When most people think of Bear Stearns, they think of its recent collapse and the resulting purchase by JPMorgan Chase. However, the demise of Bear Stearns can really be traced back to two failed hedge funds during the summer of 2007 which created a domino effect on the entirety of the company. Let’s take a look back.

Few hedge fund managers would predict that homeowners, mainly “subprime” borrowers, would be unable to make their monthly mortgage payment. The result was a foreclosure sweep across the nation, and banks are still writing down losses, upwards of $285 billion.

Both Bear’s High-Grade Structured Credit Strategies Enhanced Leverage Fund and its High-Grade Structured Credit Strategies Fund used massive amounts of leverage to purchase collateralized debt obligations backed by these subprime mortgages, as did many hedge funds around that time. However, as defaults surged on these subprime mortgages, Bear grappled with declines in the values of AAA and AA securities, as they said in a statement.

Creditors who were financing this heavy leveraged investment strategy started to panic, as they were using these subprime mortgage-backed bonds as collateral on the loans. Bear Stearns was then forced to pony up cash on their loans because the the subprime backed bonds that were used as collateral were plummeting in value. This led to a major liquidity shortage, forcing Bear to sell more bonds at a highly discounted rate in order to generate cash.

Bear Stearns then tried to infuse their Credit Strategies Fund with $1.6 billion of capital, in one of the largest bailouts in hedge fund history. But even the new influx of capital couldn’t save the sinking fund. Bear was forced to tell investors that there was “effectively no value left” in the funds which once managed over $10 billion.

To make matters worse, a judge ruled that the liquidation of the funds must be handled onshore, and not in the Caymans where the funds were originated. Bear was hoping for an offshore liquidation to shield some of its assets from creditors that were owed and to avoid transparency. Some also believe that judges in the Caymans are much more apt to favor management over creditors.

After the debacle, investors were furious, which sparked many lawsuits that are still pending. Investors argue that the fund managers were at fault, and shouldn’t have used such risky strategies involving high amounts of leverage with little cash to back it up. It was these types of funds which experienced the hardest hits when the housing market started to crash.

In one of the lawsuits, investors asserted that Bear “conceived, marketed and managed hedge funds that they knew would be viable so long as – but only so long as – the U.S. housing market continued to rise.” If this were the case, and there was no risk controls set in place, Bear would be at fault.

“Investors who sought to take advantage of the inimitable risk management reputation of Bear Stearns found themselves in a highly-complex hedge fund investment program that relied on overworked junior personnel to manage a conflict reporting process required by federal law,” said another investor who filed suit against Bear.

It didn’t take long before the bad press started circulating and Bear Stearns’ reputation started faltering.  Seemingly overnight, it lost its reputation as a reliable prime broker, and the firm’s reputation, solidified over years of industry leadership, began to crumble. While there were a multitude of factors that led to the failure and ultimate sale of Bear Stearns, investors became weary of the company after such an implosion. If you remember the fallout, the rumor of a cash shortage sent investors scrambling for money, which resulted in a real cash shortage. Maybe this lack of trust in Bear had something to do with its demise.  Anybody remember the days following Bear’s collapse?  While the Fed was helping JPMorgan purchase Bear Stearns, Bear T-shirts are selling on Ebay for more than their stock was worth.  Oh how the mighty fall.