Table of Contents

Subprime Mortgage Crisis and Bear Stearns Hedge Fund Collapse (2007)

Category: Society & Economics Key figures: Ralph Cioffi, Matthew Tannin, Warren Spector, James Cayne, Mark Zandi

Summary

The subprime mortgage crisis emerged from years of deteriorating lending standards, a collapsing housing bubble, and the proliferation of complex mortgage-backed securities throughout the global financial system. By early 2007, more than twenty-five subprime lending firms had declared bankruptcy, and New Century Financial Corporation — the nation’s largest subprime lender — filed for bankruptcy in April 2007.

The crisis crystallized as a systemic event in the summer of 2007 through the failure of two Bear Stearns hedge funds. The Bear Stearns High-Grade Structured Credit Strategies Fund and the Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund had taken heavily leveraged positions in collateralized debt obligations (CDOs) backed largely by subprime mortgages. The Enhanced Leverage Fund held approximately $900 million in investor capital against $8.5 billion in borrowed money. As the value of underlying securities declined through early 2007, the funds faced margin calls and mounting redemption requests. On June 22, 2007, Bear Stearns pledged up to $3.2 billion to rescue one of the funds. On July 16, 2007, the firm disclosed that both funds had lost nearly all of their value. On July 31, 2007, both funds filed for bankruptcy, with total investor losses estimated at approximately $1.8 billion. Co-President Warren Spector resigned on August 5, 2007.

The hedge fund managers, Ralph Cioffi and Matthew Tannin, were subsequently charged by the SEC and the Department of Justice with misleading investors about the funds’ deteriorating condition. Cioffi had quietly redeemed $2 million of his personal investment in March 2007 while telling investors the funds remained sound. Both were arrested in June 2008, acquitted at trial in 2009, and later settled civil charges with the SEC. Beyond the Bear Stearns event, by October 2007, approximately 16 percent of subprime adjustable-rate mortgages were 90 days delinquent or in foreclosure — roughly triple the 2005 rate — and lenders initiated foreclosure proceedings on nearly 1.3 million properties during 2007, a 79 percent increase over 2006.

Significance

The Bear Stearns hedge fund collapse in July 2007 is widely regarded as the proximate catalyst of the broader financial market disruption that culminated in the 2008 global financial crisis and the Great Recession. Economist Mark Zandi described the event as “arguably the proximate catalyst” for the crisis that followed. The collapse exposed the fragility of the shadow banking system, the opacity of CDO markets, and the systemic risk embedded in mortgage-backed securities held by institutions around the world. The crisis accelerated regulatory scrutiny of leverage, transparency, and risk management practices across the financial industry, ultimately contributing to landmark legislative responses including the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. For 2007, the crisis marked the moment when housing-market stress became visible systemic failure, shifting policymaker attention from isolated subprime lending problems to the stability of the global financial architecture.

Sources

• Subprime mortgage crisis — Wikipedia
• Bear Stearns — Wikipedia
• SEC Charges Two Former Bear Stearns Hedge Fund Managers With Fraud — SEC.gov
• The U.S. Financial Crisis — Council on Foreign Relations

Related

• iPhone Launch — Major technology milestone of 2007.
• Virginia Tech Shooting — Another major crisis event of 2007.
• Amazon Kindle Launch — Contemporaneous technology milestone of late 2007.