FIN 323 – Leung
John Corso managed an $800 million hedge fund and had his brokerage account at Bear Stearns. While his hedge fund wasn’t exposed to risks in the mortgage market, he held a large cash balance at Bear Stearns. He had long since been loyal to Bear Stearns, but as of late he was concerned that the firm was in jeopardy stemming from their exposure to collateralized debt obligations (CDO) and credit default swaps (CDS). Bear Stearns had reciprocated the loyalty when John Corso was the subject of scrutiny from regulators regarding his fund in 2001. Their relationship was being strained when two of Bear Stearns’ biggest hedge funds, “High Grade” and “Enhanced”, had gone bankrupt.
This was particularly troublesome due to the fact that the High-Grade fund had been marketed to investors as being conservative from its low-risk, high rated securities. Bear Stearns also maintained that this fund was being run by some of its experts in mortgage-backed securities (MBS) department that could best manage CDOs backed by these securities. Since those MBS included many sub-prime mortgages, the funds lost a tremendous amount of value when these loans began to default. Due to Bear’s decision to highly leverage its position it would reap huge gains from returns, but small declines in underlying asset value would put the CDOs on the verge of insolvency.
When CDOs were originated, they were intended to move some of the long-term illiquid assets from one financial institution to another, some who were more equipped to manage the risk. This coupled with the loans being pooled together created a need for them to be rated for investors to determine the level of risk they wanted to bear. Credit rating agencies like Moody’s and Standard & Poor’s looked to rate the CDOs on a basis of the top tranches, often advising the assemblers on how to structure them to get the most profits. Even though they rated the structure...