But Wait – There’s More

The average hedge fund uses about six to one leverage in order to obtain the performance success we have become accustomed to seeing in the hedge fund world. Investors in Bear Stearns’ fund called Enhanced Leverage put up about $638 million of their own money. The fund was then able to borrow about 10 times that amount. They used repo-financing and a credit facility at the Barclay’s Bank.

Enhanced Leverage then went out and invested about $11.5 billion in both bonds and various and assorted bank debts on the long side. On the short side, they had about $4.5 billion through credit default swaps. These transactions were originated on the ABX Index, all of which were tied into subprime mortgage bonds.

I know you are asking how it all came undone. What happened is that the underlying bonds of the whole market segment are what you could call the subprime market came undone. Back in February, this hurt Bear’s two funds. The funds and the hedges laid on by Bear went under water in March simultaneously. The hedges should have performed when the market worsened, and they didn’t. That was the killer. The hedges did not do what they were supposed to do.

In late May, Bear knew they had to do something. What Bear chose to do was close down the redemption process. In other words, not allow any investors to withdraw their remaining funds, which would create a run on the hedge fund. This is similar to Franklin Roosevelt closing down the banks in 1933, to prevent a run on the banks from taking place.

The banks who lent the money to the Bear Stearns sponsored funds quickly began selling down the securities in the funds in an attempt to back into some kind of positive equity balance. This was all the result of margin calls brought about the funds’ poorly performing, and now distressed investments. Bear finally agreed to a bail-out of one of the funds injecting $3 plus billion dollars into the fund. The firm as of now will not rescue the other fund, known as Enhanced Leverage.

In our opinion, Bear will not be the last firm to experience problems with hedge funds, and investors are in for a further rude awakening as the hedge fund industry continues along its under-regulated path of seeking maximum investment performance. Many hedge funds are overextending, and frankly have no idea as to their actual open positions in the financial world.

Bear and nobody is better than Bear says it will be another week or two before it knows the extent of the losses of its investors in these two funds. If that is true of the best managed risk taking firm in the world today, how much confidence can you have in the hundreds of other hedge funds out there that are poorly managed compared to the legendary Bear Stearns.?

The answer is you’d better sleep with your pants on, if you think your money is safe in the hedge fund world. You think you’re sleeping on a nice warm bed. What you don’t realize is that the bed is sitting on a railroad track with a 100 mile per hour train bearing down on you. The problem with hedge funds is the leverage. Six to one is normal, and then you get the ones that go crazy and start approaching 10 to 1 leverage in the race for performance. It’s great when the market is on your side, but when the market goes against you; these entities literally go out of business.

Warren Buffett has always talked about being able to sleep at night with your investments. He also talks about what would happen if you wound up in a coma, and woke up 10 years later? Would the investments you made ten years ago still be good, or not? Would you like to wake up from a coma, owning hedge fund investments for the previous ten years, maybe yes, maybe no, but as an investor, you better be able to answer that question?