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EARLY : SPREADING SUBPRIME WORRIES
case scenario in which significant amounts of assets had to be sold. Bear Stearns’s
conclusion: High-Grade still had positive value, but Enhanced Leverage did not.
On the basis of that analysis, Bear Stearns committed up to . billion—and ulti-
mately loaned . billion—to take out the High-Grade Fund repo lenders and be-
come the sole repo lender to the fund; Enhanced Leverage was on its own.
During a June Federal Open Market Committee (FOMC) meeting, members were
informed about the subprime market and the BSAM hedge funds. The staff reported
that the subprime market was “very unsettled and reflected deteriorating fundamen-
tals in the housing market.” The liquidation of subprime securities at the two BSAM
hedge funds was compared to the troubles faced by Long-Term Capital Management
in . Chairman Bernanke noted that the problems the hedge funds experienced
were a good example of how leverage can increase liquidity risk, especially in situa-
tions in which counterparties were not willing to give them time to liquidate and
possibly realize whatever value might be in the positions. But it was also noted that
the BSAM hedge funds appeared to be “relatively unique” among sponsored funds in
their concentration in subprime mortgages.
Some members were concerned about the lack of transparency around hedge
funds, the consequent lack of market discipline on valuations of hedge fund hold-
ings, and the fact that the Federal Reserve could not systematically collect informa-
tion from hedge funds because they were outside its jurisdiction. These facts caused
members to be concerned about whether they understood the scope of the problem.
During the same meeting, FOMC members noted that the size of the credit deriv-
atives market, its lack of transparency and activities related to subprime debt could
be a gathering cloud in the background of policy.
Meanwhile, Bear Stearns executives who supported the High-Grade bailout did
not expect to lose money. However, that support was not universal—CEO James
Cayne and Earl Hedin, the former senior managing director of Bear Stearns and
BSAM, were opposed, because they did not want to increase shareholders’ potential
losses. Their fears proved accurate. By July, the two hedge funds had shrunk to al-
most nothing: High-Grade Fund was down ; Enhanced Leverage Fund, .
On July , both filed for bankruptcy. Cioffi and Tannin would be criminally charged
with fraud in their communications with investors, but they were acquitted of all
charges in November . Civil charges brought by the SEC were still pending as of
the date of this report.
Looking back, Marano told the FCIC, “We caught a lot of flak for allowing the
funds to fail, but we had no option.” In an internal email in June, Bill Jamison of Fed-
erated Investors, one of the largest of all mutual fund companies, referred to the Bear
Stearns hedge funds as the “canary in the mine shaft” and predicted more market tur-
moil. As the two funds were collapsing, repo lending tightened across the board.
Many repo lenders sharpened their focus on the valuation of any collateral with po-
tential subprime exposure, and on the relative exposures of different financial institu-
tions. They required increased margins on loans to institutions that appeared to be
exposed to the mortgage market; they often required Treasury securities as collateral;
in many cases, they demanded shorter lending terms. Clearly, the triple-A-rated
