Bear's Big Loss Arouses SEC Interest

The SEC is inquiring into the near-collapse of its fund, and Bear Stearns CEO James Cayne's reputation may be on the line

by Matthew Goldstein

Bear Stearns (BSC) may have a lot of explaining to do about a big restatement of losses at one of its troubled hedge funds—and not just to its investors. BusinessWeek has learned that the Securities & Exchange Commission recently opened a preliminary inquiry into the near-collapse of Bear Stearns' High-Grade Structured Credit Strategies Enhanced Leveraged Fund. People familiar with the inquiry say regulators are interested in learning how the Wall Street investment firm came to dramatically restate the April losses for the 10-month-old fund, which invested heavily in securities backed by subprime mortgages, or home loans to consumers with shaky credit histories.

As BusinessWeek first reported, Bear Stearns told investors May 15 that the Enhanced Leveraged fund—which raised $642 million last summer—had lost 6.5% in April. But three weeks after that estimate, the investment firm shocked investors on June 7, telling them that the fund's actual April loss was 18.97%, or 23% for the year (see BusinessWeek.com, 6/12/07, "Bear Stearns' Subprime Bath").

SEC Commences Probe

The restatement, and the prospect that other hedge funds could face the same situation, has sparked widespread concern on Wall Street about the subprime housing market and the opacity of prices for assets underlying many of the securitized mortgage bonds that have flooded the market in recent years.

In the June 7 letter to investors, Bear Stearns provided no explanation for the discrepancy, but added "we do not currently have any reason to believe that the returns will change materially." At the same time Bear Stearns was serving up that sobering news, the Wall Street firm quickly moved to suspend investor redemptions, fearing the hedge fund would not able to liquidate enough bonds to satisfy the demands of investors or the other Wall Street banks that had lent the fund billions of dollars.

A spokesman for the SEC declined to comment, as did a Bear Stearns spokesman. But people familiar with the inquiry say lawyers from the SEC's main office in Washington are beginning to gather information about the troubling series of events at the hedge fund.

Under the tutelage of CEO James Cayne, Bear Stearns has become a powerful player in the hedge fund world, both through its own prime brokerage arm and in managing the firm's own in-house hedge funds. The firm generates a significant chunk of its revenue from providing back-office services and lending out stock to hedge funds. The trouble with the Enhanced Leveraged fund threatens to hurt Bear Stearns' reputation with the hedge fund community.

Bear Stearns Blames Banks

Privately, Bear Stearns is spreading the word that the April restatement was prompted by actions by some of their lender banks. People familiar with the matter say the Wall Street firm claims the banks began demanding that the hedge fund put up more collateral for the loans it had taken.

The banks, on their own accord, began marking down the value of the subprime bonds that the hedge fund had invested in, which had the effect of precipitating the current crisis, according to the people familiar with Bear Stearns' account of the events. For the past week, a number of banks that lent money to the Enhanced Leveraged Fund, including Merrill Lynch (MER), JPMorgan Chase (JPM), and Deutsche Bank (DB), all have threatened to sell some of the bonds the fund holds as a way to pay down the loans. But the banks are wary of doing that because many of the bonds are distressed and would sell for only a fraction of their initial value.

But the magnitude of the April restatement is raising eyebrows on Wall Street. Mortgage and bond traders say that while the banks may have contributed to some of Bear Stearns' higher losses, it's unlikely they were the complete cause of the restatement. Some have speculated that Bear Stearns may have had to recalculate the price of its subprime-backed bonds after liquidating some assets to honor earlier investor redemptions. Others says Bear Stearns' system for modeling the value of its subprime securities may have been too optimistic, prompting the hedge funds' auditors to raise questions about the methodology and forcing recalculations.

Bailout Unlikely

The big losses at the Enhanced Leveraged fund, combined with smaller losses tallied at a related Bear Stearns hedge fund, have roiled Wall Street for nearly two weeks. Investors are worrying about the impact a mass liquidation of the risky bonds held by the two hedge funds would have on the broader market. On June 22, Bear Stearns moved to save the related fund that has lost less money—the Bear Stearns High-Grade Structured Credit Strategies fund.