A Report on Two of Bear Stearns' Failed Hedge Funds
It's only getting worse for investors in two failed Bear Stearns 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, investors tried to exit the funds upon learning that losses far exceeded what they had been told earlier. Bear Stearns cut them off, abruptly halting redemptions. In June, Bear Stearns disclosed to clients that the High-Grade fund was down 91% and the Enhanced Fund had suffered a sharp decline. Then, in a July letter to investors, Bear Stearns stated that “there is effectively no value left” in the Enhanced Fund and “very little value left” in the High-Grade Fund. The two funds — which had had an estimated value of $1.5 billion at the end of 2006 — were essentially worthless.
Wall Street pundits blamed Bear Stearns' hedge fund demise on the subprime mortgage crisis. The letter to investors called “unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities,” the reason for the funds' failures. The real, unvarnished truth is that the funds' devastating losses are due to Bear Stearns' large investments in particularly risky mortgages, and the collapse of the market for CDOs.
Massachusetts securities regulators believe that Bear Stearns may have engaged in improper trading in the funds, causing investors to incur bigger losses. They wonder 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 stipulates that any investment adviser affiliates who engage in principal trading with clients must obtain the client's written consent in advance. If regulators find that Bear Stearns failed to give proper disclosure and/or engaged in conflicted trading, the funds may be accused of breaching their fiduciary duty.
Federal prosecutors and the Securities and Exchange Commission are conducting their own investigations of the circumstances that led to the implosion of the Enhanced and High-Grade funds.
This could be only the beginning of legal problems for Bear Stearns. The funds in question not only used enormous amounts of leverage, or borrowed money. They also relied on accounting practices that valued the securities in their portfolios based on “fair value,” or estimated value, rather than the true market price. The funds' initial high returns were based on asset values that were, arguably questionable at best, and were bound to plummet as defaults on subprime mortgage loans increased.
Before the funds went bakrupt in July, more than 60% percent of their net worth consisted of complex exotic securities calculated on a “fair value” basis. These securities were so arcane and obscure that even bond industry veterans couldn't find them in market registries. In a note to the Enhanced Fund's 2006 financial statements, Deloitte & Touche, the funds' auditor, warned that the majority of the fund's net assets had been estimated by its own managers. Some investors claim that they never received the Deloitte report: it was quietly released just two weeks the firm suspended redemptions in the Enhanced Fund.
Moreover, the High-Grade Fund and Enhanced Fund had an odd arrangement with Barclays Bank. In exchange for Barclays capitalizing the Enhanced Fund with $275 million at its launch, Bear Stearns designated Barclays as the fund's sole equity investor. Basically, Barclays had the power to withdraw its ownership interest and conceivably 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. The resulting cascading effect would almost certainly result in the collapse of both funds. And that is almost exactly what happened in July of this year. Barclays redeemed its ownership stake in the Enhanced Fund, and Bear Stearns had little choice but to declare the fund bankrupt.
The Enhanced Fund's offering memorandum mentioned that Barclays' interests “might conflict” with those of other shareholders. Most investors were probably unaware of the arrangement or did not understand its dire implications.
In short, documents uncovered by Business Week have shown that Bear Stearns took investors' money, leveraged it to the hilt and then bought CDOs backed by risky subprime and other mortgages. As bond yields declined, the funds had to buy more and more of them — using borrowed money — to boost returns. At times fund managers bought $60 worth of securities for every $1 of investors' money. They paid low interest rates, but at a dangerous cost: they gave lenders the right to demand immediate repayment. Excessive borrowing also made the funds vulnerable to margin calls.
The High-Grade Fund and the Enhanced Fund generated staggering profits for Bear Stearns Asset Management, the Bear Stearns affiliate that managed the funds. Business Week reported that 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.
We'll keep you posted.
In the summer of 2007, our group, who individually and collectively have extensive experience in representing investors against Wall Street, formed an affiliation. Our affiliation of lawyers is actively involved in advising individual and institutional investors in evaluating their legal options when confronted with subprime and other mortgage related investment losses. Contact us.
Top
Selection of Counsel
Is an important decision that should be made with great care. Review our credentials; contact us to discuss your case.
Contact our Lawyers
All fields required.
