformed their businesses, moving away from advising and conducting fee- oriented transactions for clients to a greater focus on “principal transactions,” wherein their own or shareholders’ funds were invested in securities or other activities. Increasingly, investment

8 This example is drawn from information found in “Dissecting the Bear Stearns Hedge Fund Collapse,”

Investopedia.com, http://www.investopedia.com/articles/07/bear-stearns-collapse.asp (accessed September 29, 2008).

9 This section was developed from Markus Brunnermeier, “Deciphering the 2007–08 Liquidity and Credit Crisis,” Journal of Economic Perspectives (2008, forthcoming).

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banks’ profits and compensation were based on the results of these investments and their proprietary trading. Securitization

After originating a mortgage or loan, a bank could either keep it and insure itself by

buying a CDS or sell it outright. Instead of selling or protecting individual loans, banks typically first pooled the assets to create portfolios of mortgages, loans, corporate bonds, or other assets. These assets were typically transferred to a special purpose vehicle (SPV), whose function was to collect the principal and interest from the underlying assets and convey them to the holders of the structured products or asset backed securities (ABSs).

The formation of portfolios had two purposes. The pooling of assets helped to diversify

risk, and tranching (dividing the cash flows from the portfolios into separate claims) allowed securities to be tailored to meet the preferences of different investors. The safest tranche of a structured product paid a relatively low interest rate, because it was the first to be paid out of the cash flows to the SPV. The top tranche was also safer to the extent that the underlying assets were less correlated. Holders of the most junior tranche—or equity tranche—were paid only after all other tranches had been paid. The mezzanine tranches were in between. Because the senior tranches got paid first, the junior tranches of ABSs resembled a leveraged position in the underlying cash flows. The tranches were sold to pension funds, hedge funds, structured investment vehicles (SIVs), and other investors, while the equity tranche was usually (but not always) held by the issuing bank to ensure monitoring of the loans.

Asset-backed securities went by many names. CDOs were the most common form. Each

CDO consisted of several tranches of an underlying portfolio of debt, such as corporate bonds or mortgages.10 CDOs were typically floating-rate instruments benchmarked to LIBOR or U.S. Treasury rates to protect their value from changing interest rates. Almost all CDOs were sold as private placements, and therefore there was little transparency about their ongoing value. Exhibit 2 shows the growth in structured products by the type of collateral. CDO issue volume had grown from less than $25 billion annually when they were introduced in the mid-1990s, to more than half a trillion dollars annually in 2006 and 2007.

The main advantages of securitization were that it allowed risk to be shifted to those who could bear it most efficiently and it was spread widely among market participants. The main disadvantage of securitization was that the transfer of credit risk distanced the borrowers from the lenders. The banks’ incentive to carefully approve loan applications, and their incentive to monitor (and even to collect) the loans was weakened considerably. Because a substantial portion of credit risk was soon passed on to other financial institutions, banks held the full risk of the loans for only a few months. The reduced incentives to monitor, spurred by securitization, led

10 If the tranches were derived from a portfolio of loans, they were also referred to as collateralized loan

obligations (CLOs) and if from mortgages, they were called collateralized mortgage obligations (CMOs). CDOs of a pool of CDOs were referred to as “CDO squared.”

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to an erosion of lending standards and to excesses in lending. Mortgage brokers offered teaser rates, no-documentation mortgages, and NINJA (“no income, no job or assets”) loans. These mortgages were granted on the assumption that house prices would rise, making background checks unnecessary, since the lender could always refinance against the value of the house.

Subprime mortgages accounted for about 15% of all mortgages in 2001–2007.11 The

outstanding value of U.S. subprime mortgages was estimated at $1.3 trillion as of March 2007. Exhibit 3 shows the credit standards associated with subprime loans from 2001 to 2007 and Exhibit 4 shows their associated delinquency rates through May 2007. The delinquency rates of adjustable-rate subprime mortgages rose to 16% in October 2007 and 21% in January 2008.12 Exhibit 5 shows the trend in housing values from 1995 to 2007. Role of Rating Agencies

Structured products were attractive to investors who sought the safety of high ratings and took the ratings at face value. There were differences in the ratings of structured products and corporate bonds. First, while ratings agencies charged a fee to rate either a corporate bond or a structured product, the fees were generally three times higher for CDOs. To rate a CDO issue, Standard & Poor’s charged as much as 12 basis points of the total value of the issue compared with up to 4.25 basis points for a corporate bond rating. The rating agencies claimed the higher fees were justified because the structures of CDOs were more complex.13 Structured products were also an important contributor to the growth in revenues and earnings of the three major credit rating agencies, Moody’s, Standard & Poor’s, and Fitch.14

Second, rating agencies participated at every level of packaging a CDO. Issuers of CDOs

worked closely with rating agencies to determine the “tranching attachment points,” or rating cutoffs for the tranches. Unlike the passive process of rating corporate debt, rating agencies advised CDO assemblers how to maximize the size of the top (highest rated) tranches to garner the most profit from the CDO. CDO tranches were always sliced in such a way to just result in an AAA rating (“rating at the edge”).

Third, the rating agencies rated the structure of the CDO, but did not investigate the

underlying credit quality of the assets that made up the CDO. They did not, for example, have access to individual loan files or verify the information provided in loan applications. “We aren’t

11 Subprime mortgages were the lowest-quality loans and Alternative-A mortgages were granted to borrowers

who were not quite prime borrowers, but had better credit than subprime borrowers. Subprime borrowers were generally defined as individuals with limited income or having FICO credit scores below 620 on a scale that ranged from 300 to 850. “Hybrid” mortgages initially had fixed rates that later converted to adjustable rates. Common subprime hybrids included “2-28 loans,” which offered a low initial fixed interest rate for 2 years after which the loan reset to a higher adjustable rate for the remaining 28 years of the loan.

12 “U.S. Foreclosure Activity Increases 75 Percent in 2007,” realitytrac.com January 29, 2008. 13 Richard Tomlinson and David Evans, “The Ratings Charade,” Bloomberg.com, July 2007. 14 Moody’s reported revenue of $1.52 billion in 2006 for credit rating. Structured finance accounted for 44% of

the revenues, or $667 million, compared with $485 million from company credit ratings.

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loan officers,” said Claire Robinson, head of asset-backed finance for Moody’s. “Our expertise is as statisticians on an aggregate basis. We want to know, of 1,000 individuals, based on historical performance, what percent will pay their loans?”15

The credit agencies stress-tested the structure of CDOs using Monte Carlo simulations

that were based in part on past default history and lending practices. Several assumptions drove this analysis. First, real estate markets were thought to be largely uncorrelated across the country. That is, a national market did not exist for real estate and thus, loan defaults in California, for example, would be largely uncorrelated with loan defaults in New York. Second, defaults were predicted based on an analysis of past underwriting standards with respect to mortgage lending. To the extent that lending standards had become less stringent over time, the models would fail to anticipate the increase in default rates that might arise as a consequence of this.

Investment-grade CDOs typically returned 25% more than the average yield on a

similarly rated corporate bond.16 But the higher return on CDOs ultimately derived from riskier assets (subprime mortgages) that were structured to give the higher rating. Moody’s reported that Baa-rated corporate bonds had average five-year default rates of 2.2%, whereas Baa-rated CDOs had five-year default rates of 24%.17 The differences in default rates on instruments of the same rating clearly demonstrated that the ratings on CDOs were not comparable to corporate bonds. Yet few in the market appeared to appreciate the difference.

Mismatch in Maturity Structure Because investors generally preferred assets with shorter-term maturities, banks created

off-balance-sheet vehicles that shortened the maturity of long-term structured products. Most of these off-balance-sheet vehicles were in the form of conduits or structured investment vehicles (SIVs).18 The aim of SIVs was to generate a spread between the yield on the asset portfolio and the cost of funding by managing the credit, market, and liquidity risks. Moody’s reported as of September 2007 that the total nominal value of assets under SIV management was $400 billion. SIVs invested in illiquid long-maturity assets and financed them with asset-backed commercial paper (ABCP) or medium-term notes (MTN). These instruments had an average maturity that ranged from 90 days to just over one year. ABCP was backed by the underlying assets, allowing the owner to seize and sell the collateral asset in case of default. Due to the growth of these activities, ABCP became the most popular form of commercial paper as of 2006 (Exhibit 6).

15 Roger Lowenstein, “Triple-A Failure,” New York Times Magazine (April 27, 2008). 16 One reason for the higher yields on CDOs was that their collateral was just sufficient to achieve an AAA-

rating compared with corporate debt where the collateral frequently exceeded the minimum needed for that rating. 17 Tomlinson and Evans. 18 Another motivation for SIV structures was that moving loans into off-balance-sheet vehicles and granting a

credit line to ensure an AAA-rating allowed commercial banks to save on regulatory capital. The Basel I accord imposed an 8% capital charge on banks for holding loans on their balance sheets, whereas the capital charge for contractual credit lines was much lower (Brunnermeier, 2008).

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Along with the growth in SIVs, investment banks financed a larger portion of their balance sheets with short-term collateralized lending in the form of repurchase agreements, or “repos.” In a repo contract, a firm borrowed funds by selling a collateral asset today and promising to repurchase it at a later date. Importantly, the growth in repo financing as a fraction of investment banks’ total assets was mostly due to an increase in overnight repos. Almost 25% of total assets were financed by overnight repos in 2007, an increase from 12.5% in 2000. Investment banks’ increasing reliance on overnight financing required them to roll over a substantial amount of their funding on a daily basis.19

The trend to invest in long-term assets and borrow short-term increasingly exposed

financial institutions to liquidity risk, because the ABCP or repo market might suddenly dry up. Should this happen, banks would be forced to sell assets or draw on backup lines of credit (supplied by other financial institutions). The financial system therefore bore the liquidity risk of this maturity transformation. Moreover, because banks were large purchasers of structured products themselves, a substantial amount of credit risk never left the financial system.

Growth of Credit Default Swaps

A CDS was a contract between two counterparties, whereby the buyer made periodic

payments to the seller in exchange for the right to a payoff in case of default. A CDS was insurance that could be used by a debt holder to hedge or to protect against default.20 CDSs could be used to manage credit risk without necessitating the sale of the underlying bonds. But because there was no requirement to actually hold the bonds, a CDS could also be used to speculate. For example, if a company faced financial difficulty, the company’s bonds would likely trade at a discount, and $1 million in bonds might be purchased by an investor for $900,000. If the company was able to repay its debt, the investor would receive a $1 million and make a profit of $100,000. Alternatively, one could enter into a CDS with another investor by selling credit protection and receive a premium of $100,000. If the company did not default, the investor would make a $100,000 profit without having invested in anything.

A seller in a CDS effectively had an unfunded exposure to the underlying cash bond or

“reference entity,” (e.g., firm, SPV, SIV), with a value equal to the notional amount of the CDS contract. Like the bonds themselves, CDSs could be bought and sold. The cost to purchase the swap from another party fluctuated as the perceived credit quality of the underlying company changed. Swap prices typically declined when creditworthiness improved, and rose when it worsened.21 But these pricing differences were amplified in CDSs compared with bonds, making CDSs attractive to those wishing to speculate on changes in an entity’s credit quality.

19 Brunnermeier, 2008. 20 A CDS was an insurance product but was called a “swap” to avoid the regulation associated with insurance. 21 Suppose a company had CDSs currently trading at 250 basis points (premium). This implied that the cost to

insure $10 million of its debt was $250,000 per annum (face value × premium). If the same CDS was later trading at 300 basis points, it indicated that the market believed the company had greater risk of default on its obligations.

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In many instances, the amount of CDSs outstanding for an individual company greatly exceeded the bonds or underlying collateral value. A company could have, for example, $1 billion of debt outstanding and $10 billion of CDS contracts outstanding. If the company were to default, and the recovery rate was 40 cents on the dollar, then the loss to investors holding the bonds would be $600 million. But the loss to CDS sellers would be $6 billion. As CDSs were bought and sold, it became difficult for the original purchaser of the insurance to locate the party responsible to pay the insurance and therefore judge the creditworthiness of the counterparty (Exhibit 7). When concerns about the creditworthiness of CDS counterparties rose, purchasers who bought CDSs for insurance were forced to increase their capital or reduce their exposure to credit risk by other means.

Since 2001, the CDS market had experienced explosive growth—most of it occurring

after 2005—and by mid-2007, the total notional amount of CDSs outstanding was more than $45 trillion. That was roughly twice the size of the U.S. stock market (valued at $21.9 trillion) and far exceeded the $7.1 trillion mortgage market and $4.4 trill

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