Are Hedge Funds Behind Bear Stearn’s Demise?

Date: Tuesday, March 18, 2008
Author: Ivy Schmerken, Advance Trading.com

The fire sale of Bear Stearns to JPMorgan Chase for $2 a share or $236 million has shocked the financial markets into realizing how fast a major securities firm could fall in a credit crisis.

The takeover was swiftly negotiated with the Federal Reserve Bank's backing to avoid a run on the bank which had already begun, and was in danger of spreading to other firms that had large exposures to mortgage backed securities on their balance sheets. The Fed approved a $30 billion credit line to support the takeover by J.P. Morgan, which is guaranteeing Bear Stearns' counterparty risk.

But the unraveling of Bear Stearns has its roots in the exodus of hedge fund clients, according to Denise Valentine, senior analyst at Aite Group in an email commentary. "Bear was a global leader in prime brokerage — a business which provides financing and runs back-offices for hedge funds. Bear had 21 percent of hedge fund client assets, according to Lipper Hedge World, noted Valentine.

But the main catalyst in Bear's demise is that hedge funds and other counterparties on Wall Street did not want to be on the other side of trades with Bear Stearns, according to the analyst. "Aside from the clear financial risk, any firm that is leveraged or has collateral with Bear faces a reputation risk, which certainly added to the mass client exodus," commented Valentine.

Hedge funds also have to protect their institutional clients from counterparties whose credit ratings drop. "Hedge funds hold significant amounts of institutional investor assets and these assets come with strings," continued Valentine. "Hedge funds also must demonstrate internal controls, particularly around counterparty risk and management," wrote the analyst. "And since hedge funds already do business with multiple prime brokers, it becomes fairly easy to shift some or all of the business to another firms until an outcome becomes clear," said the analyst.

What may have led to the sale of Bear is that some counterparts turned to Wall Street competitors, such as Deutsche Bank, to handle their trades. These banks were charging hedge funds an extra fee to shift their business and to assume the counterparty risk for these trades, according to media reports.