Bear Stearns explored risky strategies in order to generate large returns. Bear Stearns also made use of leverage which in general terms helps the investor as well as the firm in making investments. On the other hand, leverage comes with greater risk. When an investor makes use of leverage in making an investment and that investment moves against him or her, the loss is larger than it would have been when or if that investment was not leveraged. Financial leverage amplifies gains as well as losses. A firm uses leverage in trying to generate the shareholder’s wealth, but failing to do so, credit risk of default and the interest expense eliminates shareholder value.
Firstly, ‘hedge fund’ as a term can be confusing. ‘Hedging’ as a purpose means to make an investment to explicitly reduce risk. This could get confusing because usually hedge funds are anything but conventional. Known for using aggressive, complex and risky strategies, they are used to produce large returns.
In effect, hedge fund strategies are highly diverse and there are no descriptions that accurately encompass the range of investments. The similarity amongst hedge funds is the way managers are compensated and this usually engages a management fee of 1 to 2 % on assets and 20 % of all profits for incentive fees. As it can be seen, this compensation structure encourages risk taking behaviours that as a rule engages leverage in order to generate adequate returns justifying the enormous incentive and management fees. Bear Stearns' initially troubled funds in the summer of 2007 fit well in this generalization. In addition to this, it was the use of leverage that mainly hurried their failure.
The strategy used by the Bear Stearns investments bank’s funds was simple and is best classified as a leveraged credit investment. This could be explained in four steps.
Firstly the company purchases (CDOs) collateralized debt obligations which pay an interest rate above and over borrowing cost. In this instance tranches of triple 'AAA' rating of subprime and mortgage backed securities were used. Secondly, using leverage in buying more CDOs than it can be paid for only with capital. Since these CDOs are paying an interest rate above and over their cost of borrowing, each additional unit of leverage adjoins to the overall expected return. In other words, the more leverage the company employs, the larger the expected return is from a trade.
Thirdly, the bank uses credit default swaps as an insurance policy against any movement in the credit market. Because the leverage use increases the overall risk exposure of the portfolio, the following step is to acquire insurance covering movements in the credit market. Such ‘insurance’ instruments are identified as credit default swaps, which are intended to profit during times when bonds fall in value because of credit concerns, in effect hedging away part of the risk.
Lastly the bank watches the money coming in. When the bank nets out the leverage cost or in other words its debt in order to purchase subprime debt rated triple ‘AAA’, in addition to the credit insurance cost, the bank remains with a positive rate of return. This rate of return is also called ‘positive carry’.
In cases when the credit market behaves in line with expectations, these strategies generate positive and consistent returns with modest deviations. This above explained strategy as well as others, works as long as markets and economic conditions are fairly stable. UBS, the largest bank in Switzerland, in May 2004 had record profits in its first quarter. At the time the net profit of the banks was 2.43 billion CHF, GBP 1.06 billion which is an amount double than the one reported in the same previous of the previous year, 2003. The risk taking paid off and the strategy the bank used was the one of proprietary trading which is capitalising on improving conditions of the market by taking additional risk in buying and selling stocks on the behalf of the bank.
Returning to more recent periods, these strategies do not seem to work in a bearish market and especially when actual economic data do not meet expectations. By hedging it is impossible to hedge away the whole risk because the returns would then be too low. Consequently, the deception with these strategies is for the market to perform as expected and, if at all possible, to improve or remain stable.
When the subprime debt problems arose the markets became everything but stable. To simplify the situation that occurred with Bear Stearns, the subprime mortgage backed securities market performed outside of portfolio managers’ expectations, thus starting a chain of events which imploded the funds. This is when the other side of risk came along increased by the use of leverage to increase it. The fundamental idea is the relationship between risk and return. The greater the amount of risk the bank is willing to accept, the larger the possible returns are.
Bear Stearns portfolio managers were unsuccessful in foreseeing the beginning of the subprime mortgage problems thus the price movements in the markets and, as a result, did not have enough credit insurance in order to protect the bank against these losses. For the reason that the managers leveraged their opened positions significantly, the funds experienced large losses.
The huge losses made the creditors uneasy because they were financing these highly leveraged investments, while taking mortgage backed bonds, subprime as collateral on loans. Moreover lenders required that Bear Stearns provide supplementary cash on the loans taken because of the collateral which are the subprime bonds and which were quickly falling in value. This is similar to a margin call for an investor with an account with a broker. Because these funds had no cash left on the sideline, there was the need to sell part of the bonds to generate cash. This was in effect the beginning of the end.
In the beginning of 2007, the effects of subprime mortgage became apparent when subprime lenders as well as homebuilders were bearing under defaults followed by a steep weakening in the housing market.
The fund managers in Bear Stearns made mistakes and the first one was failing to predict accurately the behaviour of the subprime market under the given extreme circumstances. Effectively, these funds were not accurately protected from the event risk.
Secondly, the bank failed in having enough liquidity to cover debt obligations. Given they had the adequate liquidity; the bank would not have to close their positions in a bearish market. Even as this may well lead to smaller returns because of less leverage, it might have prevented the on the whole collapse. In retrospection, by giving up a small part of possible returns might save the investor millions of dollars.
In addition, it is debatable that the bank should have researched better the macroeconomic situation and understood that subprime mortgages could face tough times. Bear Stearns could have then made appropriate corrections to the risk models used. Liquidity growth globally in the recent years was tremendous, and resulted in low interest rates as well as credit spreads and lastly resulted in lenders’ record high level of risk-taking to low credit quality borrowers.
Since 2005, economy of the US has been slowing down and one of the causes was the peak in the housing market and borrowers of the subprime are particularly at risk to an economic slowdown. Thus, it was reasonable assuming that the economy heading towards a correction. Ultimately, the flaw for the investments banks, Bear Stearns, could be considered the high level of leverage engaged in their strategy. This was driven by the call for justifying the high fees the bank charged for its services and achieving the potential compensation, more exactly 20 % of profits. In another order of ideas, the managers should not combine leverage with greed.
Just as Bear Stearns, starting in 2005, UBS was buying mortgage backed securities, making profits from the high yields bonds, and trusting at the same time that the bank’s triple AAA credit rating could protect UBS if or when the risky underlying MBS began to sour. The bank’s fixed income division was also buying mortgages and was repackaging these mortgages as securities, trying to sell them to potential investors otherwise simply adding them to the already heavy inventory of the bank. With parts of the bank doubling down on mortgages, revenues and profits rose. But, by the beginning of 2007, trouble was coming up as the US subprime lenders such as New Century were filling for bankruptcy. Losses were rising; UBS became the first casualty of toxic mortgage debt on Wall Street.
In April 2008 UBS admitted that its hunger for profit together with poor risk control, was the cause for its huge credit losses. The Swiss bank declared that: ‘UBS Investment Bank was focused on the maximisation of revenue. There appears to have been a lack of challenge on the risk and reward to business area plans within the investment bank at a senior level’ (Litterick, 2008).
The report to shareholders, which was a review of the summary of the bank’s losses ordered by EBK, Switzerland's banking watchdog, exposed an ‘asymmetric’ focal point at UBS senior management on revenues, profits and loss. It was also added: ‘Especially when compared to discussions of risk issues’ (Gow, 2008). The review also showed that the bank allowed the considerable growth in UBS investment banking division to run its course unchecked.
UBS had write downs in the first quarter of 2008 of 37 billion dollars which is 18 billion pounds, two thirds of which is related to its CDOs within its fixed income division. Proposed improvements were not mentioned in the report which covers only the period up to the end of 2007, with further losses to be reported since UBS was considered at that point Europe's prime casualty of the so called ‘credit crunch’. The bank losing 4.3 billion dollars in 2007 was said to incur additional substantial losses for the first quarter of 2008.
David Gow’s article (2008) points out the absence of risk management, the deficiency of operational limits and the imperfect risk control methodology on top of the lack of response to changing market conditions since the subprime crisis arose.
UBS has 2.8 trillion dollars in assets, made a large ‘bet’ (Schwartz, 2008) on subprime mortgages. UBS‘s write downs were more than Citigroup, Merrill Lynch, or globally more than any other bank in April 2008. Dirk Hoffmann Becking, who is an analyst with Sanford Bernstein in London, mentioned that ‘People now question UBS's ability to manage risk and judge just what a conservative investment is’ (Litterick, 2008).
At any point in time every trader may feel either pessimistic or optimistic. Most of the time, from corner to corner of the market as a whole, the traders’ feelings are more or less cancelling one another out, otherwise too much of an imbalance is not created either way. However occasionally, such as in a credit crisis, sentiment spreads similar to a contagious disease. The wisdom of the crowds becomes more of the madness of the crowds. This is the moment when the risk is negatively rewarded because the situation occurs faster than the banks can actually escape the toxic debt.
A wealthy, perfectly viable and healthy system may possibly exist with the overall levels of return being lower. But the current expectations demand taking on board risky positions, leverage, and the usage of complex financial instruments in order to satisfy demand for that high risk.
References
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