June 27, 2007

Updated Epilogue added July 2025.

By Janet Tavakoli

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.

2025 Update: What This 2007 Analysis Got Right

The Prophetic Nature of the June 2007 Warning

This June 2007 analysis proved remarkably prescient, accurately predicting the sequence of events that would lead to Bear Stearns’ collapse and the broader 2008 financial crisis. The warning that “investors in leveraged hedge funds should expect this scenario to play out any time the chips are down” materialized exactly as predicted when Bear Stearns collapsed on March 16, 2008, and was acquired by JPMorgan Chase for $2 per share.

The 2008 Bear Stearns Collapse Timeline

The timeline of Bear Stearns’ demise followed the script outlined in this analysis:

• July 2007: Bear Stearns liquidated the two hedge funds mentioned in this article after they lost nearly all their value.
• January 2008: CEO James Cayne stepped down and was replaced by Alan Schwartz
• March 13, 2008: Bear Stearns notified the Federal Reserve that it expected it would not have enough funding or liquid assets to meet its financial obligations the following day.
• March 14, 2008: The Federal Reserve authorized a $12.9 billion bridge loan to Bear Stearns through JPMorgan Chase Bank.
• March 16, 2008: Bear Stearns agreed to a government-backed fire sale and was acquired by JPMorgan Chase for $2 per share, later revised to $10 per share.

JPMorgan Acquisition and Federal Assistance Details

The federal assistance extended far beyond initial reports. The Federal Reserve Bank of New York created Maiden Lane LLC and extended approximately $29 billion in credit to facilitate the acquisition, while JPMorgan contributed an additional $1 billion subordinated loan to purchase approximately $30 billion of Bear Stearns’ most toxic assets.

JPMorgan initially viewed the acquisition as a bargain, but the legal costs proved substantial. By 2014, JPMorgan agreed to a $13 billion payment to settle charges related to mortgage-backed securities, with CEO Jamie Dimon noting that nearly 70% of the bank’s $19 billion in legal costs came from Bear Stearns and Washington Mutual acquisitions. Dimon later wrote: “No, we would not do something like Bear Stearns again — in fact, I don’t think our board would let me take the call.”

Ultimately, the Maiden Lane LLC portfolio generated a net gain of $2.5 billion for the U.S. public when it was fully wound down in 2018.

Litigation Outcomes: Ralph Cioffi and Matthew Tannin

The criminal prosecution of the two hedge fund managers had mixed results:

Criminal Trial (2009): Ralph Cioffi and Matthew Tannin were acquitted on all criminal charges in November 2009, including securities fraud, wire fraud, and conspiracy. Federal prosecutors had accused them of falsely inflating portfolio values while knowing the mortgage-backed assets were at risk of collapse. The jury deliberated for seven hours before returning not guilty verdicts on all six counts.

SEC Civil Settlement (2012): Despite their criminal acquittal, both managers settled SEC civil charges in 2012. Cioffi paid $700,000 in disgorgement and a $100,000 civil penalty, while Tannin paid $200,000 in disgorgement and a $50,000 civil penalty. They were also barred from the securities industry for three and two years respectively.

Additional Civil Litigation: As late as 2013, the managers continued to face civil lawsuits from various counterparties, though they won dismissal of a Bank of America lawsuit that year.

Modern Parallels: “Too Big to Fail” in 2025

The core issues identified in this 2007 analysis remain remarkably relevant today:

Expansion Beyond Banks: U.S. regulators have laid the groundwork to extend “too big to fail” oversight to hedge funds and asset managers, reversing Trump-era guidance that made it harder to label non-bank companies as systemically important.

Persistent TBTF Problems: Research from 2025 shows that while reforms have reduced bailout expectations, there remains roughly an 87% probability that globally systemically important banks will still be bailed out. Post-2008 reforms were tested during the 2023 banking crisis and revealed serious shortcomings.

Current GSIB Classifications: The 2024 Financial Stability Board list identifies 29 “too big to fail” banks globally, with JPMorgan Chase (ironically, Bear Stearns’ acquirer) in the highest tier requiring a 2.5% capital buffer.

Lessons for Today’s Hedge Fund Regulation Debates

This 2007 analysis remains a masterclass in identifying systemic risks before they materialize. The key insights that continue to resonate:

1. Independence Fiction: The prediction that “prime brokers seemed to think Bear Stearns should assume the hedge funds’ liabilities like a parent stepping in on behalf of a minor child” proved accurate when Bear Stearns felt compelled to bail out its funds.
2. Moral Hazard: The warning about creating expectations of bailouts proved prophetic. The Bear Stearns rescue set the template for subsequent interventions during the 2008 crisis.
3. Liquidity Spirals: The analysis correctly predicted how leveraged funds with illiquid assets would face insurmountable pressure when investors demanded redemptions while lenders demanded additional collateral.
4. Competitive Dynamics: The prediction that troubled funds would become less competitive than new funds with fresh capital proved accurate as Bear Stearns’ funds became unable to compete effectively.

The prescience of this analysis underscores the importance of monitoring leverage, liquidity mismatches, and the interconnectedness of financial institutions—lessons that remain crucial as regulators grapple with the growing influence of hedge funds and other non-bank financial institutions in 2025.

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.

Related Articles

Tavakoli, Janet. “2008 Crisis: Bailouts Without Accountability (2025 Update).” Tavakoli Structured Fiannce, July 20, 2025.

Tavakoli, Janet. “Financial Media Commentary: When Watchdogs Fail to Bark.” Tavakoli Structured Finance,Originally published as separate commentaries 2009-2014, consolidated and updated 2025.

Tavakoli, Janet. “Letter to the Editor: Greater Global Risk Now Than At Time of LTCM.” Financial Times, May 7, 2007.

References

Board of Governors of the Federal Reserve System. “Bear Stearns, JPMorgan Chase, and Maiden Lane LLC.” Accessed July 21, 2025.

Board of Governors of the Federal Reserve System. “Support for Specific Institutions.” Accessed July 21, 2025.

Campbell, Benton J., and Mark J. Mershon. “Two Senior Managers of Failed Bear Stearns Hedge Funds Indicted on Conspiracy, Securities Fraud, and Wire Fraud Charges.” U.S. Attorney’s Office, Eastern District of New York, June 19, 2008.

CNN Business. “Bear Stearns hedge fund managers acquitted.” November 10, 2009.

CNN Money. “JPMorgan acquires troubled Bear.” March 16, 2008.

Federal Reserve Bank of New York. “Maiden Lane Transactions.” Accessed July 21, 2025.

Federal Reserve Bank of New York. “New York Fed Sells Remainder of Maiden Lane LLC Securities; Approximately $2.5 Billion Net Gain Generated for U.S. Public from the Portfolio.” September 18, 2018.

Federal Reserve History. “Support for Specific Institutions.” Accessed July 21, 2025.

History.com. “Bear Stearns collapses, sold to J.P. Morgan Chase.” March 16, 2008.

Institute for New Economic Thinking. “Rewarding Bad Behavior: The Bear Stearns Bailout.” March 14, 2018.

Marketplace. “How the Bear Stearns deal looks 10 years later.” March 12, 2018.

NPR. “Former Bear Stearns Executives On Trial.” October 27, 2009.

NPR. “Former Bear Stearn Execs Not Guilty.” November 11, 2009.

Passmore, Wayne, and Colleen Faherty. “Mitigating Too Big to Fail.” FEDS Notes, Board of Governors of the Federal Reserve System, June 14, 2024.

Securities and Exchange Commission. “Ralph R. Cioffi and Matthew M. Tannin.” Litigation Release No. 22398, June 18, 2012.

The Washington Post. “Lessons from Bear Stearns’s collapse 17 years ago.” April 1, 2025.