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Business Finance: Investment Risk and Return September 11, 2009
Bear Sterns Page 1
Business Finance: Investment Risk and Return
Studying the collapse of Bear Ste arns
Companies, Inc.
Introduction
Hedge funds have played a significant part in the financial
markets in the recent decade. Armed mostly with funds
obtained from 99 investors (according to US regulations),
hedge funds have been known to use ever increasing
amounts of leverage to garner enough funds to overpower
the fundamental prices of securities and commodities. Worst
still is the involvement of hedge funds in derivatives which
Warren Buffett coined as the financial weapons of mass
destruction.1 However, it is not only derivatives like the
Collateral Debt Obligation (CDO) that investors must worry
about. In today’s highly complex financial market, investors
must never forget the basic principles of investment risk and
return and must learn of in some cases relearn to respect
risk.1 This research paper is therefore focused on the failure
and collapse of two hedge funds under Bear Sterns
investment bank whose reputation is now at stake in the
midst of the subprime crisis.
Working Paper
Sheffield Business
School
At Sheffield Hallam
University
Ee Suen Zheng
Bachelor of Arts with First Class
Honours in Banking and Finance
+603-9283 8950
+6016-696 6566
jamesesz.wordpress.com
Word Count: 3289 words
(excluding references and
appendix)
Business Finance: Investment Risk and Return September 11, 2009
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Contents
NO. Details Page Number
I. II. III. IV. V. VI. VII. VIII.
Introduction Summary Stand Alone Risks Risk In a Portfolio Context Capital Asset Pricing Model (CAPM) Risk and Return Recommendations Conclusion Bibliography Diagram 1 Diagram 2 Timeline Articles
1
2 – 4
5 – 8
9 – 11
12 – 14
15 – 16
17 - 19
20
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I.
Introduction
Hedge funds have played a significant part in the financial markets in the recent
decade. Armed mostly with funds obtained from 99 investors (according to US regulations),
hedge funds have been known to use ever increasing amounts of leverage to garner enough
funds to overpower the fundamental prices of securities and commodities. Worst still is the
involvement of hedge funds in derivatives which Warren Buffett coined as the financial
weapons of mass destruction.1 However, it is not only derivatives like the Collateral Debt
Obligation (CDO) that investors must worry about. In today‟s highly complex financial
market, investors must never forget the basic principles of investment risk and return and
must learn of in some cases relearn to respect risk.2 This research paper is therefore focused
on the failure and collapse of two hedge funds under Bear Sterns investment bank whose
reputation is now at stake in the midst of the subprime crisis.
1 http://news.bbc.co.uk/go/pr/fr/-/hi/business/2817995.stm 11/09/2007 6.00 PM 2 Jack D. Schwager, Market Wizards, 1989. New York Institute of Finance, United States of America.
Business Finance: Investment Risk and Return September 11, 2009
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II.
Summary
Hedge fund are an alternative investment, that aims at reducing risks and offering
investors returns that can offset losses in their traditional investment portfolio. However, the
lack of transparency of hedge funds can result in a different outcome altogether. Many
individual investors did not seem to mind a lack of transparency by the hedge funds as long
as the fund was delivering high returns. The collapse of LTCM Long Term Capital
Management clearly shows us the need to further study the reason of hedge fund failures.
Ralph R. Cioffi, the 51-year-old manager of two Bear Stearns hedge funds (High
Grade fund and Enhanced fund) was going against the collapsing subprime mortgage crisis.
He made a statement to convince its investors that the hedge funds under his management are
going to make profit out of the market. Deloitte & Touche, a well-known accounting firm
who was the auditor for Bear Stearns‟s High Grade fund and Enhanced fund warned the
fund‟s investors about the poor performance of the funds. This was proven by showing that
more than 60% of Bear Stearns‟s net worth was tied up in securities, signaling a serious
illiquidity that would make the hedge funds fall into trap of severe financial condition.
As the subprime crisis worsens and recovery seems unlikely, credit risk increased and
the hedge fund‟s portfolio of security became extremely risky. If a firm owns securities that
fail to attract buyers during a time of market stress, the fund will have a significant liquidity
risk. (Keith H. Black, 2004, p67). This is made true when Bear Stearns was soon unable to
sell its securities which turned the funds into a disaster. Furthermore, the two hedge funds
were holding some additional lightly traded security. Selling these securities in one of the
hedge funds back into the market would drive down their prices sharply and in turn affect the
other hedge fund‟s net worth.
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In 2006, Cioffi‟s investment strategy started to increasingly use short term debts to
buy lightly traded bonds. Thus, higher borrowings lead to an extremely high gearing ratio,
approximately 1:60. In order to pave the way of getting loans at low interest rates, Cioffi had
made a critical trade-off by offering big lenders like Barclays (Barclays was the sole equity
investor) the right to demand immediate repayment. As the CDOs values dropped sharply and
lenders starting to demand repayment, the borrow-and-buy game was over. Contributing to
the hedge fund‟s downfall is also the fact that the emergency funds of the two Bear Stearns
hedge fund were only 1% of their assets.
Due to the correlation between the Enhance Fund and the High-Grade Fund as
mentioned above, if anything should happen to the Enhanced Fund, the High-Grade fund will
also be affected. This is because both funds were investing in similar underlying securities.
Thus, when Barclays demanded repayment of its funds from Bear Stearns, Enhanced Fund
started to dump its holdings to pay back Barclays and in turn caused the prices of the
securities in High-Grade fund to also fall sharply.
Furthermore, the High Grade funds became more risky as the Cioffi‟s management
team did not disclose the incident about Enhance leverage fund. Moreover, the funds also
grew at a less profitable rate since the Bear hedge funds were using extensive borrowings to
invest. To further add to their deceit, the securities in these two hedge funds were valued by
Cioffi‟s management team without following widely available market values. A hedge fund‟s
net asset value is its assets minus its liabilities. It is therefore critical to track its profitability
based on the valuation of the securities the hedge funds are holding. To make matters worst,
the hedge funds were using the “smoothing returns” strategy in their valuation of illiquid
assets. Since the prices used are often not up-to-date market prices, the fund‟s fair value
would be less volatile. Thus, the investors were told that they will receive a steady flow of
returns every month.
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Other than that, Cioffi‟s team was driven by performance fees based on the
performance of the funds. Therefore, they were using aggressive investment ways to boost
returns for their own interest. As results, these managers remained artificially optimistic
although the subprime market was going to collapse. As a last resort, Cioffi wanted to list
Public Everquest Financial so as to raise funds from the public to save the two hedge funds.
However, this public offering had failed. Now Cioffi faces legal problems as lawyers found
that valuation of securities will stimulate the prosecutor‟s interest. All this reminds us of the
downfall of Barings bank and its rogue trader Nick Leeson.
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III.
Stand Alone Risk
Generally, Bear Stearns hedge funds invested in structured-finance products, The
Bear Stearns hedge funds, which are the High-Grade fund and the Enhanced fund, begin
buying risky pieces of collateralized debt obligations (CDOs), high-yield bonds and etc. We
will look into the risk portion in these aggressive investment activities and its danger inherent
in the market.
Firstly, the CDOs are an important example of asset-backed securities and normally
are backed by a pool of assets (Bingham & Kiesel, 2004, pp.404). The CDOs which the
hedge funds invested in are backed by sub-prime and others mortgages. Cioffi was actively
trading in the booming CDO market by holding nearly $30billion worth of this type of
securities. They were basically taking the investor‟s money, leveraging it to the maximum
and dumping everything into the CDO market.
Normally, an institutional investor such as Bear Stearns will not only invest in one
identified type of asset but it is crucial for us to understand the stand-alone risk in CDO and
high-yield bonds before understanding the effect of this type of securities on the overall
investment risk associated in his portfolio selection. Stand alone risk is the risk an investor
would face it if he or she held only this one asset (Bingham E. 2004, pp.170).
When Cioffi entered into the market of CDOs, he probably invested solely in sub-
prime and others mortgages that are positively correlated to each others because it is in the
same industry that is involved securitization activity. The typical structured of securitization
is shown on the next page, (Liaw, 2004. pp.306):
The Process of Securitization (Liaw, 2004. pp.306)
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Loan Originator
Loans
Special Purpose Vehicle
Asset-backed securities
Underwriter
Institutional investors
Credit EnhancerRating Agency
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Normally, the lenders would bundle or pool together the bad debts and preferable
loans into one basket of loans and sell them to investment banks, which in turn will resell
them to their other investors. These mortgage-backed securities will be rated accordingly to
their repayment ability and default risk by rating agencies. Before the subprime crisis
happened, these securities were actually being rated good gradings, eg AAA marks, because
these securities are accompanied by collateral and default risk were at a minimum rate with a
booming housing industry. All of a sudden risky consumer loans were reconstituted into
something seemingly no more risky than a government Treasury bond. After the housing
bubble burst, house prices started falling and the rating agencies were not even quick enough
to downgrade the risky investments.
What prompted Cioffi into investing in these securities? CDOs have a probability to
generate higher return because of their high risk attached to it. This higher expected return
will works as an additional compensation for the higher rate of failures induced in the CDOs
market. By assuming the Bear hedge funds have riskier assets, CDOs, the graph for
probability distribution of the hedge funds to gain return is shown below.
-70 0 20 100
CDOs
Rate of Return (%)
Probability Density
Treasury bond
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The above figure shows us the assuming probability that CDOs‟ return will less than
-70% or more than 100%, any return that will fall within these limits is possible. Thus, the
risk distribution for CDOs (curve in blue) is in a wider range showing that there is a higher
probability of the actual outcome being different from the expected return.
Comparatively, the risk within Treasury bond, which normally involves inflation risk
alone are showed in the tighter curve (curve in red) that implicate the greater probability of
actual outcomes being similar to the expected return. If the Bear funds did include the
Treasury bond into its investment selection, the risk could be diversified and we will discuss
it in the risk in a portfolio context.
References:
Bingham N.H & Kiesel R. (2004), Risk-Neutral Valuation-Pricing and Hedging of
Financial Derivatives, second edition, Springer-Verlag London limited.
Brigham, E (2004), Fundamentals of Financial Management, tenth edition, South-
Western.
Liaw, K. Thomas (2004), Capital markets, Thomson South-western.
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IV.
RISK IN A PORTFOLIO CONTEXT
An ideal portfolio produces returns that have a low correlation to traditional
investments, as well as a low standard deviation of returns. This goal is most likely to be
achieved when the fund of funds manager carefully diversifies their portfolio. Correlations
are very important, as portfolio theory explains that we can invest in high-risk, high-return
assets without increasing standard deviation when the correlation between that fund and the
portfolio return is low enough to offset the high volatility of the additional investments.
(Keith H. Black, 2004, p 314)
Risks are divided into systematic and unsystematic risk. Unsystematic risk is
associated with an individual company or industry; it may be diversified away in a large
portfolio. (Geoffrey A. Hirt and Stanley B. Block, 2006, p 602) As more assets are added into
portfolio, Bear Stearns may be able to fully diversify its unsystematic risk.
Theoretically it is said that a perfectly negative correlation between two stocks can offset the
standard deviation and bear no risks. However, in the world of reality, it is impossible to
achieve such correlation because there is risk that is unavoidable which called the market
risk. Therefore, risk in a portfolio context in practice depends on the correlations among the
individual stocks that are hopefully generally positive. However, not all risk can be
eliminated and what is left are the risks that cannot be eliminated.
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Portfolio Risk, σp
(%)
Diversifiable Risk
a) b) c)
Number of
Assets in
Portfolio
a) Portfolio‟s Stand Alone Risk: Declines as More Assets Are Added
b) Portfolio‟s Market Risk: Remains Constant
c) Minimum Attainable Risk in a Portfolio of Average Assets
The market risk or systematic risk cannot be diversified away even in a large portfolio is
measured by its beta coefficient and the following benchmarks are held:
b = 0.5 : Security is only half as volatile, or risky, as an average stock.
b = 1.0 : Security is of average risk
b = 2.0 : Security is twice as risky as an average stock.
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Relating back to the Bear Stearns hedge funds case, the assets in its portfolio is
definitely at a high risk as Cioffi engaged the hedge funds in irregular and illiquid securities
such as CDOs, lightly traded securities, and so on.
Bear Stearns may be able to make profit and diversify its portfolio unsystematic risk
by selecting high risks assets into its portfolio provided the correlation between the assets
must be at low or negative correlation or diversify by selecting assets that are of high risks
and low risks assets such as Treasury Bills. Unfortunately, Bear Stearns allocated the funds
into highly correlated and similar type of stand alone assets that brought about extremely high
risks and positively correlated among the assets, making its portfolio risky.
In some cases a fund manager (here, Bear Stearns) may be able to borrow funds in
order to purchase even greater amounts of a portfolio than his own funds will allow. The risks
in Bear Stearns hedge funds increased tremendously when the fund manager, Ralph R. Cioffi
used a type of short-term debt to borrow billions more; yet made a critical trade-off: For
lower interest rates, he gave lenders the right to demand immediate repayment. This increases
the illiquidity when both of the High-Grade fund and enhanced fund collapsed when
investors demand for repayment.
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V.
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a model of market equilibrium in which
the return on a given security is related to the risk premium on that security. In turn the risk
premium is related to the covariance of the asset return with the return available on the
market portfolio (Maximo V.Eng, et al, 1998, pp.564). CAPM concludes that the investors
mix risky assets and less risky assets in their portfolio. Risk-free assets may also be involved
in the given market portfolio. The expected return for any portfolio on the line is equal to the
risk-free rate plus a risk premium. If investors are to invest in risky assets, they must be
compensated for this additional risk with the risk premium. There are 2 important
relationships in the CAPM that are Capital Market Line (CML) and the Security Market Line
(SML).
CML specifies the equilibrium relationship between expected return and risk for an
efficient portfolio.3 It is only useful for efficient portfolios and can‟t be used to assess the
equilibrium expected return on a single security. The efficient portfolio means a portfolio that
is well diversified in which the highest level of return at the given level of risk or the highest
level of risk at the given level of return. All the combination of efficient portfolios is on the
CML line. CML is used to determine the optimal expected return.
Equation for CML:
p
M
Mp
RFRERFRE
)()(
However, the Bear Stearns High-Grade Structured fund and High Grade Structured
Credit Strategies Enhance Fund is not efficient as they failed to apply this theory. This is
3
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because the portfolios were mainly consisted of the high-risk securities such as the mortgage-
backed securities. These funds aimed at maximizing returns but not to minimize risk by
investing in high-risk high return securities.
SML specifies the equilibrium relationship between expected return and systematic
risk.4 SML depicts the tradeoff between risk and expected return for individual securities. It is
also applicable to individual securities and portfolios. The security‟s risk will be measured
based on beta. Beta is a benchmark to determine the individual asset‟s riskiness with the
market portfolio of all the assets. It measures the systematic risk of the asset that cannot be
diversified such as interest rate risks. The market portfolio has a beta of 1.0 which means that
for every 1-percent change in market‟s return, on average, this security‟s returns change 1-
percent. If the beta is more than 1.0, it means the assets are more volatile (risky). If the beta is
less than 1.0, it means the assets are less volatile (risky. If the value of beta is higher, the risk
of individual assets is higher.
Equation of SML:
RFERRFR Mii
According to the formula above, RFERM is referring to the market risk premium
which is the risk premium on the average securities (Brigham, E. 2004, pp.195). The size of
this premium depends on the perceived risk of the securities market and investors‟ degree of
risk aversion. However, it is hard to measure the market risk premium as the market expected
return cannot estimate accurately. So, it is normally based in the market past performance to
measure and this might mislead the investors. According to the case, as the hedges funds
depend on the illiquid assets which the prices used are often not up-to-date market price,
makes the funds fair value would be less volatile and thus less risky.
4
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For RFERMi , it is the risk premium on a single security (Brigham, E. 2004,
pp.195). This risk premium will vary from each individual security and it is goes in line with
its beta. Thus, Cioffi invested more than 60% of their net worth in exotic securities as they
offered higher risk premium.
The SML has important implications for securities price whether the security is
overvalued or undervalued. When each security lies on the line, the investors required rate of
returns are same with the market expected rate of returns. In order to know whether the
security is overvalued or undervalued, investors must first know the beta for any security. If
the market expected return of a security is higher than the required rate of return, it is
undervalued and investors will buy or hold it. When the required rate of returns higher than
the expected returns, it is overvalued and rational investors will sell or would not buy it. The
funds were overvalued by Cioffi‟s own management team as they valued their funds in the
absent of market values. However, the investors were misled by Cioffi as they were told that
they shall receive steady gain of 1% - 2% a month, makes them feel confidence with their
investment.
„
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VI.
RISK and RETURN
(Two Sides of the Investment Coin)
Investment decisions are determined by various reasons. For most investors,
individuals and institutions, one of their primary motives is to earn returns (Prasanna
Chandra, 2006, pp.127). The investors would naturally wish that their returns to be as large as
possible. In Bear Stearns hedge fund‟s case, the management team aggressively invested in
the high risk securities as they will be paid according to their hedge funds performance fees.
As evidence, Cioffi is going to keep 20% of any profits they generated, plus 2% of the net
assets under management. However, they should understand that the returns would bear some
risk in which is the possibility of the expected returns being different from the actual returns.
Generally, there is positive relationship between risk and return and this trade-off would be
the centre for any investment decision.
Basically, there are components which investors must consider in forming their
expected rate of return of their investment (Brigham, E. 2004, pp.195). First, it is their
required rate of returns, which is the minimum return that an investor expects from an
investment. Investors basically will buy and hold the securities if the expected rates of returns
are higher than the required rate of returns. The required rate of returns for the Bear Stearns
High-Grade Structured fund and High Grade Structured Credit Strategies Enhance Fund must
be at least the interest rates of their borrowings.
In order to involve in high-risk investment, investors must be rewarded by a risk
premium, which is the additional returns investors expect to obtain for assuming additional
risk (Prasanna Chandra, 2006, p.127). The hedge fund managers willingly invested in the
exotic and lightly traded bonds as the investments offered higher yields mainly due to the
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default risk premium. The higher yields of bonds also lead to lower bond prices. Thus, the
funds will not only earn a higher yield but also a higher capital gain.
Besides that, the liquidity risk premium is another concern for an investor. If the
security is easy to sell at a fair price, then the premium will be lower and vice versa. In the
article, one of the motives Cioffi invested in the mortgage-backed securities is that they
offered higher liquidity risk premium. This is because houses are not easy to sell at their fair
value and liquidity is subject to the market condition. If the funds become increasingly
illiquid, then funds are more likely to be failed (Black, 2004, pp.66). Therefore, the two funds
collapsed during the subprime crisis.
For the hedge fund‟s investors, the hedge funds were supposed to minimise their risks
for a given level of returns as they were told to expect a small but steady return every month.
However, the returns were not guarantee. In this case, the agency relationship problem arose;
the investment strategies caused the investors to invest indirectly in the risky instruments,
arrangement with lenders (Barclays), the failure of disclosure, etc. Moreover, they also faced
pricing and model risk where these mortgage-backed securities and high yield bonds are
often illiquid and difficult to value (Black, 2004, pp.71). The overvaluation of the funds made
the investors‟ expected rate of returns became irrational. Thus, if the investment risks go
beyond manageable level, it will generate substantial losses.
Reference:
Prasanna Chandra, Investment Analysis and Portfolio Management, 2nd
edition, 2006
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VII.
Recommendations
The Bear Sterns hedge funds were actually involved in murky dealings with investor‟s
money. They lied to their investors that even if the market is in a bad and unfavorable
condition, that they will still make profits and garner returns. As such, we recommend that
investors need to have more information about the complex assets that their hedge funds are
investing into so as to avoid misleading information by hedge fund managers such as Cioffi‟s
CDO investments that were of nature extremely high in risk. Thus, investors can make better
rational decisions based on the level of risk of the funds. The failure of investors to make
rational decisions (especially before the funds collapse) is due to the fact that hedge funds are
not required to disclose positions and trading strategies. As a result, no one knew who was
holding what, no one trusted counter parties, leading to credit crunch (refer to The EDGE
Malaysia, the week of October 29,2007).
In addition, if the two hedge funds are to be supervised by an independent party in
their investment structure, misuse of funds will be minimizes.
Despite Cioffi‟s considerable expertise in the investment field, Bear Stearns should let
him be in full control of both hedge funds in Bear Stearns Asset Management. Cioffi‟s
overconfidence and his risky investment strategy thus made it certain that it defies and
neglect the real purpose of the hedge fund which is to involve in low risk, and low-correlated
strategies (Black, 2004, pp.120).
Besides, Cioffi‟s team needs to have ethical behaviors towards his responsibility.
According to agency theory, it is common for management teams to invest for a personal
goal, in this case to obtain high performance fees rather than the maximization of investor‟s
return. When they are dealing with investor‟s money, they should hedge the risk away instead
of speculating for higher return. With the excessive leveraging in short-term debts, the hedge
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funds actually double the risk involved. Moreover, the arrangement with Barclays actually
represents a conflict of interest with investors. As a golden rule, Cioffi should safeguard
investor‟s interests. Moreover, Cioffi must be more conservative, and reserve at least 10% of
emergency funds in lieu of the 1% they were actually holding.
In order to manage the risk of the funds, it is important to understand the relationship
between the type of trading strategies and the risks and returns in the market environment
(Black, 2004, pp.84). Investing heavily in the mortgage market can have large losses during
the property market crisis occured. (plz cont. urself in risk mgt : insufficient info.
Diversification is an essential indication to a portfolio selection. In our case, the Bear
Sterns hedge funds were not well diversified. At first, Cioffi and many other fund managers
thought that investing in mortgage-backed securities provided some sort of diversification
through the combination of the prime and subprime loans. Therefore, Cioffi should invest in
negative correlated industry such as commodity market.
Most hedge fund activities do not start up to commit fraudulent activities. But losses
are incurred; people will try to cover up illegally. The Bear hedge funds exercised
overvaluation, and used the „smoothing returns‟ strategy to mislead investors. As a solu tion,
regulation should play a more important role in hedging activities. The financial system needs
better supervision and governance in relating issues arise such as it must set a standard
requirement for their disclosures. Valuation methods also must be supervised by government
agencies to avoid inconsistent practices.
References
Keith H. Black (2004), Managing a Hedge Fund: a complete guide to trading,
business strategies, operations, and regulations, The McGraw-Hill.
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Subprime Crisis
Risky Investments
(CDO)
Excessive Leverage
Dangerous Structure (Deal with Barclays)
Low Reserves
Collapse of Bear Sterns
Hedge Funds
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Oct 1, 2003
•Bear Sterns High-Grade hedge funds opens
Dec 31,2004
•The Funds reported a one-year gain of 16.88%
August,2006
•Bear Sterns Enhance hedge funds opens
October, 2006
•Everquest Financial, a Bear Sterns affiliate, begins buying risky pieces of collateral debt obligations from the two hedge funds
February, 2007
•Problems at New Century Financial and other lenders spark the subprime meltdown
•The manager, Ralph Cioffi, talks about a 'catharsis' in the mortgage industry
March, 2007
•The Enhanced and High-Grade funds report monthly losses of 5.41% and 3.71% respectively
•Investors start redeeming their money
May 9, 2007
•Everquest Financial files for an initial public offering
May 15, 2007
•Bear Sterns warns investors in the Enhanced fund to expect a 6.5% drop for April
June 7, 2007
•Bear Sterns revises the April decline for the Enhanced fund to 18.97% and freezes investor redemption
June 22,2007
•Bear Sterns announces a $1.6 billion loan for the High-Grade fund
June 30, 2007
•Bear Sterns halts redemption from the High-Grade fund
June 31, 2007
•The two funds file for bankruptcy