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.