Reference no: EM133171423

The Bear Stearns Companies, Inc. was a New York-based global investment bank, securities trading and brokerage firm that failed in 2008 as part of the global financial crisis. In the years leading up to the failure, Bear Stearns was heavily involved in securitization and issued large amounts of asset-backed securities. The collapse of the company was a prelude to the risk management meltdown of the investment banking industry in the United States.

Two of the Bear Sterns' hedge funds that invested in mortgage-backed securities (MBSs) was the HighGrade Structured Credit Strategies Master Fund ("High-Grade") and High-Grade Structured Credit Strategies Enhanced Master fund ("Enhanced"). The funds may have touted their sophisticated investment strategies, but in truth their strategies were simple and formulaic in nature:

Step 1: The funds invested in collateralized debt obligations (CDOs) which were backed by AAA-rated subprime, mortgage-backed securities (MBSs), and financed these investments using short-term collateralized lending in the form of repurchase agreements, or "repos". In a repo contract, a firm borrowed funds by selling a collateral asset today and promising to repurchase it at a later date.

Step 2: Through the use of leverage, the funds bought more CDOs than they could have with their own capital. Because CDOs paid an interest rate higher than the cost of borrowing, every incremental unit of leverage added to the funds' total expected return. The net adjusted leverage ratio of Bear Sterns was as high as 19.3 (Net adjusted assets/Tangible equity capital) in 2007.

Step 3: The funds purchased credit default swaps (CDSs) as insurance against movements in the credit market. CDSs were expected to pay off when credit concerns caused the bonds' value to fall, effectively hedging some of the risk of falling collateral values. However, Bear Sterns failed to expect the substantial decreases in market values of CDOs and, therefore, had insufficient credit insurance to protect against these losses.

On July 17, 2007, in a letter sent to investors, Bear Stearns Asset Management reported that its HighGrade Fund had lost more than 90% of its value, while the Enhanced Fund had lost virtually all of its investor capital. On July 31, 2007, the two funds filed for bankruptcy. Bear Stearns effectively wound down the funds and liquidated all of its holdings.

Qualitatively discuss the interest rate, credit risk, liquidity risk, and market risk Bear Sterns was facing in the two hedge funds.