Bear CDO Series: Management Overhaul: Questions on Risk Management

The blame game is not over. This week, Bear Stearns ousted one of its senior executives, Warren Spector, under whose watch the firm brought out two leverage hedge funds exposed to the shady sub-prime market. To calm the jittery markets over uncertainty that other credit problems were lurking, the firm promoted Alan Schwartz, a relationship-oriented investment banker, as sole president.The blame game is not over. This week, Bear Stearns ousted one of its senior executives, Warren Spector, under whose watch the firm brought out two leverage hedge funds exposed to the shady sub-prime market. To calm the jittery markets over uncertainty that other credit problems were lurking, the firm promoted Alan Schwartz, a relationship-oriented investment banker, as sole president.

The firm had already dismissed the portfolio manager of the two hedge funds (Ralph Cioffi) and his boss (Richard Marin) who headed the Bear Stearns Asset Management unit. But the move to push out the top executive who has expertise in fixed-income, trading and risk management, suggests the firm is committed to an overhaul of its trading and risk management practices.

On the other hand, it's not clear what those practices were or whether they mattered since the funds were highly leveraged and were invested in illiquid bonds and derivatives that were difficult to value and fell so precipitously.

In a response to Standard & Poor's decision last week to change its outlook on Bear Stearns from stable to negative, the company said S&P's concerns related to the hedge funds are "unwarranted" and called them "isolated incidences that are by no means an indication of broader issues at Bear Stearns." Noting that the company has been solidly profitable in the first two months of the quarter, while it's balance sheet, capital base and liquidity profile have never been stronger," Bear Stearns said, "its risk exposures to high profile sector are moderate and well-controlled." (In March of 2006 Wall Street & Technology reported that Bear Stearns appointed Michael Alix to the newly created role of chief risk officer.)

The question is what were the risk management practices on the trading desk at BSAM? Did the firm have a separate risk czar for the hedge funds - someone other than the trader or portfolio manager?

I spoke with a source with expertise in risk management who questioned whether the two hedge funds, Bear Stearns High Grade and Enhanced Leverage funds, used a risk engine, whether it was their own risk engine or that of Bear Stearns. Bear Stearns acquired MeasureRisk about three years ago. "Bear Stearns is a leader in fixed income securities, trading and market analysis," says the source. " They purport to have the most advanced analysis on fixed-income. Next they have an in-house risk engine in-house and they have made available to the risk engine all of Bear's analytics," the sources continues.

Since the funds were "independent of the broker-dealer maybe they didn't have to use the broker's risk engine," speculates the risk expert. "If your owned by Bear Stearns, naturally one would assume they'd have trading limits, risk limits, just like you had good accounting standards," says the source. "I would be shocked if policies like this weren't required by Bear," says the source.

Is it common for hedge funds to have separate risk managers? According to Damian Handzy, chairman and CEO of Investor Analytics in New York, "The best practice is for hedge funds to have a risk manager who is not the portfolio manager and not the trader and not using the same models as either. Because if you're trading system is using the same model as your risk system, of course it's going to show low risk. It's going to show whatever the trader wants it to show," says Handzy, whose firm provides a risk management and transparency service to hedge funds, fund of funds and investment advisors. The risk manager should have an independent set of data and run the gamut of scenarios of market risk and 'what if' scenarios, advises Handzy. "The role of risk management in a hedge fund is to understand relatively quickly what the fund's exposures are to markets and what the possible losses are to significant movements," he says.

Check out the other articles in the Bear CDO Series:
A Credit Crisis and More Bloodletting Hits Hedge Funds

Valuation CrisisThe blame game is not over. This week, Bear Stearns ousted one of its senior executives, Warren Spector, under whose watch the firm brought out two leverage hedge funds exposed to the shady sub-prime market. Ivy is Editor-at-Large for Advanced Trading and Wall Street & Technology. Ivy is responsible for writing in-depth feature articles, daily blogs and news articles with a focus on automated trading in the capital markets. As an industry expert, Ivy has reported on a myriad ... View Full Bio