Lesson 7 of 25 · 6 min
An investment bank's two funds, 2007: the financing underneath them
The assets were illiquid and the financing was overnight, so the marks were set by the people lending against them.
In 2007 Bear Stearns sponsored two credit funds that held structured mortgage exposure — securitisation tranches and related derivatives — one of which ran materially more leverage than the other. The assets were long-dated and traded rarely. The financing was repurchase agreements and swaps with other dealers, renewable in days or overnight.
That combination creates a specific vulnerability. When an asset trades rarely, its collateral value is whatever the financier says it is, and the financier revises that value whenever it chooses. Two levers move at once: the mark falls and the haircut rises. Track 8 lesson 11 describes the general form, where the same asset receives a new advance rate without anything happening to the asset.
Through the spring of 2007 mortgage indices weakened and the marks came down. Margin calls followed, and the funds could not meet them from cash. Counterparties exercised their right to seize and auction collateral, and the auctions themselves produced observable prices well below the previous marks, which fed into the next round of marks for everyone holding similar paper.
Both funds ceased in July 2007. The sponsor extended a secured loan reported at around 1.6 billion dollars to the less leveraged of the two; the more leveraged one was left to liquidate, and investors in it were reported to have recovered close to nothing. Legal proceedings followed. The sponsor's own reliance on short-dated secured funding is the subject of the next lesson, one year later.
Key terms
- Repurchase agreement
- A sale of an asset with an agreement to buy it back shortly after. Economically a secured loan, with a term measured in days and a haircut the lender can reset.
- Mark
- The value assigned to a position for collateral and reporting purposes. For a rarely traded asset it is an opinion, and usually the financier's opinion.
- Collateral seizure
- A financier taking and selling pledged assets after a failed margin call. The sale price then becomes a market observation others must mark against.
Worked example
Two levers moving at once
Illustrative figures scaled down so the arithmetic is followable; they are not the reported amounts. $90,000,000 of face value marked at 96 with a 3 percent haircut, financed to the maximum.
- Collateral value at the start
- $86,400,000
- Borrowing at a 3 percent haircut
- $83,808,000
- Equity, and implied leverage
- $2,592,000 at 33.3x
- Mark cut to 82, haircut raised to 15 percent
- $62,730,000 of permitted borrowing
- Cash demanded immediately
- $21,078,000
- That demand against equity
- 8.13x
$90,000,000 × 0.96.
$86,400,000 × 0.97.
$86,400,000 ÷ $2,592,000.
$73,800,000 × 0.85.
$83,808,000 − $62,730,000.
$21,078,000 ÷ $2,592,000.
The call was eight times the entire equity of the position, and roughly two fifths of it came from the haircut change rather than from the price.
Check yourself
Collateral worth $40,000,000 is financed at a 4 percent haircut. The mark then falls 18 percent and the haircut rises to 12 percent. How large is the resulting call?
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Educational only. Nothing in this lesson is investment, legal or tax advice, or a recommendation to enter into any transaction. Figures are illustrative and computed from the inputs stated in the lesson.