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Business Finance: Investment Risk and Return September 11, 2009

Bear Sterns

Business Finance: Investment Risk and Return

Studying the collapse of Bear Ste arns

Companies, Inc.

Introduction

Hedge funds have played a significant part in the financial

markets in the recent decade. Armed mostly with funds

obtained from 99 investors (according to US regulations),

hedge funds have been known to use ever increasing

amounts of leverage to garner enough funds to overpower

the fundamental prices of securities and commodities. Worst

still is the involvement of hedge funds in derivatives which

Warren Buffett coined as the financial weapons of mass

destruction.1 However, it is not only derivatives like the

Collateral Debt Obligation (CDO) that investors must worry

about. In today’s highly complex financial market, investors

must never forget the basic principles of investment risk and

return and must learn of in some cases relearn to respect

risk.1 This research paper is therefore focused on the failure

and collapse of two hedge funds under Bear Sterns

investment bank whose reputation is now at stake in the

midst of the subprime crisis.

Working Paper

Sheffield Business

School

At Sheffield Hallam

University

Ee Suen Zheng

Bachelor of Arts with First Class

Honours in Banking and Finance

+603-9283 8950

+6016-696 6566

[email protected]

jamesesz.wordpress.com

Word Count: 3289 words

(excluding references and

appendix)


Bear Sterns

Contents

NO. Details Page Number

I. II. III. IV. V. VI. VII. VIII.

Introduction Summary Stand Alone Risks Risk In a Portfolio Context Capital Asset Pricing Model (CAPM) Risk and Return Recommendations Conclusion Bibliography Diagram 1 Diagram 2 Timeline Articles

1

2 – 4

5 – 8

9 – 11

12 – 14

15 – 16

17 - 19

20


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I.

Introduction

Hedge funds have played a significant part in the financial markets in the recent

decade. Armed mostly with funds obtained from 99 investors (according to US regulations),

hedge funds have been known to use ever increasing amounts of leverage to garner enough

funds to overpower the fundamental prices of securities and commodities. Worst still is the

involvement of hedge funds in derivatives which Warren Buffett coined as the financial

weapons of mass destruction.1 However, it is not only derivatives like the Collateral Debt

Obligation (CDO) that investors must worry about. In today‟s highly complex financial

market, investors must never forget the basic principles of investment risk and return and

must learn of in some cases relearn to respect risk.2 This research paper is therefore focused

on the failure and collapse of two hedge funds under Bear Sterns investment bank whose

reputation is now at stake in the midst of the subprime crisis.

1 http://news.bbc.co.uk/go/pr/fr/-/hi/business/2817995.stm 11/09/2007 6.00 PM 2 Jack D. Schwager, Market Wizards, 1989. New York Institute of Finance, United States of America.

http://news.bbc.co.uk/go/pr/fr/-/hi/business/2817995.stm


Bear Sterns

II.

Summary

Hedge fund are an alternative investment, that aims at reducing risks and offering

investors returns that can offset losses in their traditional investment portfolio. However, the

lack of transparency of hedge funds can result in a different outcome altogether. Many

individual investors did not seem to mind a lack of transparency by the hedge funds as long

as the fund was delivering high returns. The collapse of LTCM Long Term Capital

Management clearly shows us the need to further study the reason of hedge fund failures.

Ralph R. Cioffi, the 51-year-old manager of two Bear Stearns hedge funds (High

Grade fund and Enhanced fund) was going against the collapsing subprime mortgage crisis.

He made a statement to convince its investors that the hedge funds under his management are

going to make profit out of the market. Deloitte & Touche, a well-known accounting firm

who was the auditor for Bear Stearns‟s High Grade fund and Enhanced fund warned the

fund‟s investors about the poor performance of the funds. This was proven by showing that

more than 60% of Bear Stearns‟s net worth was tied up in securities, signaling a serious

illiquidity that would make the hedge funds fall into trap of severe financial condition.

As the subprime crisis worsens and recovery seems unlikely, credit risk increased and

the hedge fund‟s portfolio of security became extremely risky. If a firm owns securities that

fail to attract buyers during a time of market stress, the fund will have a significant liquidity

risk. (Keith H. Black, 2004, p67). This is made true when Bear Stearns was soon unable to

sell its securities which turned the funds into a disaster. Furthermore, the two hedge funds

were holding some additional lightly traded security. Selling these securities in one of the

hedge funds back into the market would drive down their prices sharply and in turn affect the

other hedge fund‟s net worth.


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In 2006, Cioffi‟s investment strategy started to increasingly use short term debts to

buy lightly traded bonds. Thus, higher borrowings lead to an extremely high gearing ratio,

approximately 1:60. In order to pave the way of getting loans at low interest rates, Cioffi had

made a critical trade-off by offering big lenders like Barclays (Barclays was the sole equity

investor) the right to demand immediate repayment. As the CDOs values dropped sharply and

lenders starting to demand repayment, the borrow-and-buy game was over. Contributing to

the hedge fund‟s downfall is also the fact that the emergency funds of the two Bear Stearns

hedge fund were only 1% of their assets.

Due to the correlation between the Enhance Fund and the High-Grade Fund as

mentioned above, if anything should happen to the Enhanced Fund, the High-Grade fund will

also be affected. This is because both funds were investing in similar underlying securities.

Thus, when Barclays demanded repayment of its funds from Bear Stearns, Enhanced Fund

started to dump its holdings to pay back Barclays and in turn caused the prices of the

securities in High-Grade fund to also fall sharply.

Furthermore, the High Grade funds became more risky as the Cioffi‟s management

team did not disclose the incident about Enhance leverage fund. Moreover, the funds also

grew at a less profitable rate since the Bear hedge funds were using extensive borrowings to

invest. To further add to their deceit, the securities in these two hedge funds were valued by

Cioffi‟s management team without following widely available market values. A hedge fund‟s

net asset value is its assets minus its liabilities. It is therefore critical to track its profitability

based on the valuation of the securities the hedge funds are holding. To make matters worst,

the hedge funds were using the “smoothing returns” strategy in their valuation of illiquid

assets. Since the prices used are often not up-to-date market prices, the fund‟s fair value

would be less volatile. Thus, the investors were told that they will receive a steady flow of

returns every month.


Bear Sterns

Other than that, Cioffi‟s team was driven by performance fees based on the

performance of the funds. Therefore, they were using aggressive investment ways to boost

returns for their own interest. As results, these managers remained artificially optimistic

although the subprime market was going to collapse. As a last resort, Cioffi wanted to list

Public Everquest Financial so as to raise funds from the public to save the two hedge funds.

However, this public offering had failed. Now Cioffi faces legal problems as lawyers found

that valuation of securities will stimulate the prosecutor‟s interest. All this reminds us of the

downfall of Barings bank and its rogue trader Nick Leeson.


Bear Sterns

III.

Stand Alone Risk

Generally, Bear Stearns hedge funds invested in structured-finance products, The

Bear Stearns hedge funds, which are the High-Grade fund and the Enhanced fund, begin

buying risky pieces of collateralized debt obligations (CDOs), high-yield bonds and etc. We

will look into the risk portion in these aggressive investment activities and its danger inherent

in the market.

Firstly, the CDOs are an important example of asset-backed securities and normally

are backed by a pool of assets (Bingham & Kiesel, 2004, pp.404). The CDOs which the

hedge funds invested in are backed by sub-prime and others mortgages. Cioffi was actively

trading in the booming CDO market by holding nearly $30billion worth of this type of

securities. They were basically taking the investor‟s money, leveraging it to the maximum

and dumping everything into the CDO market.

Normally, an institutional investor such as Bear Stearns will not only invest in one

identified type of asset but it is crucial for us to understand the stand-alone risk in CDO and

high-yield bonds before understanding the effect of this type of securities on the overall

investment risk associated in his portfolio selection. Stand alone risk is the risk an investor

would face it if he or she held only this one asset (Bingham E. 2004, pp.170).

When Cioffi entered into the market of CDOs, he probably invested solely in sub-

prime and others mortgages that are positively correlated to each others because it is in the

same industry that is involved securitization activity. The typical structured of securitization

is shown on the next page, (Liaw, 2004. pp.306):

The Process of Securitization (Liaw, 2004. pp.306)


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Loan Originator

Loans

Special Purpose Vehicle

Asset-backed securities

Underwriter

Institutional investors

Credit EnhancerRating Agency


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Normally, the lenders would bundle or pool together the bad debts and preferable

loans into one basket of loans and sell them to investment banks, which in turn will resell

them to their other investors. These mortgage-backed securities will be rated accordingly to

their repayment ability and default risk by rating agencies. Before the subprime crisis

happened, these securities were actually being rated good gradings, eg AAA marks, because

these securities are accompanied by collateral and default risk were at a minimum rate with a

booming housing industry. All of a sudden risky consumer loans were reconstituted into

something seemingly no more risky than a government Treasury bond. After the housing

bubble burst, house prices started falling and the rating agencies were not even quick enough

to downgrade the risky investments.

What prompted Cioffi into investing in these securities? CDOs have a probability to

generate higher return because of their high risk attached to it. This higher expected return

will works as an additional compensation for the higher rate of failures induced in the CDOs

market. By assuming the Bear hedge funds have riskier assets, CDOs, the graph for

probability distribution of the hedge funds to gain return is shown below.

-70 0 20 100

CDOs

Rate of Return (%)

Probability Density

Treasury bond


Bear Sterns

The above figure shows us the assuming probability that CDOs‟ return will less than

-70% or more than 100%, any return that will fall within these limits is possible. Thus, the

risk distribution for CDOs (curve in blue) is in a wider range showing that there is a higher

probability of the actual outcome being different from the expected return.

Comparatively, the risk within Treasury bond, which normally involves inflation risk

alone are showed in the tighter curve (curve in red) that implicate the greater probability of

actual outcomes being similar to the expected return. If the Bear funds did include the

Treasury bond into its investment selection, the risk could be diversified and we will discuss

it in the risk in a portfolio context.

References:

Bingham N.H & Kiesel R. (2004), Risk-Neutral Valuation-Pricing and Hedging of

Financial Derivatives, second edition, Springer-Verlag London limited.

Brigham, E (2004), Fundamentals of Financial Management, tenth edition, South-

Western.

Liaw, K. Thomas (2004), Capital markets, Thomson South-western.


Bear Sterns

IV.

RISK IN A PORTFOLIO CONTEXT

An ideal portfolio produces returns that have a low correlation to traditional

investments, as well as a low standard deviation of returns. This goal is most likely to be

achieved when the fund of funds manager carefully diversifies their portfolio. Correlations

are very important, as portfolio theory explains that we can invest in high-risk, high-return

assets without increasing standard deviation when the correlation between that fund and the

portfolio return is low enough to offset the high volatility of the additional investments.

(Keith H. Black, 2004, p 314)

Risks are divided into systematic and unsystematic risk. Unsystematic risk is

associated with an individual company or industry; it may be diversified away in a large

portfolio. (Geoffrey A. Hirt and Stanley B. Block, 2006, p 602) As more assets are added into

portfolio, Bear Stearns may be able to fully diversify its unsystematic risk.

Theoretically it is said that a perfectly negative correlation between two stocks can offset the

standard deviation and bear no risks. However, in the world of reality, it is impossible to

achieve such correlation because there is risk that is unavoidable which called the market

risk. Therefore, risk in a portfolio context in practice depends on the correlations among the

individual stocks that are hopefully generally positive. However, not all risk can be

eliminated and what is left are the risks that cannot be eliminated.


Bear Sterns

Portfolio Risk, σp

(%)

Diversifiable Risk

a) b) c)

Number of

Assets in

Portfolio

a) Portfolio‟s Stand Alone Risk: Declines as More Assets Are Added

b) Portfolio‟s Market Risk: Remains Constant

c) Minimum Attainable Risk in a Portfolio of Average Assets

The market risk or systematic risk cannot be diversified away even in a large portfolio is

measured by its beta coefficient and the following benchmarks are held:

b = 0.5 : Security is only half as volatile, or risky, as an average stock.

b = 1.0 : Security is of average risk

b = 2.0 : Security is twice as risky as an average stock.


Bear Sterns

Relating back to the Bear Stearns hedge funds case, the assets in its portfolio is

definitely at a high risk as Cioffi engaged the hedge funds in irregular and illiquid securities

such as CDOs, lightly traded securities, and so on.

Bear Stearns may be able to make profit and diversify its portfolio unsystematic risk

by selecting high risks assets into its portfolio provided the correlation between the assets

must be at low or negative correlation or diversify by selecting assets that are of high risks

and low risks assets such as Treasury Bills. Unfortunately, Bear Stearns allocated the funds

into highly correlated and similar type of stand alone assets that brought about extremely high

risks and positively correlated among the assets, making its portfolio risky.

In some cases a fund manager (here, Bear Stearns) may be able to borrow funds in

order to purchase even greater amounts of a portfolio than his own funds will allow. The risks

in Bear Stearns hedge funds increased tremendously when the fund manager, Ralph R. Cioffi

used a type of short-term debt to borrow billions more; yet made a critical trade-off: For

lower interest rates, he gave lenders the right to demand immediate repayment. This increases

the illiquidity when both of the High-Grade fund and enhanced fund collapsed when

investors demand for repayment.


Bear Sterns

V.

Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a model of market equilibrium in which

the return on a given security is related to the risk premium on that security. In turn the risk

premium is related to the covariance of the asset return with the return available on the

market portfolio (Maximo V.Eng, et al, 1998, pp.564). CAPM concludes that the investors

mix risky assets and less risky assets in their portfolio. Risk-free assets may also be involved

in the given market portfolio. The expected return for any portfolio on the line is equal to the

risk-free rate plus a risk premium. If investors are to invest in risky assets, they must be

compensated for this additional risk with the risk premium. There are 2 important

relationships in the CAPM that are Capital Market Line (CML) and the Security Market Line

(SML).

CML specifies the equilibrium relationship between expected return and risk for an

efficient portfolio.3 It is only useful for efficient portfolios and can‟t be used to assess the

equilibrium expected return on a single security. The efficient portfolio means a portfolio that

is well diversified in which the highest level of return at the given level of risk or the highest

level of risk at the given level of return. All the combination of efficient portfolios is on the

CML line. CML is used to determine the optimal expected return.

Equation for CML:

p

M

Mp

RFRERFRE

)()(

However, the Bear Stearns High-Grade Structured fund and High Grade Structured

Credit Strategies Enhance Fund is not efficient as they failed to apply this theory. This is

3


Bear Sterns

because the portfolios were mainly consisted of the high-risk securities such as the mortgage-

backed securities. These funds aimed at maximizing returns but not to minimize risk by

investing in high-risk high return securities.

SML specifies the equilibrium relationship between expected return and systematic

risk.4 SML depicts the tradeoff between risk and expected return for individual securities. It is

also applicable to individual securities and portfolios. The security‟s risk will be measured

based on beta. Beta is a benchmark to determine the individual asset‟s riskiness with the

market portfolio of all the assets. It measures the systematic risk of the asset that cannot be

diversified such as interest rate risks. The market portfolio has a beta of 1.0 which means that

for every 1-percent change in market‟s return, on average, this security‟s returns change 1-

percent. If the beta is more than 1.0, it means the assets are more volatile (risky). If the beta is

less than 1.0, it means the assets are less volatile (risky. If the value of beta is higher, the risk

of individual assets is higher.

Equation of SML:

RFERRFR Mii

According to the formula above, RFERM is referring to the market risk premium

which is the risk premium on the average securities (Brigham, E. 2004, pp.195). The size of

this premium depends on the perceived risk of the securities market and investors‟ degree of

risk aversion. However, it is hard to measure the market risk premium as the market expected

return cannot estimate accurately. So, it is normally based in the market past performance to

measure and this might mislead the investors. According to the case, as the hedges funds

depend on the illiquid assets which the prices used are often not up-to-date market price,

makes the funds fair value would be less volatile and thus less risky.

4


Bear Sterns

For RFERMi , it is the risk premium on a single security (Brigham, E. 2004,

pp.195). This risk premium will vary from each individual security and it is goes in line with

its beta. Thus, Cioffi invested more than 60% of their net worth in exotic securities as they

offered higher risk premium.

The SML has important implications for securities price whether the security is

overvalued or undervalued. When each security lies on the line, the investors required rate of

returns are same with the market expected rate of returns. In order to know whether the

security is overvalued or undervalued, investors must first know the beta for any security. If

the market expected return of a security is higher than the required rate of return, it is

undervalued and investors will buy or hold it. When the required rate of returns higher than

the expected returns, it is overvalued and rational investors will sell or would not buy it. The

funds were overvalued by Cioffi‟s own management team as they valued their funds in the

absent of market values. However, the investors were misled by Cioffi as they were told that

they shall receive steady gain of 1% - 2% a month, makes them feel confidence with their

investment.

„


Bear Sterns

VI.

RISK and RETURN

(Two Sides of the Investment Coin)

Investment decisions are determined by various reasons. For most investors,

individuals and institutions, one of their primary motives is to earn returns (Prasanna

Chandra, 2006, pp.127). The investors would naturally wish that their returns to be as large as

possible. In Bear Stearns hedge fund‟s case, the management team aggressively invested in

the high risk securities as they will be paid according to their hedge funds performance fees.

As evidence, Cioffi is going to keep 20% of any profits they generated, plus 2% of the net

assets under management. However, they should understand that the returns would bear some

risk in which is the possibility of the expected returns being different from the actual returns.

Generally, there is positive relationship between risk and return and this trade-off would be

the centre for any investment decision.

Basically, there are components which investors must consider in forming their

expected rate of return of their investment (Brigham, E. 2004, pp.195). First, it is their

required rate of returns, which is the minimum return that an investor expects from an

investment. Investors basically will buy and hold the securities if the expected rates of returns

are higher than the required rate of returns. The required rate of returns for the Bear Stearns

High-Grade Structured fund and High Grade Structured Credit Strategies Enhance Fund must

be at least the interest rates of their borrowings.

In order to involve in high-risk investment, investors must be rewarded by a risk

premium, which is the additional returns investors expect to obtain for assuming additional

risk (Prasanna Chandra, 2006, p.127). The hedge fund managers willingly invested in the

exotic and lightly traded bonds as the investments offered higher yields mainly due to the


Bear Sterns

default risk premium. The higher yields of bonds also lead to lower bond prices. Thus, the

funds will not only earn a higher yield but also a higher capital gain.

Besides that, the liquidity risk premium is another concern for an investor. If the

security is easy to sell at a fair price, then the premium will be lower and vice versa. In the

article, one of the motives Cioffi invested in the mortgage-backed securities is that they

offered higher liquidity risk premium. This is because houses are not easy to sell at their fair

value and liquidity is subject to the market condition. If the funds become increasingly

illiquid, then funds are more likely to be failed (Black, 2004, pp.66). Therefore, the two funds

collapsed during the subprime crisis.

For the hedge fund‟s investors, the hedge funds were supposed to minimise their risks

for a given level of returns as they were told to expect a small but steady return every month.

However, the returns were not guarantee. In this case, the agency relationship problem arose;

the investment strategies caused the investors to invest indirectly in the risky instruments,

arrangement with lenders (Barclays), the failure of disclosure, etc. Moreover, they also faced

pricing and model risk where these mortgage-backed securities and high yield bonds are

often illiquid and difficult to value (Black, 2004, pp.71). The overvaluation of the funds made

the investors‟ expected rate of returns became irrational. Thus, if the investment risks go

beyond manageable level, it will generate substantial losses.

Reference:

Prasanna Chandra, Investment Analysis and Portfolio Management, 2nd

edition, 2006


Bear Sterns

VII.

Recommendations

The Bear Sterns hedge funds were actually involved in murky dealings with investor‟s

money. They lied to their investors that even if the market is in a bad and unfavorable

condition, that they will still make profits and garner returns. As such, we recommend that

investors need to have more information about the complex assets that their hedge funds are

investing into so as to avoid misleading information by hedge fund managers such as Cioffi‟s

CDO investments that were of nature extremely high in risk. Thus, investors can make better

rational decisions based on the level of risk of the funds. The failure of investors to make

rational decisions (especially before the funds collapse) is due to the fact that hedge funds are

not required to disclose positions and trading strategies. As a result, no one knew who was

holding what, no one trusted counter parties, leading to credit crunch (refer to The EDGE

Malaysia, the week of October 29,2007).

In addition, if the two hedge funds are to be supervised by an independent party in

their investment structure, misuse of funds will be minimizes.

Despite Cioffi‟s considerable expertise in the investment field, Bear Stearns should let

him be in full control of both hedge funds in Bear Stearns Asset Management. Cioffi‟s

overconfidence and his risky investment strategy thus made it certain that it defies and

neglect the real purpose of the hedge fund which is to involve in low risk, and low-correlated

strategies (Black, 2004, pp.120).

Besides, Cioffi‟s team needs to have ethical behaviors towards his responsibility.

According to agency theory, it is common for management teams to invest for a personal

goal, in this case to obtain high performance fees rather than the maximization of investor‟s

return. When they are dealing with investor‟s money, they should hedge the risk away instead

of speculating for higher return. With the excessive leveraging in short-term debts, the hedge


Bear Sterns

funds actually double the risk involved. Moreover, the arrangement with Barclays actually

represents a conflict of interest with investors. As a golden rule, Cioffi should safeguard

investor‟s interests. Moreover, Cioffi must be more conservative, and reserve at least 10% of

emergency funds in lieu of the 1% they were actually holding.

In order to manage the risk of the funds, it is important to understand the relationship

between the type of trading strategies and the risks and returns in the market environment

(Black, 2004, pp.84). Investing heavily in the mortgage market can have large losses during

the property market crisis occured. (plz cont. urself in risk mgt : insufficient info.

Diversification is an essential indication to a portfolio selection. In our case, the Bear

Sterns hedge funds were not well diversified. At first, Cioffi and many other fund managers

thought that investing in mortgage-backed securities provided some sort of diversification

through the combination of the prime and subprime loans. Therefore, Cioffi should invest in

negative correlated industry such as commodity market.

Most hedge fund activities do not start up to commit fraudulent activities. But losses

are incurred; people will try to cover up illegally. The Bear hedge funds exercised

overvaluation, and used the „smoothing returns‟ strategy to mislead investors. As a solu tion,

regulation should play a more important role in hedging activities. The financial system needs

better supervision and governance in relating issues arise such as it must set a standard

requirement for their disclosures. Valuation methods also must be supervised by government

agencies to avoid inconsistent practices.

References

Keith H. Black (2004), Managing a Hedge Fund: a complete guide to trading,

business strategies, operations, and regulations, The McGraw-Hill.


Bear Sterns

Subprime Crisis

Risky Investments

(CDO)

Excessive Leverage

Dangerous Structure (Deal with Barclays)

Low Reserves

Collapse of Bear Sterns

Hedge Funds


Bear Sterns

Oct 1, 2003

•Bear Sterns High-Grade hedge funds opens

Dec 31,2004

•The Funds reported a one-year gain of 16.88%

August,2006

•Bear Sterns Enhance hedge funds opens

October, 2006

•Everquest Financial, a Bear Sterns affiliate, begins buying risky pieces of collateral debt obligations from the two hedge funds

February, 2007

•Problems at New Century Financial and other lenders spark the subprime meltdown

•The manager, Ralph Cioffi, talks about a 'catharsis' in the mortgage industry

March, 2007

•The Enhanced and High-Grade funds report monthly losses of 5.41% and 3.71% respectively

•Investors start redeeming their money

May 9, 2007

•Everquest Financial files for an initial public offering

May 15, 2007

•Bear Sterns warns investors in the Enhanced fund to expect a 6.5% drop for April

June 7, 2007

•Bear Sterns revises the April decline for the Enhanced fund to 18.97% and freezes investor redemption

June 22,2007

•Bear Sterns announces a $1.6 billion loan for the High-Grade fund

June 30, 2007

•Bear Sterns halts redemption from the High-Grade fund

June 31, 2007

•The two funds file for bankruptcy

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