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Bear Stearns High Grade Credit Funds - Subprime CDOs

2007-06-20

Count of distinct funds: 2

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stories: marketwatch.com, wsj.com, wsj.com, nypost.com, safehaven.com, businessweek.com, businessweek.com, businessweek.com, seekingalpha.com, rawstory.com, thestreet.com, seekingalpha.com, courant.com

Update, 2007-08-18:

Another Bear fund, Asset-Backed Securities Fund, has been hit. Bear does not, however, plan to shut it down at this time:

The $850 million Bear Stearns Asset-Backed Securities Fund has suspended investor redemptions and expects losses in July. During the first half of 2007, the fund was up roughly 5%... The Bear Stearns Asset-Backed Securities Fund isn't leveraged, which means there's little pressure for the fund to sell positions. The fund also has less than 0.5% of its assets in subprime securities. Most of the assets are higher-rated mortgage-related securities.

Update 2007-08-01

It's now become official that SELF and SF have filed for bankruptcy protection.

Update 2007-07-17

On July 17th Bear Stearns sent out a letter (pdf) to investors telling them more or less what happened in June and that both SF and SELF are essentially worthless and will be disbanded (Reprinted in entirety below, emphasis ours):

Dear Client of Bear, Stearns & Co. Inc.

Let me take this opportunity to provide you with an update on the status of the High-Grade Structured Credit Strategies and High-Grade Structured Credit Strategies Enhanced Leveraged Funds managed by Bear Stearns Asset Management. A team at BSAM has been working diligently to calculate the 2007 month-end performance for both May and June for the Funds. This process has been much more time-consuming than in prior months due to increasingly difficult market conditions.

As you know, in early June, the Funds were faced with investor redemption requests and margin calls that they were unable to meet. The Funds sold assets in an attempt to raise liquidity, but were unable to generate sufficient cash to meet the outstanding margin obligations. As a result, counterparties moved to seize collateral or otherwise terminate financing arrangements they had with the Funds. During June, the Funds experienced signiicant declines in teh value of their assets resulting in losses of net asset value. The Funds' reported performance, in part, reflects the unprecedented declines in valuations of a number of highly-rated (AA and AAA) securities.

Fund managers and account executives have been informing the Funds' investors of the significant deterioration in performance for May and June. The preliminary estimates show there is effectively no value left for the investors in the Enhanced Leverage Fund and very little value left for the investors in the High-Grade Fund as of June 30, 2007. In light of these returns, we will seek an orderly wind-down of the Funds over time. This is a difficult development for investors in these Funds and it is certainly uncharacteristic of BSAM's overall strong record of performance.

Bear Stearns has been working to achieve the best possible outcome for investors under these circumstances. On June 26th, Bear Stearns committed $1.6 billion in a collateralized repo line to the High-Grade Fund. At this time, approximately $1.4 billion remains outstanding on this line and we continue to believe there are sufficient assets available in the High-Grade Fund to fully collateralize the repo facility.

In the past weeks, Bear Stearns has taken action to restore investor confidence in BSAM. On June 29th, we announced that Jeff Lane was appointed chairman and cheif executive officer of BSAM. Tom Marano, head of Bear Stearns' mortgage department, ahs been assigned to BSAM to aid in achieving orderly sales of the Funds' assets. The risk management function at BSAM has been restructured so that it will now report up to Mike Aliz, Bear Stearns' chief risk officer, creating an additional layer of oversight. Mike Winchell, former head of risk management for Bear Stearns and most recently with Bear Wagner, has been engaged to consult with BSAM with regard to its hedge fund risk management function.

Throughout this time, we have appreciated the support of our loyal client base and we will work to continue to provide you with the high quality products and services you have come to expect from Bear Stearns. Let us take this opportunity to reconfirm that the Bear Stearns franchise is financially strong and committed to meeting your investment needs.

Our highest priority is to continue to earn your trust and confidence each and every day, consistent with the Firm's proud history of achievement. As always, please contact us if we can be of service.

How it all started:

Two Bear Stearns hedge funds that together managed some $20 billion, High Grade Structured Credit Strategies Enhanced Leverage Fund (or "SELF") and High Grade Structured Credit Strategies Fund (or "SF"), found themselves on the losing side of their subprime bets (Made in the form of investments in CDOs).

Bear Stearns made an attempt to console SELF's creditors by suggesting a plan whereby they contributed some $1.5 billion in capital to the funds. However, major drama unfolded on Wall Street as Merrill Lynch rejected Bear Stearns plan choosing instead to seize control of its collateral (Nominally around $800 million). John Mauldin at SafeHaven elucidates the entire debacle as follows:

There were two funds, with the names High Grade Structured Credit Strategies Fund and High Grade Structured Credit Enhanced Leverage Fund. The first was three years old and had 40 straight months without a loss, and the second was started last August. The first used its $925 million in capital to bet $9.7 billion on the bull side and $4 billion on the bear side of the subprime mortgage market for about a six times leverage.

[SELF] "had $638 million in investor capital on March 31 and borrowed at least $6 billion to make $11.5 billion in bullish bets and $4.5 billion in bearish wagers." That is ten times leverage if your shorts and longs were truly opposite each other, and a lot more if they were not. ...

From January through April, the Enhanced Leverage Fund (which could also be called the Enhanced Loss Fund) was down 23%. The gentle margin clerks at Merrill Lynch decided they wanted some of their collateral back to sell on the market when Bear Stearns refused to pay off the loans. ...

So Merrill tried to sell $850 million in collateral. Except there was a problem. The best stuff was getting bids of only 85 cents or so on the dollar, and others were getting bids as low as 30%. Let's review the math above. At a 15% discount of the assets, the fund would be more than bankrupt, and the lending institutions would be losing money they had lent at very low rates and very high margin on what they thought was investment-grade debt. ...

Some investors in the Enhanced Fund have offered to sell their positions for 11 cents on the dollar. The offer is 5 cents. They should take it. And I will make you a leveraged bet that the offer comes from very litigious fund managers that are betting they can get Bear Stearns to pony up a lot more than 5 cents in settlement.

The dark cloud over Wall Street is that, upon repricing SELF's CDO collateral, a chain reaction will be set off whereby CDOs in the general market are repriced to reflect their current market value. Regarding this predicament, Dan Denning notes on Australia's the Daily Reckoning:

Well, the bonds just aren't worth what most people are carrying them on their balance sheet for. If Merrill sells, it's admitting whole huge chunks of mortgage-backed assets should be revalued to reflect market pricing. "No one in the subprime business wants to ask the question of whether they need to re-mark all the assets. That would open the floodgates," says Janet Tavakoli in the Journal article. "Everyone is trying to stop the problem, but they should face up to it. The assets may all be mispriced."

The SEC is currently conducting a probe into SELF, which has suspended investor redemptions and seems to have been financially abandoned by Bear Stearns. SF, on the other hand, has received $1.6 billion in funding from Bear Stearns. Notably, whereas SELF was net leveraged (netting bullish bets against bearish) around 10 times, SF was merely managing net leverage of close to six times.

The full outcome of the fallout in SF and SELF is yet to be determined. Rest assured the implications will be far reaching. Stay tuned ...

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Important: This fund is on our list of hedge funds that have "imploded" (see also ailing lenders). However, please note that "imploded" is a somewhat subjective. The "imploded" list contains hedge funds (or other unregulated and autonomous speculative investment funds) which have gone through some sort of permanent adverse change. This is a somewhat subjective call, and does not necessarily mean total shutdown or bankruptcy. It can also mean steep and rapid mark-downs in net asset value; or abnormal "bail-out" by corporate parents or peers in order to avoid write-downs and provide liquidity. The funds are of any type and sector.