Bear Stearns' Subprime Bath

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But the trouble at Bear Stearns' hedge fund is another illustration of the danger facing funds that rely heavily on borrowed money to make investment bets. True to its name, the High-Grade Structured Credit Strategies Enhanced Leverage Fund made liberal use of borrowed money. People familiar with the fund say many investments were leveraged 3 to 1, meaning for every dollar invested in a risky bond, the fund would borrow another three. Making highly leveraged bets works well if the value of an investment rises, but it can quickly crush a hedge fund if the investment declines in value.

That's what happened last September to Amaranth Advisors, which lost nearly $6 billion in a single week after a highly leveraged bet on the future price of natural gas prices blew up. "While leverage is great for returns in good times, leverage also magnifies the effects of a mistake and can hurt returns," says Janet Tavakoli, a Chicago financial consultant who specializes in advising clients on asset-backed investments

The losses this year are much smaller at another Bear Stearns hedge fund which invests in similar bonds, but doesn't use as much borrowed money. Bear Stearns' High-Grade Structured Credit Strategies is down about 5%, according to sources. Launched in October, 2003, it has enjoyed a good run. The fund has generated annualized average returns of 12.82%, according to a Bear Stearns investor letter. The "structured credit" fund was the model for the "enhanced leverage" fund. The marketing literature for both hedge funds say they mainly invest in "high quality, floating rate, structured finance securities," which includes asset-backed bonds, collateralized debt obligations (CDOs), and bank loans.

Meanwhile, the poor performance of the 10-month-old "enhanced leverage" fund is another black eye for Bear Stearns' plans to roll out an initial public offering for its Everquest Financial affiliate. The investment firm created Everquest last fall, and filed documents on May 10 to sell a stake to the public (see BusinessWeek.com, 5/11/07, "Bear Stearns' Subprime IPO").

Bear Stearns' two hedge funds then sold some of their riskiest CDO investments to the new entity. A CDO is a sophisticated bond made up of pieces of lots of other asset-backed bonds—often bonds backed by subprime loans. Nearly two-thirds of Everquest's portfolio of CDOs were purchased from two hedge funds. In return, the hedge funds got $149 million in cash and 16 million shares, valued at $400 million, in the soon-to-be public company. But even that largesse from the Everquest deal wasn't enough to overcome the fund's poor April showing.

Matthew Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.