Hedge Funds Mystify Markets, Regulators

The new financial system seemed to be working.

Still, a growing number of market watchers wonder whether the system is encouraging hedge funds to take on too much risk.

"It's a weird dynamic that the market has now," said Dan Freed, a senior writer at Investment Dealer's Digest. "You used to have a small number of institutions taking a lot of risk. Now you take something that's toxic and you divide it into a thousand pieces and you say, okay, well, it's not toxic anymore. . . . But if it's toxic, isn't it [still] toxic?"

The Bear Stearns hedge-fund managers not only made risky bets but also did so with massive loans. They raised hundreds of millions of dollars from wealthy investors and other hedge funds, and borrowed many times that amount from Wall Street banks. With $20 billion at their disposal, they traded obscure securities backed by mortgage loans made to homeowners with shoddy credit histories.

The securities were so exotic that few knew whether the managers were getting good prices as they traded them.

The problem is similar to what happens in the housing market. Because houses are "traded" infrequently, homeowners often struggle to figure out the right price to attract interest. An appraisal can help, but a house's actual value is established only when a buyer and seller agree on a price.

Stocks, on the other hand, are exchanged every day, so their prices generally are considered accurate.

In the case of the Bear Stearns funds, the managers appeared to struggle to value their assets accurately or find buyers for them. In May, they said the funds had lost 6.75 percent of their value in April. In June, they revised that loss to 18 percent. The revision spooked traders, and ultimately some of their assets had to be dumped in a fire sale. Bear Stearns also lent $3.2 billion to bail out one of the funds after Wall Street banks demanded their money back.

Analysts worried about the ripple effects. Other hedge funds holding similar securities had to mark down the value of their assets. Banks suddenly got skittish about making big loans.

Some analysts wondered whether the era of easy money was ending. Daniel A. Strachman, author of "The Fundamentals of Hedge Fund Management," noted that the markets had put a lot of confidence in the new hedge-fund-dominated financial system even though it had not been tested seriously during the economic expansion of the past five years.

"I think there are a significant amount of people who call themselves hedge-fund managers who have been very lucky because they were able to ride the market wave," he said.

But as the Bear Stearns case showed, it may be impossible to know from where the next crisis will emerge and whether there are other troubled hedge funds.

"Wall Street creates all these increasingly sophisticated financial products, and no one really seems to understand them but the people involved in creating them," Freed said. "They assure everybody that everything's going to be okay, and we are forced to believe them."