Bear Stearns Cos. told investors in its two failed hedge funds that they will get little if any money back after "unprecedented declines" in the value of AAA-rated securities used to bet on subprime mortgages.
Estimates show there is "effectively no value left" in the High-Grade Structured Credit Strategies Enhanced Leverage Fund and "very little value left" in the High-Grade Structured Credit Strategies Fund, Bear Stearns said in a two-page letter.
The second fund still has "sufficient assets" to cover the $1.4 billion it owes Bear Stearns, which as creditor gets paid back first, according to the letter, obtained Tuesday by Bloomberg News from a person involved in the matter.
"This is a watershed," said Sean Egan, managing director of Egan-Jones Ratings Co. in Haverford, Pennsylvania. "A leading player, which has honed a reputation as a sage investor in mortgage securities, has faltered. It begs the question of how other market participants have fared."
Bear Stearns provided the second fund with $1.6b. of emergency funding last month in the biggest hedge fund bailout since the collapse of Long-Term Capital Management LP in 1998.
The losses investors now face underscore the severity of the shakeout in the market for collateralized debt obligations, or CDOs, investment vehicles that repackage bonds, loans, derivatives and other CDOs into new securities.
The risk of owning corporate bonds soared to the highest in two years in Europe and rose in the US, credit-default swap prices show. Bear Stearns spokeswoman Elizabeth Ventura declined to comment.
Bear Stearns shares have dropped 14 percent this year, sliding further as the crisis in subprime mortgages deepened and the two funds flirted with collapse. The risk of owning corporate bonds issued by Bear Stearns surged to the highest since November 2002, according to credit default swap traders. The credit swaps rose $1,000 to $75,000, according to broker Phoenix Partners Group in New York.
Ralph Cioffi, the 22-year Bear Stearns veteran who managed the two funds, sought to minimize risk by investing in the top-rated portions of CDOs, hence the "high-grade" label. Under Cioffi, 51, the funds also borrowed money in an effort to boost returns. Instead, as defaults surged on subprime mortgages, they grappled with declines in the values of AAA and AA securities, Bear Stearns said in the letter.
"That has implications for credit weakness in the next several days and weeks," said Peter Plaut, an analyst at New York-based hedge fund Sanno Point Capital Management. "There's going to be more risk aversion."
In an interview with the New York Times published on June 29, Bear Stearns Chief Executive Officer Jimmy Cayne said the debacle was a "body blow of massive proportion." Sanford C. Bernstein & Co. analyst Brad Hintz estimated in a July 16 report that Bear Stearns's profit may decline 6.8% this year as the firm restricts lending to hedge funds and declining demand for mortgage bonds cuts trading revenue.
Hedge funds are private, largely unregulated pools of capital whose managers participate substantially in any gains on the money invested.
The letter, addressed "Dear Client of Bear, Stearns & Co. Inc.," recounts how the firm's two funds unraveled in less than a month. In early June, faced with redemption requests from investors and margin calls from lenders, the funds were forced to sell assets. When those efforts failed to raise enough cash, creditors moved to seize collateral or terminate financing.
Tremont, Paradigm The fund that now has nothing left for investors, known as the enhanced fund, had $638 million of capital as of March 31, according to performance reports sent to clients at the time. It also borrowed about $11b. to make bigger bets.
The larger fund, which had $925m. is down about 91% this year, according to a person with direct knowledge of the performance, who declined to be identified because the figures aren't public. It borrowed almost $9b.
Investors in that second fund include Tremont Capital Management Inc. and Paradigm Cos., two firms that place client money with other hedge fund managers. Together, they have more than $9m. at risk.
Bear Stearns itself invested about $35m. in the funds, Chief Financial Officer Samuel Molinaro said on a June 22 conference call. The firm bailed out the larger pool to keep lenders from auctioning off assets and driving down the value of its investments.
"For them to put up so much capital, just for reputational risk, wouldn't make sense unless they believe they won't lose money on it," said Erin Archer, an analyst at Minneapolis-based Thrivent Financial for Lutherans, which owns about 200,000 Bear Stearns shares.
Merrill Lynch & Co., which was among the creditors to seize collateral, considers its "exposure" to be "limited" and "appropriately marked" to market, Chief Financial Officer Jeff Edwards said on a conference call Tuesday. Merrill reported a 31% increase in second-quarter profit, even after revenue in the business that includes mortgages and CDOs declined.
Bear Stearns shook up its asset-management unit last month, as the losses mounted.
The firm ousted Richard Marin as head of the division, replacing him with Lehman Brothers Holdings Inc.
Vice Chairman Jeffrey Lane, 65. Tom Marano, 45, Bear Stearns's top mortgage trader, moved over to asset management to help sell the fund assets. Marin, 53, and Cioffi remain advisers to the firm.
In today's letter, Bear Stearns said it made such moves to "restore investor confidence" in its asset-management division.
"Let us take this opportunity to reconfirm that the Bear Stearns franchise is financially strong and committed to meeting your investment needs," the letter reads. "Our highest priority is to continue to earn your trust and confidence every day."