I am a proponent of minimum regulation of hedge funds, and Bear Stearns just made my position harder to defend. Bear Stearns’ bailout – originally reported as $3.2 billion and shortly later revised to $1.6 billion – of its Bear Stearns High Grade Structured Credit Strategies fund may give regulators the excuse they are looking for to impose rules on hedge funds (Bear Stearns did not bail out its Bear Stearns High Grade Structured Credit Enhanced Leverage fund – at least as of this writing).

Bear Stearns is a publicly traded SEC-regulated company bailing out an independent “off-balance sheet” hedge fund. At least one of the hedge fund lenders is also regulated by the Federal Reserve, among other regulators. It is rumored that Deutsche Bank, JP Morgan Chase and Merrill Lynch seemed to expect Bear Stearns to provide a bailout for the credit lines they had extended the hedge fund, even though there was no upfront agreement for it to do so. The lenders apparently do not view the hedge fund as independent.

Ironically, Bear Stearns was against bailing out Long-Term Capital Management. If hedge funds want to lever up and trade assets that are bound to become illiquid in an unwind scenario, then they have to be prepared for a world of hurt. That is the flip side of the ecstasy enjoyed when the markets are going their way.

Consenting non-committed adults should feel free to enter into these torrid market romances without the interference of other adults. When adults are caught up in the emotion of the moment, it is almost impossible to get them to listen to dispassionate advice. Besides, if you are talked out of a thrilling experience, you may never forgive your adviser. Sometimes the thrills are most definitely worth it, and who would want to miss that experience? But if the market affair ends badly, one cannot expect one’s pain—pathetic as it may be—is any one else’s responsibility. That is the price we must be willing to pay for non-interference. If you are truly independent, no one expects other adults to take responsibility for your decisions. By asking Bear Stearns to heal their wounds, the investment banking lenders and sophisticated investors are endangering everyone else’s potential thrills.

Banks and investment banks will have a harder time winning the argument that their off-shoot hedge funds are truly independent. How can these funds be truly off-balance sheet when prime brokers seemed to think Bear Stearns should assume the hedge funds’ liabilities like a parent stepping in on behalf of a minor child? If Bear Stearns is the lender of last resort, then it makes it seem that the entire prime brokerage industry is a sham. Do lenders expect to earn risk-free fees? Perhaps these are merely acting fees—for acting as straw men.

Bear Stearns’ strategy was unsuccessful, and other hedge funds will have unsuccessful strategies in future, too. Are investors to expect to be bailed out simply because a failure is unexpected and dramatic?

Investors in leveraged hedge funds should expect this scenario to play out any time the chips are down and a hedge fund has invested in high-yielding financially engineered assets. When the prices of these assets drop, they will be illiquid and put downward price pressure on like-kind assets. When investors ask for their money back, they will further pressure the hedge fund. Investment banks that had provided leverage (loans) will note that the value of their collateral had declined and will ask for more collateral. The more leveraged the hedge fund and the more fully invested it is, the more difficult it will be to raise cash without causing further downward pressure on the price of the fund’s assets. Furthermore, the hedge fund will be less competitive than new funds investing in the same type of assets. Since the troubled fund’s assets had declined in value, funds with new investor money can purchase those assets and much more for the same initial investment—making the troubled fund less competitive.

 Afterword: On July 17, 2007, BSAM sent a letter to investors saying the BS High-Grade Structured Credit Fund had lost 90% of investors’ capital. The BS High-Grade Structured Credit Enhanced Leveraged Fund investors were wiped out; the fund was less than a year old. The funds filed for bankruptcy on July 31, 2007. By September 2008 Bear Stearns was in trouble. JPMorgan purchased it at a deep discount. First BSAM’s hedge funds came back on Bear Stearns’ balance sheet and then Bear Stearns’ balance sheet risk ended up on JPMorgan’s balance sheet along with more than $29 billion in assistance for the purchase (the Fed bought some of Bear’s assets) from the Fed.

This commentary was published with permission in LIPPER HedgeWorld on June 27, 2007, under the title: “Bear’s Bailout a Bad Idea.”  Tavakoli Structured Finance retains the copyright.

See also: “Greater Global Risk Now Than At Time of LCTM”

Read more finance articles by Janet Tavakoli