Saturday, October 6, 2007

Bad News for Bear Stearns

As if the meltdown of two of Bear Stearns' large hedge funds over the summer wasn't enough, it appears federal prosecutors are looking into whether the collapse of the funds involved any criminal conduct.  The two funds, the High-Grade Structured Credit Strategies Fund and High-Grade Structured Credit Strategies Enhanced Leverage Fund, suffered over $1.6 billion in losses when the maelstrom from the subprime mortgage market caused the value of their investments to decline so quickly that the funds could not meet the requirements for large loans taken out to leverage their assets.  When you lose that much money in a short period of time, prosecutors are likely to ask at least a few questions.  According to reports (here), the U.S. Attorney's Office for the Eastern District of New York has only requested that Bear Stearns provide information, and no grand jury subpoenas have been issued to this point.

While a preliminary inquiry is understandable, will a criminal case develop?  The loss of $1.6 billion is striking, but the amount alone does not signal the likelihood of illegal conduct.  In September 2006, Amaranth Advisors LLC lost over $6 billion in just a couple weeks due to wayward bets on natural gas prices, but no criminal case has emerged.  It's the nature of the hedge fund beast that high-risk strategies, particularly the use of leverage to increase returns, means there is a commensurately greater possibility of significant losses, and those can accumulate very quickly.  While one can fault the Bear Stearns funds for not anticipating the problems in the subprime mortgage market when there were plenty of indicators that housing prices were declining, that's not a crime -- at least not yet.  Absent evidence of shuffling of assets or intentional misstatements to investors, the inquiry may turn out to be a small blip. (ph)

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