bear stearns case

Topics: Subprime mortgage crisis, Bear Stearns, Collateralized debt obligation Pages: 9 (2039 words) Published: October 7, 2014

1.) Investment Strategies:
The investment strategy of the High Grade Structured Credit Strategies Master Fund was to raise capital from investors and that capital was used to buy “collateralized debt obligations” backed by highly rated subprime mortgage back securities. These CDO’s had a higher rate than that of their borrowing rate, thus, they had added to their expected return by levering more and then buying more CDO’s. To hedge some of the risk of the underlying asset, they bought credit default swaps. If the underlying exposure had a deficit, the swap would offset the loss with a gain. These CDS’s provided some protection against any movements in the credit market (Bear Stearns and the Seeds of its Demise, 2008). The investment strategy of the High Grade Structured Credit Strategies Enhanced Master Fund was essentially the same as the one above; however, there was a greater investment into low-risk securities. Thus, increasing the amount of leverage to enable this additional investment. This investment would then create a higher return, but with limited risk (Bear Stearns and the Seeds of its Demise, 2008). 2.) Profits 2003-2007:

The profits of these funds from 2003-2007 are shown in the table below. There was a significant decrease in the yields from 2003-2007 because of the collapse of the funds. Year
CDO yields

Borrowing Costs
(1year LIBOR rates + CDS rates)
Profits from the funds
(CDO – Borrowing Costs)
2003
5.67*1.25= 7.09
1.37+.30=1.67
5.42
2004
5.63*1.25= 7.04
2.19+.36=2.55
4.49
2005
5.24*1.25= 6.55
4.09+.30=4.39
2.16
2006
5.59*1.25= 6.99
5.35+.23=5.58
1.41
2007
5.56*1.25= 6.95
5.17+.79=5.96
.99

3.) Success to Collapse:
The investment strategy was very successful in its early periods because the housing market was very active. Low interest rates allowed an influx of borrowing and higher house prices. This created the need for an investment that could produce a substantial yield and was a “safe” investment. This was produced with AAA-rated mortgage backed securities. These factors made it possible for cumulative returns to be about 50% until 2007 (Bear Stearns and the Seeds of its Demise, 2008). In 2007, the hedge funds started to collapse. This collapse was originated by several factors, one of which being the housing market began to decline. The banks did not monitor their loans because they had little stake in them after they were securitized. This also led to the banks more hastily approving loans. This created a surplus of bank lending and the only safety net of these loans was the thought that when house prices rose, the lender could refinance (Bear Stearns and the Seeds of its Demise, 2008). Another factor was the rating agencies. These agencies charged up to .12% of the value of the issue for their services to rate the CDO’s. The percentage that the rating agencies obtained from rating the CDO’s, generated an increase in their revenues. This high fee was warranted because CDO’s were more intricate than say rating a bond. In addition, upon rating these CDO’s, the agency did not look at the “credit quality of the assets” in the CDO. Thus, they had no factual knowledge of the accuracy of the application information or who could actually pay back the loans. Not only did these agencies play a role rating the finished product, but also how to package the CDO’s themselves. They advised CDO issuers of where each level of tranche should be (Bear Stearns and the Seeds of its Demise, 2008). Correspondingly, the testing of the CDO’s using the Monte Carlo simulations proved highly inaccurate. Assumptions that were made for this analysis were erroneous, thus leading to a false positive on the CDO’s. The rating given to the CDO’s were not accurate either. The agencies failed to properly adjust the rating for their higher default rate compared to bonds. This gave the appearance of a safer asset than actuality (Bear Stearns and the Seeds of its...

Cited: Bear Stearns and the Seeds of its Demise, UV1064 (October 22, 2008). Retrieved from https://cb.hbsp.harvard.edu/cbmp/content/26588959
Gorton, G., & Metrick, A. (2012). Getting up to Speed on the Financial Crisis: A One‐Weekend‐Reader’s Guide. Retrieved from https://moodle.oakland.edu/pluginfile.php/2286770/mod_resource/content/1/Yale-GortonMetrick12.pdf
Cohan, W. (2009). Inside the Bear Stearns Boiler Room. Retrieved from:
http://money.cnn.com/2009/03/02/magazines/fortune/cohan_houseofcards_full.fortune/
Gray, A. (2009). The Future of Banking. Retrieved from:
https://www.pwc.com/en_TH/th/publications/assets/future-of-banking.pdf
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