Bear Stearns's `Friends' Reject Hedge Fund Rescue in LTCM Redux

Date: Monday, June 25, 2007
Author: Jody Shenn and Bradley Keoun, Bloomberg

June 25 (Bloomberg) -- Bear Stearns Cos. is getting a taste of its own medicine.

It was Bear Stearns, the biggest broker to hedge funds, that nine years ago declined to join 14 other investment banks in the bailout of Long-Term Capital Management LP. Then last week, as New York-based Bear Stearns pleaded for help to rescue two of its hedge funds teetering on the brink of collapse, many of the same firms refused to come to its aid.

Merrill Lynch & Co., which pumped $300 million into LTCM, said no and seized $850 million of bonds held as collateral for loans it had made to the funds. Lehman Brothers Holdings Inc., JPMorgan Chase & Co. and Cantor Fitzgerald LP also pulled out, leaving Bear Stearns to sort through the wreckage of bad bets on subprime mortgage bonds and collateralized debt obligations.

``There is a good analogy to Long-Term Capital,'' said Anthony Sanders, a former director of mortgage-bond research at Deutsche Bank AG who starts next month as a professor of finance and real estate at Arizona State University's W.P. Carey School of Business in Tempe, Arizona. ``They were all friends with Bear Stearns when they thought the spreads were huge. Now that the market has turned, Bear's standing there like the lone grizzly.''

Without assistance from his Wall Street peers, Bear Stearns Chief Executive Officer James E. ``Jimmy'' Cayne, 73, was forced to salvage the healthier of the two funds, putting $3.2 billion of the firm's capital at risk in the biggest bailout since LTCM. Bear Stearns may dissolve the second fund after more than $600 million of investors' money dwindled to less than $200 million.

Reducing Earnings

The debacle, and the risks Bear Stearns faces in the mortgage-backed securities market, may cost the firm 7.2 percent of its earnings this year and wipe out more than $1.5 billion in market value as the stock declines, according to estimates by Sanford C. Bernstein & Co. analyst Brad Hintz. Shares of Bear Stearns, the second-largest U.S. underwriter of mortgage bonds, have dropped 16 percent since reaching a record in January, just before the subprime market started melting down.

``Equity investors will not know the ultimate impact of the subprime market problems until the slow-motion train wreck of rising mortgage delinquencies and defaults is played out over the rest of this year,'' Hintz, who works in New York, said in a June 21 report. ``As one of the largest fixed-income houses and MBS underwriters, Bear is in the challenging point of the cycle where the potential downside performance risk of the company is greater than the upside performance potential.''

The decline turned into a tailspin last month when Bear Stearns Asset Management, which had more than $29 billion of ``structured-credit assets'' as of Dec. 31, suspended redemptions in the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund.

Investors Barred

Barring investors from withdrawing money from a hedge fund typically is the first sign of an impending collapse. Amaranth Advisors LLC, the $9.5 billion hedge fund that made wrong-way bets on natural-gas prices, took similar steps in the days before it failed in September.

Bear Stearns's enhanced fund and the Bear Stearns High- Grade Structured Credit Fund, a similar pool that wasn't as highly leveraged, speculated mostly in collateralized debt obligations, securities that hold pieces of junk-rated corporate bonds, mortgage bonds, high-interest loans, derivatives or even other CDOs.

Sales of CDOs skyrocketed to $503 billion in 2006, according to estimates from Morgan Stanley. Ralph Cioffi, 51, the funds' manager at Bear Stearns, was among the biggest buyers of CDOs backed by subprime mortgages, home loans to people with poor credit ratings or heavy debt loads.

`Risk and Return'

While some layers of CDOs are designed to earn higher credit ratings than their underlying investments, the securities are hard to value and can decline precipitously. That's what happened earlier this year as defaults on subprime loans accelerated.

Then an additional bet Cioffi had made to protect his investors, using derivative contracts on ABX indexes to hedge against a decline in the subprime market, also went bad. By the end of April, the enhanced Bear Stearns fund was down more than 20 percent for the year.

``They looked at these high yields, this growing market, and they forgot the basic concept of risk and return,'' Sanders said. ``They got caught drinking their own Kool-Aid.''

Bear Stearns raised almost $2 billion from investors for the two funds and borrowed more than $10 billion against that equity to make bigger bets and earn higher returns. On a June 22 conference call, Bear Stearns Chief Financial Officer Samuel Molinaro said the high-grade fund, which was older, had had ``something like 40 consecutive quarters of profitable performance.'' The enhanced fund was started about 10 months ago.

CDOs as Collateral

The funds added leverage by pledging CDOs as collateral for loans in so-called repurchase, or repo, agreements. One lender who dealt with the funds said a transaction might involve buying $100 million of securities from the funds for $95 million, with the funds agreeing to buy them back for $95 million plus interest. The $5 million difference provided a cushion in the event a fund couldn't make good on the loan.

The enhanced fund increased leverage by taking on so-called mezzanine debt from Barclays Plc, the third-largest U.K. bank, people with knowledge of that arrangement said. In all, the two Bear Stearns funds dealt with 17 different financiers, according to Douglas Lucas, a UBS AG bond analyst in New York.

As creditors began asking the funds to post more collateral to back the loans in mid-June, Cioffi sold about $4 billion of the funds' holdings to stave off a cash crunch.

Blackstone Gets Hired

The gambit failed. Lenders led by New York-based Merrill, the third-largest U.S. securities firm by market value, threatened to declare the funds in default of repo agreements and seize investments. Bear Stearns hired Blackstone Group LP, the New York-based buyout firm, as an adviser and began hosting daily conference calls with Richard Marin, the CEO of Bear Stearns Asset Management. Timothy Coleman, a senior managing director at Blackstone, also spoke, according to an executive who was on the calls.

Bear Stearns presented its first bailout proposal on June 18, offering to take over $1.5 billion of repo agreements provided it could raise $500 million of new equity.

The lenders were unimpressed. On at least one conference call, several accused Bear Stearns of holding back too much information, the executive who participated said.

As the situation unraveled, Bear Stearns Co-President Warren Spector appealed to the funds' lenders on behalf of the firm, according to the same executive, who also was involved in the negotiations.

Some Strike Deals

JPMorgan, Goldman Sachs Group Inc. and Bank of America Corp. reached agreements with Bear Stearns Asset Management that involved settling the difference between repo debts and money the funds were owed from hedging contracts, according to people who were briefed on the dealings or heard them described on conference calls. That meant the firms got out mostly unscathed. Cantor Fitzgerald also avoided losses and expects to return millions of dollars of excess margin to the funds, spokesman Robert Hubbell said.

The firms are based in New York except Bank of America, whose headquarters are in Charlotte, North Carolina.

Merrill on June 19 began auctioning off $850 million of collateral, eventually selling a portion of that. At least seven other lenders, including New York-based Lehman and Frankfurt's Deutsche Bank, also circulated lists of CDOs and other bonds, according to traders who considered making bids.

`Vicious Circle'

``If I were Merrill today, I'm sure I would do the same thing they're doing, which is to protect my position,'' said Clayton Rose, a former JPMorgan vice chairman who attended the 1998 meeting at the New York Federal Reserve where Wall Street chiefs met to craft a bailout plan for Long-Term Capital Management, the Greenwich, Connecticut-based hedge fund run by John Meriwether.

Spokesmen for the all the lenders declined to comment. London-based Barclays said in a statement that its position was ``not material'' to the bank's earnings.

Molinaro described the situation on the June 22 call with analysts.

``There have been some counterparties who have moved to liquidate collateral,'' he said. ``When you have difficulty raising liquidity to meet margin calls, more margin calls come and it becomes a bit of a vicious circle.''

Marin came back with a second proposal at about 8 a.m. on June 21. Bear Stearns would provide $3.2 billion of financing for the high-grade fund, enough to cover all the outstanding repos, so long as the lenders agreed to withhold any margin calls on the enhanced fund for a set period.

No Strings Attached

Again the banks balked. Finally, at about 3 p.m. that day, Bear Stearns offered an unconditional bailout for the high-grade fund.

Investors in the enhanced fund, which at its peak borrowed more than 10 times its equity, may get little if anything back unless Bear Stearns steps up with a salvage plan.

Recoveries in the high-grade fund will depend on how CDO prices fare as Bear Stearns reduces leverage over the next few weeks. Traders who participated in auctions of the funds' assets last week said some bids were lower than 30 cents on the dollar, as investors tried to test the depths of the meltdown.

``Further deterioration in the market or further declines in underlying collateral values will impact all of that,'' Molinaro said on June 22. ``But we think based upon the information that we have right now, which of course seems to change by the minute, that we do feel that we are adequately secure there.''

No Alarm

The bailout of the Bear Stearns fund is the largest since LTCM, which received more than $3.6 billion in 1998.

In the case of Long-Term Capital, lenders agreed to invest equity in the fund after William McDonough, the New York Fed's president at the time, arranged the rescue effort to prevent a shock to the financial system. The firms then sold assets over time to limit the impact of LTCM's collapse.

For now, the trouble at Bear Stearns hasn't mushroomed into a crisis. Moody's Investors Service and Standard & Poor's, the two largest debt-rating companies, both said June 22 that the bailout doesn't put Bear Stearns's credit at risk.

The prospects are dimmer for Bear Stearns shareholders. Even if the firm doesn't sustain losses on the loan, $3.2 billion of its $75 billion in equity and long-term debt capital will be tied up, possibly for months. That's money Bear Stearns can't use for proprietary trading or underwriting.

Increasing Risk

``I would have liked to see them shut down the funds, admit their mistake and move on, instead of doing this internal bailout,'' said William Fitzpatrick, who helps oversee more than $1 billion, including Bear Stearns shares, at Johnson Asset Management in Racine, Wisconsin. ``Clearly, it's increasing Bear's risk.''

Bear Stearns also invested about $35 million in the funds, Molinaro said on the conference call.

The situation may have wider implications for Wall Street, where firms including Goldman, JPMorgan and New York-based Citigroup Inc., the largest U.S. bank, manage tens of billions of dollars in hedge funds, according to Moody's. Even if those products are handled on an arms-length basis, as they were at Bear Stearns Asset Management, the parent company may face pressure to take action in times of distress.

Moody's analyst Blaine Frantz said that ``moral responsibility'' is a concern because ``it raises important questions around potential reputation risk.''

``Asset management is typically a low capital intensive, low-risk business,'' Moody's said in a June 22 statement. ``Bear will need to maintain a delicate balance as it seeks to protect its reputation, support value for the fund investors, and protect the firm from collateral losses.''

For all the criticism it faced over Long-Term Capital, Bear Stearns has no regrets. In a May 21 speech to the Mortgage Bankers Association in New York, Alan ``Ace'' Greenberg, the 79- year-old chairman of Bear Stearns's executive committee, said the crisis was overblown.

``People are being told today that Long-Term Capital had America on the precipice, ruined America, ruined the financials,'' Greenberg said. ``Nonsense. It never was even close.''

To contact the reporter on this story: Bradley Keoun in New York at bkeoun@bloomberg.net ; Jody Shenn in New York at jshenn@bloomberg.net .