Bear Stearns is again under the spotlight. This time the subject is hedge fund fraud related to subprime crisis.
SEC recently charged two former Bear Stearns Asset Management (BSAM) portfolio managers for fraudulently misleading investors about the financial state of the firm's two largest hedge funds and their exposure to subprime mortgage-backed securities before the collapse of the funds in June 2007.
SEC alleges that when the hedge funds took increasing hits to the value of their portfolios during the first five months of 2007 and faced escalating redemptions and margin calls, then-BSAM senior managing directors Ralph Cioffi and Matthew Tannin deceived their own investors and certain institutional counterparties about the funds' growing troubles until they collapsed and caused investor losses of US$1.8 billion.
The Bear Stearns High-Grade Structured Credit Strategies Fund and Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund collapsed after taking highly leveraged positions in structured securities based largely on subprime mortgage-backed securities. Cioffi acted as senior portfolio manager and Tannin acted as portfolio manager and chief operating officer for the funds, and they misrepresented the funds' deteriorating condition and the level of investor redemption requests in order to bring in new money and keep existing investors and institutional counterparties from withdrawing money.
For example, Cioffi misrepresented the funds' Apr 2007 monthly performance by releasing insufficiently qualified estimates — based only on a subset of the funds' portfolios — that projected essentially flat returns. Final returns released several weeks later revealed actual losses of 5.09% for the High-Grade Structured Credit Strategies Fund and 18.97% for the High-Grade Structured Credit Strategies Enhanced Leverage Fund.
Cioffi and Tannin also misrepresented their funds' investment in subprime mortgage-backed securities. Monthly written performance summaries highlighted direct subprime exposure as typically about 6% to 8% of each fund's portfolio. However, after the funds had collapsed, the BSAM sales force was ultimately told that total subprime exposure — direct and indirect — was approximately 60%.
Cioffi and Tannin continually exaggerated their own investments in the funds while using their personal stake as a selling point to investors. Tannin repeatedly told investors, directly and through the Bear Stearns sales force, that he was adding to his own stake in the funds in order to take advantage of the buying "opportunity" presented by the funds' losses. Tannin never actually added to his investment. He mocked as "silly" at least one investor who sought to redeem instead of following Tannin's supposed example. Meanwhile, Cioffi redeemed US$2 million, which was more than one-third of his personal investment in the funds at the end of March 2007. Cioffi transferred it to another BSAM fund that he described as "short subprime," which he knew was profitable at the time.
The real hazard of hedge funds is often operational risk rather than market risk. Subprime fund managers are more terrible than subprime securities.
Attorneys defending both managers state that they were the scapegoats of the mortgage/subprime crisis. Do you think that there was a conflict of interest? Cioffi, for example, pulled money out of the high risk fund, while informing investors that the fund was performing well. Also, what do you think about their ethics? Do you think they not ethical in any way?
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