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Did Bear Stearns Soft-Pedal The Risks?


By Matthew Goldstein How inflated did the market for subprime mortgages become during the recent bubble? Take a look at two Bear, Stearns & Co. (BSC) hedge funds that blew up in July. Investors lost $1.6 billion all told. Now some are claiming that Bear marketed the fundswhich bought risky mortgage-backed securities largely with borrowed moneyas conservative investments. Even more surprising, some of the world's savviest investors, including at least one inside Bear, were willing to suspend their disbelief long enough to buy in.

At a London conference in February, 2006, Matthew Tannin, a senior managing director at Bear, told investors that buying into one of the hedge funds he was hawking, the Bear Stearns High-Grade Structured Credit Strategies Fund, was akin to putting money in an ordinary bank account, according to a person in attendance. Investors say other Bear officials promised at various times that while the value might slide in any given year, shareholders could always get their initial investment back. The marketing was so slick it persuaded one of Bear Stearns' top brokers, Shelley Bergman, to dive in. Says one investor who asked not to be named and has recently hired a lawyer: "[The fund] was described as very low volatility, very conservative, and very low risk. They said a doomsday scenario was a 5% to 10% loss."

That, of course, proved inaccurate. The High-Grade Structured Credit Strategies Fund and the related Bear Stearns High-Grade Structured Credit Strategies Enhanced Fund both imploded in June, wiping out $1.6 billion in investor capital. The funds had gorged on collateralized debt obligations (CDOs)--complex bonds often backed by the riskiest subprime mortgages--and employed $16 billion in borrowed money to lever up the returns. One of the funds was at times borrowing $20 for every dollar investors put in--an enormous amount even in the freewheeling hedge fund world. The Bear funds joined a long list of leverage-driven blowups, from Long-Term Capital Management in 1998 to Amaranth Advisors in 2006.

SETTLE OR FIGHT

Now investors are crying foul. Regulatory filings reveal that 17 customer complaints have been lodged against Tannin and Ralph R. Cioffi, the other senior managing director who oversaw the hedge funds' operations. On Wall Street, the grievance process usually starts with the investor filing a complaint with the firm. Having received the complaints, Bear can try to settle, or it can fight, at which point the matter will go before an independent arbitration panel. Thus far, Bear seems ready to fight. Says a spokesman: "We will defend ourselves vigorously."

A thumbnail summary of each complaint, compiled by Bear for regulators, charges the same thing: "Customer alleges inconsistency between the fund's described investment strategy and actual investments." The Bear spokesman disputes the allegations, arguing that the "high-net-worth investors in the fund were made very aware that this was a high-risk, speculative investment vehicle." Cioffi declined to comment. Tannin, through the spokesman, says he never compared the fund to a bank account and never implied it was a "very safe investment."

The truth likely lies somewhere in between. The prospectuses for the funds offered clear caveats that "there is a risk that an investment in the fund will be lost entirely or in part." And the degree of leverage was described in detail in monthly reports sent to shareholders.

But investors say Bear Stearns went out of its way to downplay the risk. A half-dozen investors and their lawyers contacted by BusinessWeek say most investors came away from meetings with Bear officials believing that the funds were "very conservative" and "low-risk" ventures that promised "no loss of principal." In a due diligence survey submitted to the Alternative Investment Management Assn., which collects information on funds' strategies and passes it along to investors, Bear's managers said they had taken a number of steps to reduce risk during a "financial crisis or a broad deterioration of credit quality." They also said the market for CDOs was "fairly liquid."

The 2006 audited financial statement for the hedge funds, prepared by Deloitte & Touche, tells a different story. An auditor's letter, dated Apr. 24 and sent to investors in May, just as the funds were collapsing, notes that 70% of the funds' net assets consisted of securities whose values were estimated by the fund managers "in the absence of readily ascertainable market values." The auditors warned that the difference between the real values and Bear's estimated ones "could be material."

RED-FACED

Investors chose to believe the sunny sales talk. And not only outsiders: Bear also marketed the funds to its own brokers during internal "road shows." Bergman manages about $1.2 billion for some of Bear's wealthiest clients and ranked 37th among U.S. brokers in a 2006 survey published in Barron's. People who know him say he was so convinced by the sales pitch that he put around $1 million of his own money into the funds and recommended that some three dozen clients do the same. Three of them have since filed complaints. Nelson A. Boxer, an Alston & Bird lawyer who is representing Bergman, says the broker "has never had a customer complain about him or an investment" before this incident. In a regulatory filing describing the complaints against him, Bergman deflects blame for recommending the funds, arguing that the customers in question "relied upon communications from the fund's portfolio manager" in making their investment decisions.

The swirling allegations could prove embarrassing for Bergman and Bear--especially if investors can prove the sales pitch was a curveball. Then again, the big-league investors buying into the risky funds should have seen it coming.

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


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