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The much admired firm offered a wide range of successful financial services beyond just investment banking, including but not limited to wealth management and securities trading. In 2006, Bear Stearns hit record highs, claiming that net income had climbed 40 percent, to $2.05 billion), and revenue had risen 25 percent, to $9.23 billion.
But just a year later, revenue dropped to $5.95 billion. This dip and eventual freefall in 2008 was very much caused by securities trading, handled by Bear Stearns’ hedge fund division. JPMorgan Chase eventually bought and thus dissolved the company.
The Hedge Fund 2 and 20
A major reason for Bear Stearns collapse, as well as the mortgage crisis in general, was the ‘2 and 20.’
The 2 and 20 refers to the standard compensation structure for hedge fund managers: 2% of assets in management fees, and 20% in incentive fees on all profits. As a point of comparison, investment managers receive no cut of the profits.
The combination of the low management fees and high incentive fees motivates hedge fund managers to take big risks in order to generate as much profits as possible. That’s how they can maximize their 20% incentive fee. Their high-risk investment typically depends on leverage (using borrowed capital as a funding source) to generate adequate returns to justify the considerable fees involved in using hedge fund managers.
Leverage, all that capital Bear Stearns had borrowed, ended up bringing about its failure. Specifically, its hedge fund managers were using leverage to profit from collateralized debt obligations and other debt securities (more on this later).
Did you know AIG played a major role in the 2008 financial crisis?
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Bear Stearns’ Investment Strategy
The company’s investment strategy was neither cutting edge nor unique in the hedge fund world. In truth, it was simple enough to explain in a four-step process.
Collateralized Debt Obligation (CDO): Debts of varying types and risk levels (a.k.a. tranches) bundled into a single package and sold to investors.
Credit Default Swap (CDS): A financial swap agreement where the seller of the CDS compensates the buyer in the event of a debt default (failure by the borrower to mee the legal requirements and/or obligations of the loan).
Mortgage-backed Security (MBS): An investment comprised of a bundle of home loans issued by banks and offered to investors. Subprime loans: Loans offered to borrowers who cannot qualify for a conventional loan because they have low credit. These loans come with high interest rates and fees.
- Buy collateralized debt obligations (CDOs) that pay an interest rate exceeding the cost of borrowing. AAA-rated (the highest grade in credit rating) tranches of subprime mortgage-backed securities (MBS) were used.
- Use leverage to purchase more high-interest CDOs than you can afford with capital. The more leverage used, the greater the expected return from each trade. But also the more leverage used, the greater the risk for the investment portfolio.
- Purchase insurance in the form of credit default swaps (CDS) to protect against defaults in the credit market.
- Subtract the price of the leverage (or debt) and CDS from the returns or ‘positive carry.’ That’s the actual profit the hedge fund manager has made.
For this to work, credit markets must either remain quite stable or behave similarly to historical trends. This strategy produces consistent positive carry under these conditions. Of course, matters drastically and quickly changed when it came to the 2008 mortgage crisis.
The Collapse of Bear Stearns
The housing bubble burst, and the home loans included in these securities plummeted in value. That means, those high-risk investments were not generating profits, which in turn caused a run on the shadow banking system. Traders in Bear Stearns’ High-Grade Structured-Credit Strategies Fund and the Enhanced Leverage Fund, in other words, began redeeming their investments en masse.
From The New York Times
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