Q2 Bear Stearns
Q2: What forces contributed to the collapse of the two hedge funds?
There are several factors which caused two hedge funds to collapse. Generally speaking, we divide them to two parts-internal factors and external factors. And internal elements are the root of the collapse of the hedge funds. For inside factors:
Over leveraged in subprime debt. In 2007, as American house started to collapse, the subprime debt borrowers began to default, enormous numbers of CDOs owned by Bear Stearns also turned to collapse as they were linked to subprime mortgage. As we know now, subprime debt has instability and high risky characteristics. The majority of borrowers have a low credit history. While what hedge funds thinking was as in a market with soaring house prices, the risk of incurring losses on a mortgage was low. Unfortunately, it was not a case with American market. In addition, we also think the fund managers lacked plan to protect themselves from event risk. Though Bear Stearns funds managers bought Swaps, their assumptions were just based on normal real estate conditions. They never thought the condition that real estate sector became collapse.
Over trusted AAA ratings. As case mentioned, when the funds invested, they always chose AAA ratings CDOs. But in fact, these AAA ratings securities were not real AAA. Compared to same rating corporate bonds, the default rates for CDOs was much higher, so there is very high risk for hedge funds’ strategy.
Ignoring liquidity risk. In the case, when lenders asked hedge funds to provide additional cash, the funds had no cash on the sidelines, they needed to sell bonds to get cash. They failed to have ample liquidity to cover their debt obligations. What’s more, there is also lack of transparency about the funds’ assets. Though, Ralph R. Cioffi and Matthew M. Tannin, two hedge fund managers, themselves were unsure about the future of the two hedge funds, they portrayed an upbeat picture to worried investors without disclosing that
There are several factors which caused two hedge funds to collapse. Generally speaking, we divide them to two parts-internal factors and external factors. And internal elements are the root of the collapse of the hedge funds. For inside factors:
Over leveraged in subprime debt. In 2007, as American house started to collapse, the subprime debt borrowers began to default, enormous numbers of CDOs owned by Bear Stearns also turned to collapse as they were linked to subprime mortgage. As we know now, subprime debt has instability and high risky characteristics. The majority of borrowers have a low credit history. While what hedge funds thinking was as in a market with soaring house prices, the risk of incurring losses on a mortgage was low. Unfortunately, it was not a case with American market. In addition, we also think the fund managers lacked plan to protect themselves from event risk. Though Bear Stearns funds managers bought Swaps, their assumptions were just based on normal real estate conditions. They never thought the condition that real estate sector became collapse.
Over trusted AAA ratings. As case mentioned, when the funds invested, they always chose AAA ratings CDOs. But in fact, these AAA ratings securities were not real AAA. Compared to same rating corporate bonds, the default rates for CDOs was much higher, so there is very high risk for hedge funds’ strategy.
Ignoring liquidity risk. In the case, when lenders asked hedge funds to provide additional cash, the funds had no cash on the sidelines, they needed to sell bonds to get cash. They failed to have ample liquidity to cover their debt obligations. What’s more, there is also lack of transparency about the funds’ assets. Though, Ralph R. Cioffi and Matthew M. Tannin, two hedge fund managers, themselves were unsure about the future of the two hedge funds, they portrayed an upbeat picture to worried investors without disclosing that