Although the financial crisis caused a public outcry, there was no reckoning for the bankers who were blamed for the crisis. Two managers at Bear Stearns hedge funds were arrested for misleading investors, but they were found not guilty. The only successful prosecution was of Kareem Serageldin, a Credit Suisse executive who was convicted of mismarking bond prices to hide the bank's losses.
Formerly one of the largest investment banks on Wall Street, the collapse of Bear Stearns is now regarded as a cautionary tale against corporate greed and the whims of the free market. In the housing bubble of the early s, Bear Stearns leaned heavily into mortgage-backed securities, vastly underestimating the risks of the subprime housing market.
When the housing market collapsed and borrowers began to default, the value of those securities plummeted. Since the purchase was supported by the Federal Reserve, the acquisition raised ethical questions about corporate bailouts and the government's role in a market economy. International Markets. Top Stocks. Hedge Funds Investing. Alternative Investments. Your Privacy Rights. To change or withdraw your consent choices for Investopedia. At any time, you can update your settings through the "EU Privacy" link at the bottom of any page.
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Your Money. Personal Finance. Your Practice. Popular Courses. Business Company Profiles. Table of Contents Expand. List of Partners vendors. The headline-grabbing collapse of two Bear Stearns hedge funds in July offers a look into the world of hedge fund strategies and their associated risks.
Here, we'll examine how hedge funds work and explore the risky strategies they employ to produce their big returns. To begin with, the term "hedge fund" can be a bit confusing. Hedging usually means making an investment to specifically reduce risk. It is generally seen as a conservative, defensive move. This is confusing because hedge funds are usually anything but conservative. They are known for using complex, aggressive, and risky strategies to produce big returns for their wealthy backers.
In fact, hedge fund strategies are diverse and there is no single description that accurately encompasses this universe of investments. This is in stark contrast to traditional investment managers , who do not receive a piece of profits. As you can imagine, these compensation structures encourage greedy, risk-taking behavior that normally involves leverage to generate sufficient returns to justify the enormous management and incentive fees.
Both of Bear Stearns' troubled funds fell well within this generalization. In fact, as we'll see, it was leverage that primarily precipitated their failure. The strategy employed by the Bear Stearns funds was actually quite simple and would be best classified as being a leveraged credit investment. In fact, it is formulaic in nature and is a common strategy in the hedge fund universe:. In instances when credit markets or the underlying bonds' prices remain relatively stable, or even when they behave in line with historically based expectations, this strategy generates consistent, positive returns with very little deviation.
This is why hedge funds are often referred to as " absolute return " strategies. However, the caveat is that it is impossible to hedge away all risks because it would drive returns too low.
Therefore, the trick with this strategy is for markets to behave as expected and, ideally, to remain stable or improve. Unfortunately, as the problems with subprime debt began to unravel the market became anything but stable. To oversimplify the Bear Stearns situation, the subprime mortgage-backed security market behaved well outside of what the portfolio managers expected, which started a chain of events that imploded the fund. To begin with, the subprime mortgage market by mid had recently begun to see substantial increases in delinquencies from homeowners, which caused sharp decreases in the market values of these types of bonds.
Unfortunately, the Bear Stearns portfolio managers failed to expect these sorts of price movements and, therefore, had insufficient credit insurance to protect against these losses. Because they had leveraged their positions substantially, the funds began to experience large losses. The large losses made the creditors who were financing this leveraged investment strategy uneasy, as they had taken subprime, mortgage-backed bonds as collateral on the loans. Morgan was aggressively expanding the prime services business, taking it to Europe and Asia, according to Dimon's shareholder letter.
But from the beginning there were also costs. Morgan's Park Avenue offices. In his letter to shareholders in , Dimon defended the purchase. Listen Now. Share Now on:. Hundreds of housing activists overwhelmed security and stormed the lobby of the Bear Stearns skyscraper in Manhattan, staging a noisy rally and protesting the government-backed sale and bailout of the investment bank. Could the financial crisis happen again?
Did the government meddle too much during the financial crisis? Bear Stearns employees: "Poor, smart and had a deep desire to be rich".
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