Bear Stearns to the Rescue—Sort Of

The firm's plan to shore up two hedge funds hit by the subprime mortgage mess favors the one that's in better shape

by Matthew Goldstein

Bear Stearns (BSC) says it has a plan for rescuing its two hedge funds that are drowning in a sea of risky bonds backed by subprime mortgages. But the Wall Street firm's June 22 effort to provide up to $3.2 billion in last-ditch financing will do little to help investors in the hedge fund that has suffered the bigger losses.

That's because Bear Stearns is planning to use all of those billions to shore up its High-Grade Structured Credit Strategies Fund, a four-year-old fund that raised $916 million from investors. That fund is in much better shape than the 10-month-old High-Grade Structured Credit Strategies Enhanced Leverage Fund, which lost 23% of its value at the end of April.

It was the big declines at the enhanced leverage fund that prompted Bear Stearns to suspend investor redemptions, forced it to sell off $4 billion in high-quality mortgage-backed bonds, and caused a crisis of confidence on Wall Street (see BusinessWeek.com, 6/13/07, "Bear Stearns' Hunt for Big Cash"). The underlying assets in the enhanced leverage fund are believed to be so battered that Bear Stearns isn't inclined to pour in money, according to mortgage bond traders.

Bear Stearns' answer to the problems at the enhanced leverage fund doesn't seem much different from what it has been trying to do for the better part of the past week: negotiate deals with the many banks that lent money to the fund. It's still not clear whether Bear Stearns will be successful in getting those banks, which include Merrill Lynch (MER), JPMorgan Chase (JPM), Deutsche Bank (DB), and Lehman Brothers Holdings (LEH), to hold off liquidating the fund's remaining assets—distressed mortgage-backed bonds—to pay down the loans.

Investors Out of Luck

But one thing is clear. Investors in the enhanced leverage fund are lucky if they get any money back at the end of the day. A Bear Stearns spokesman declined to comment on the prospects for investors in that fund, which raised $642 million last summer. But people familiar with the situation say it appears that the original equity investors in that fund, which relied heavily on borrowed money to buy risky subprime-backed bonds, are going to be out of luck. Before Bear Stearns suspended redemptions in the fund, investors had sought to redeem up to $250 million (see BusinessWeek.com, 6/12/07, "Bear Stearns' Subprime Bath"). But some investors may have gotten money out of the fund before Bear Stearns shut the door.

Bear Stearns Chief Financial Officer Sam Molinaro Jr. tried to sell the hedge bailout to Wall Street analysts and investors during a June 22 conference call. "All of the threatened liquidations (at the enhanced fund) have been pulled while we are negotiating with counterparties," Molinaro said. "We do think the asset values have been beaten down significantly. But we do think there is significant value in the high-grade fund." But the plan got a cool reception. In trading June 22, shares of Bear Stearns fell 1.4%, to $143.75, on the New York Stock Exchange. The firm's shares have fallen about 4% since the crisis began in its hedge funds.

The fate of the negotiations between Bear Stearns and the banks that lent money to the enhanced leverage fund is critical and being watched closely by all on Wall Street. The big fear is that a mass liquidation of those poor-performing bonds, called collateralized debt obligations (CDOs), will force hedge funds and banks with similar CDOs in their portfolios to mark down their values. A mass reduction in CDO values could cause other banks and hedge funds to report sizable losses and scare off institutional investors. In a worst-case scenario, it could prompt lenders to get more protective and stop making loans of all sorts, not just to subprime borrowers.

The prospect of investors in the enhanced leverage fund getting nothing back may fuel litigation. Already, a number of investors in that fund have begun talking with lawyers. Ron Geffner, an attorney in New York with Sadis & Goldberg, which specializes in representing hedge funds, says a number of investors in the troubled enhanced leverage fund have contacted his office. The firm is exploring whether litigation is a possibility.

Meanwhile, the trouble at the Bear Stearns hedge fund has forced the bank to scuttle its plan for an initial public offering for Everquest Financial, an affiliated entity that had bought some of the riskiest subprime bonds from the two hedge funds. Bear Stearns filed an IPO prospectus for Everquest in early May, at the same time its hedge funds were beginning to rack up big losses on the subprime market (see BusinessWeek.com, 5/11/07, "Bear Stearns' Subprime IPO").

Bear Stearns and the hedge funds are the majority shareholders in Everquest, a company that was founded only in October. But now that the IPO has been shelved, it's not clear what happens to Everquest.

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