I’m a bit late to this article from Friday’s Financial Times, “Bear Stearns assured investors on leverage,” which gives some new information on the formation of the Enhanced Leverage Fund, the one that went into crisis first, and how it went pear shaped. Cioffi had the bad luck to not only have some trades fall in price, but also to have his hedge against them go the wrong way at the same time.
The piece also cleared up a point I (and perhaps my sources) got wrong. I was perplexed that the Enhanced Leverage Fund, the bigger fund with what was reportedly riskier assets, was allowed to fail (the smaller fund is being worked out). “Bigger” and “riskier assets” presumably mean greater losses to the lenders, and if the rest of Wall Street forced Bear to salvage the other fund, ti was a mystery to me why they wouldn’t be even more insistent with this one.
It turns out the Enhanced fund was riskier all right, but not by having riskier assets (in fact, it had higher quality assets) but by being more leveraged. Remember, that was the fund that scheduled an auction for $4 billion of its assets that went off well. Apparently the lenders thought it best just to take the whatever losses there were on the loans against the remaining assets and call it a day.
From the Financial Times:
Bear Stearns told potential investors in a now-stricken hedge fund that it could cope with even higher leverage because it put money into “high quality” assets – many of them hard-to-value structured products based on subprime mortgage bonds.
However, Bear also warned investors that taking on higher leverage could increase its volatility and brings with it “an additional risk element”.
That warning, in marketing material inviting investors to switch into a more highly-geared version of its High-Grade Structured Credit Strategies fund last year, proved prescient.
Bear last week agreed a $3.2bn bail-out of the older fund, and is negotiating with lenders who provided $7bn to the highly-geared High-Grade Structured Credit Strategies Enhanced Leveraged fund.
The prospect of forced sales of the rarely-traded collateralised debt obligations in which the Bear funds invested has unnerved the market and contributed to a re-evaluation of how bonds issued by CDOs, which invest in portfolios of other bonds, should be valued.
Ralph Cioffi, manager of the two Bear funds, invited investors last year to switch to the new Enhanced Leverage fund, saying in a letter: “Additional leverage brings with it additional risk, however we feel the form of leverage we are utilising will complement our current strategy.”
The new fund was created after Barclays Bank in London agreed to provide a financing facility of up to three times investor capital through an over-the-counter derivative, according to people familiar with the structure.
Bear trumpeted the borrowing facility when it was agreed last year, telling investors that it gave the fund more flexibility and was “better quality leverage” than previous funding.
Enhanced Leverage had attracted $638m from investors by the end of March, which it geared up more than 10 times using a mixture of repo financing and the Barclays facility, documents sent to investors show.
Barclays said its exposure was “not material”, and it is understood Bear did not draw down all the financing facility provided by the bank because it was cheaper to borrow through repos. According to documents Bear sent out in late May, Enhanced Leverage had $11.5bn invested in bonds and bank debt and short positions of $4.5bn via credit default swaps, primarily on the ABX index linked to bonds backed by subprime mortgages.
All of the long positions were in bonds and bank loans with AAA or AA credit ratings, which have first call on assets and are supposedly safe. But increased scrutiny by markets of the assets underlying CDOs led to a fall in the value of top-rated CDO bonds this year, hurting both the Bear funds in February.
The credit default swaps, a form of hedge, should have partially protected both funds against a fall in credit quality and so in the value of the bonds they had bought. However, in a note to investors Bear revealed the funds had been caught out in March when both the bonds and hedges worsened.
“The widening in [credit] spreads we experienced in February and March was the result of fear of an unprecedented increase in the cumulative losses these portfolios will suffer over time, not of an actual deterioration in credit on the underlying bonds in our portfolio,” Bear wrote in May.
At the same time, its hedges – bought in late 2006 using the ABX index of credit derivatives linked to subprime mortgage bonds – failed to perform as the ABX rallied after a sharp drop in February.
As a result, the 10-month old Enhanced Leverage fund then fell sharply. Its older sibling, which was less geared with 5.8 times leverage at the end of March, saw its first down month.
The older fund was the larger, with $925m from investors, but it also had a larger exposure to lower-rated bonds. It had $9.6bn invested in bonds at the end of March, with credit default swap hedges of $4bn.
The falls in March were reported in late May, when Bear also closed the funds to redemptions. Further falls in April and a mark down of previous valuations led to margin calls by banks owed money, which last week seized and began to sell assets before Bear agreed to the bail-out.
Bear has now said it will not rescue Enhanced Leverage. It did not reply to requests for comment on its warnings to investors.