Bear Stearns hedge fund collapse -- It feels like 1998

August 8, 2007

Last week, two Bear Stearns hedge funds declared bankruptcy, costing investors $1.6 billion. The two funds were highly leveraged in mortgage-backed securities, and were two of the most prominent funds affected by the sub-prime mortgage meltdown.

This week, stock markets continued their decline in reaction to these further developments:

• The Bear Stearns CFO said this was the worst credit market he had seen in 22 years.
• Standard & Poor's cut Bear Stearns credit rating to negative, stating that its mismanagement of hedge funds left it liable to investor lawsuits.
• The Co-President, Warren Stearns, resigned.

(Source: FT.com, "Bear Stearns president resigns, 8/5/07; Stocks face nervous start to week, WSJ.com, Market swoons as Bear Stearns bolsters finances, 8/4/07; Economist.com, Abandon ship, 8/3/07)

What the Bear Stearns hedge fund collapse means:
The swiftness of the hedge funds' collapse, the enormity of the money lost, and the severity of the stock market plunge are indicative of the potential turmoil in the global economy that could be caused by hedge funds.

It is estimated that hedge funds have at least $1 trillion in global assets, but nobody really knows where this large amount of money is invested. Since hedge funds are not required to register with the SEC, they are less regulated than mutual funds, bonds and savings accounts.

Hedge funds use complicated trading techniques, including commodity options, currency futures and short selling. They are often guided by sophisticated computer programs that automatically generate buy or sell orders when the market triggers certain parameters. The amount of leverage these funds use greatly magnifies any market corrections.

Their focus on leveraged derivatives also means that when the market changes direction, these funds must make huge shifts in their investments to cover their positions. This increases the swings in the market, and ultimately the volatility in your portfolio.

Long-Term Capital Management (LTCM) was a hedge fund that nearly collapsed in the summer and fall of 1998. Since so many banks and pension funds were invested in LTCM, its problems led to the global market decline that year. Without the swift intervention of Fed Chair Alan Greenspan, the entire financial system was threatened with a collapse.

There is growing concern that the large role of hedge funds in today’s markets could cause a repeat of that panic. The situation at Bear Stearns seems to confirm that fear.

(Source: Hedge Funds, Leverage and the Lessons of Long Term Capital Management by The President’s Working Group on Financial Markets, 1999;  Remarks by Chairman Ben S. Bernanke At the Federal Reserve Bank of Atlanta’s 2006 Financial Markets Conference, Sea Island, Georgia, May 16, 2006)

Action steps:
Now is a good time to review your portfolio and perhaps shift some of your holdings into safer funds, such as commodities or bonds, and out of riskier ones, such as small cap.

Hedge funds related articles

Hedge funds impact, 6/6/07

The growth of hedge funds, 6/10/07

Trade surplus driving asset bubbles, 6/20/07

Global risk shifting to you, 3/27/07

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