1.) Investment Strategies:
The investment strategy of the High Grade Structured Credit Strategies Master Fund was to raise capital from investors and that capital was used to buy “collateralized debt obligations” backed by highly rated subprime mortgage back securities. These CDO’s had a higher rate than that of their borrowing rate, thus, they had added to their expected return by levering more and then buying more CDO’s. To hedge some of the risk of the underlying asset, they bought credit default swaps. If the underlying exposure had a deficit, the swap would offset the loss with a gain. These CDS’s provided some protection against any movements in the credit market (Bear Stearns and the Seeds of its Demise, 2008). The investment strategy of the High Grade Structured Credit Strategies Enhanced Master Fund was essentially the same as the one above; however, there was a greater investment into low-risk securities. Thus, increasing the amount of leverage to enable this additional investment. This investment would then create a higher return, but with limited risk (Bear Stearns and the Seeds of its Demise, 2008).
2.) Profits 2003-2007:
The profits of these funds from 2003-2007 are shown in the table below. There was a significant decrease in the yields from 2003-2007 because of the collapse of the funds.
3.) Success to Collapse:
The investment strategy was very successful in its early periods because the housing market was very active. Low interest rates allowed an influx of borrowing and higher house prices. This created the need for an investment that could produce a substantial yield and was a “safe” investment. This was produced with AAA-rated mortgage backed securities. These factors made it possible for cumulative returns to be about 50% until 2007 (Bear Stearns and the Seeds of its Demise, 2008). In 2007, the hedge funds started to collapse. This collapse was originated by several factors, one of which being the housing market began to decline. The banks did not monitor their loans because they had little stake in them after they were securitized. This also led to the banks more hastily approving loans. This created a surplus of bank lending and the only safety net of these loans was the thought that when house prices rose, the lender could refinance (Bear Stearns and the Seeds of its Demise, 2008).
Another factor was the rating agencies. These agencies charged up to .12% of the value of the issue for their services to rate the CDO’s. The percentage that the rating agencies obtained from rating the CDO’s, generated an increase in their revenues. This high fee was warranted because CDO’s were more intricate than say rating a bond. In addition, upon rating these CDO’s, the agency did not look at the “credit quality of the assets” in the CDO. Thus, they had no factual knowledge of the accuracy of the application information or who could actually pay back the loans. Not only did these agencies play a role rating the finished product, but also how to package the CDO’s themselves. They advised CDO issuers of where each level of tranche should be (Bear Stearns and the Seeds of its Demise, 2008). Correspondingly, the testing of the CDO’s using the Monte Carlo simulations proved highly inaccurate. Assumptions that were made for this analysis were erroneous, thus leading to a false positive on the CDO’s. The rating given to the CDO’s were not accurate either. The agencies failed to properly adjust the rating for their higher default rate compared to bonds.
This gave the appearance of a safer asset than actuality (Bear Stearns and the Seeds of its Demise, 2008). An additional factor was to borrow short-term assets while investing in long-term assets. This created a maturity mismatch, which leads to liquidity risk. The banks relied on shorter term lending such as repurchase agreements. These agreements created short-term funds that would then need to be paid back later. These funds were continually rolled over and in the long run created a huge amount of illiquidity (Bear Stearns and the Seeds of its Demise, 2008). Also contributing to the liquidity risk, were the Credit Default Swaps. These swaps created protection against default. The problem was encountered when the CDS amounts were more than the company’s bonds or collateral value. Thus, in the event of a default, CDS sellers would have a huge loss. These losses made it difficult for funds to be collected from the sellers and the purchasers were not being paid. The creditworthiness of the sellers were also in question, leading to purchasers needing to increase their capital or reduce their exposure (Bear Stearns and the Seeds of its Demise, 2008).
4.) Addressing the Problem:
In light of the collapse of the hedge funds, Bear Stearns’ problems were very serious. If they were not able to raise capital, they could face bankruptcy like Lehman Brothers. Management did not take many steps to address the problems. Instead, they made the problems worse by appearing to ignore the crisis and continue business as normal. They did not want to scare investors, lenders, and clients away, fearing that they would want to take their money back. Therefore, they made a few in house decisions, by switching management and going about business as usual. They continued to tell the investors that their assets, liquidity, and capital were remaining strong when they were failing. They were being greedy and wanted to try to fix the issue by hopefully continuing to borrow money and selling CDOs.
5.) Alternative Steps:
Bear Stearns had created their own problem when they did not properly gauge the risks associated with their hedge funds. From there the collapse of the hedge funds happened and all they needed to do whatever they could to keep any consumer confidence they could. I think internally Bear Stearns had a toxic environment with people that did not take proper precautions; became reckless and greedy. In the beginning, it seemed they did not take things serious enough and that led to larger problems. Bear Stearns needed to greatly increase their capital. In order to regain public confidence, they needed to show they could overcome this setback and it would not be the demise of the firm. They also needed greater diversification and not to have had so much capital invested in a certain area. More due diligence and increased awareness of what could happen in the worst-case scenario with proper assumptions would have helped them. Another step was that they needed a backup liquidity plan. This plan needed to be of scale as well, in prospective of all of the short-term borrowings they had. These short-term repos also needed to be scaled back as well. They needed to cut back on short-term borrowing and increase their long-term borrowing. Increase the duration of their assets by selling short-term assets and buying long-term assets.
6.) Commonality of Collapse:
The reason for the collapse was not unique to Bear Stearns. “Nearly every large firm on Wall Street with a significant capital markets business – Lehman Brothers, Merrill Lynch, Goldman Sachs and Morgan Stanley to name several – have been damaged by the still-unfolding crisis.”(Cohan, 2009) Because the defaults on subprime mortgages have become very high, the mortgage-backed securities that were linked to them were now considered toxic assets. Many of these firms failed because investors and lenders became skeptical on the worth of their assets. Expectantly, the markets further declined after the collapse of the Bear Stearns funds. The number and size of mortgaged-related losses affected the liquidity of certain securities and also an uncertainty in value.
7.) Accountability for Turmoil:
Many things and people accounted for the financial crisis in 2007. Going back to the beginning, housing prices increased and the banks lent to inadequate borrowers. The housing prices proceeded to decline and the sub-prime mortgage market looked to be suffering major losses. Another contributing factor was shadow banks. These banks grew, in large part because of the credit boom and the increase of securitizations. These shadow banks led to systemic vulnerabilities with emphasis on short-term debt. The money markets that these short-term debts were coming from were not regulated and they were growing enormously. The demand for institutional cash pools’ were greater than the “amount of short-term government guaranteed instruments.” This supply and demand inequality allowed these shadow banks to enter and provide the CDO’s. Asset Backed Commercial Paper also played a heavy role in the financial crisis when that market fell. This led to Money Market Fund problems (Gorton & Metrick, 2012). This short-term debt problem led to foreign market distress as well.
There was a U.S. dollar shortage in the global markets; this affected the foreign currency swap market. Consequently, all of these factors led to a complete loss of public confidence, and the final straw was when Lehman Brothers went bankrupt (Gorton & Metrick, 2012). The contributing factors most responsible for the situation were the housing and credit booms. However, because these are factors that are not directly controllable by humans, they cannot be to blame. It was the actions of the people that made these booms get out of control that led to a financial crisis. The increase in housing prices led to an increase in borrowing. This increase in borrowing led to the bank being less accountable for their screening process and lending to unqualified borrowers. This, then, was the catalyst for the onslaught of the sub-prime mortgage debacle.
8.) Implications for Future:
There are many implications of failure of independent investment banks, such as Bear Stearns, for the future business model of banking. First, investment banks did not realize the items on their balance sheet and specifically weed out toxic assets. Many of the independent investment banks, such as Bear Stearns, toxic assets were mortgage-related assets. Since the mortgage market was failing, there were no wiling investors or buyers of these assets. However, in order to keep investor confidence levels stable, Bear Stearns informed the public that their balance sheet, liquidity, and capital were remaining strong. This misleading information only dug them into a deeper hole, which I would consider greed. Instead of trying to fix the issue, they wanted to have their cake and eat it too. Another issue is the regulation on investment banks. The SEC supervises large investment banks, however, they could not force them to report their capital, maintain liquidity, or submit leverage requirements. There was not enough supervision on the investment banks, which also led to their failure.
The management did not have much experience in risk management, or many other areas of investment banking, at Bear Stearns, however, there was no action taken against it. For the future business model of banking, banks need to “address their balance sheet problems quicker, in order to stabilize their liquidity and capital strategies, and emerge from a crisis in the strongest position.”(Gray,2009) They have to provide clarity about their toxic and non-toxic assets to investors and lenders, in order to build market and investor confidence. Also, the regulation on independent investment companies will become a lot stricter and that will help prevent failures. Management of these companies will also have to be qualified to handle risks and other common issues of the banking industry.
Bear Stearns and the Seeds of its Demise, UV1064 (October 22, 2008). Retrieved from https://cb.hbsp.harvard.edu/cbmp/content/26588959 Gorton, G., & Metrick, A. (2012). Getting up to Speed on the Financial Crisis: A One‐Weekend‐Reader’s Guide. Retrieved from https://moodle.oakland.edu/pluginfile.php/2286770/mod_resource/content/1/Yale-GortonMetrick12.pdf Cohan, W. (2009). Inside the Bear Stearns Boiler Room. Retrieved from: http://money.cnn.com/2009/03/02/magazines/fortune/cohan_houseofcards_full.fortune/ Gray, A. (2009). The Future of Banking. Retrieved from: