Hedge Funds Also Caught in Tempest

Some financial analysts blame the recent swings in the stock markets on hedge funds covering their short selling. This occurs when a hedge fund borrows shares and then incorrectly bets that the price of the shares will fall. The funds' losses are magnified because they often use borrowed money to make such investments and must pay back both the lender of the stock and the lender of the money.

To mitigate those losses, hedge funds often try cover their shorts by scrambling to buy more of the stock as it rises in price. This frantic buying can make it look like markets are rallying, when in fact they are simply being driven by hedge-fund activity.

Baker said that the bankruptcy of Lehman Brothers also staggered several funds that had relied on that investment bank as a business partner or owned Lehman's bonds or stock.

The restructuring of Goldman Sach and Morgan Stanley are likely to have less of a major impact because their investment banking divisions will not change fundamentally, other hedge-fund managers said.

Even before the events of last week, the credit crisis had claimed some funds, including two run by Peloton, a firm that specialized in mortgage-backed securities, as well as Turnberry Capital Management, which focused on distressed debt. The Ospraie Fund began winding down after losing bets on commodities stocks, while Windmill Management put two of its SageCrest funds in Chapter 11 bankruptcy protection to head off a forced asset sale.

Jaeson Dubrovay, who advises institutional investors on hedge-fund investments for the consulting firm NEPC in Cambridge, Mass., said more failures are ahead for the industry, especially the 2,900 small to medium-size hedge funds.

"I would venture to say that a lot of these in this environment are not going to survive," Dubrovay said.

In the late 1990s, massive losses at a hedge fund called Long Term Capital Management threatened the financial markets and ultimately required the Federal Reserve to offer a bailout of $3.6 billion to stop a broader crisis from developing.

Since then, hedge funds have become critical cogs in the credit markets. Many of them buy corporate loans, mortgages and other kinds of debt that have been turned into securities and can be traded like shares on the stock market. With hedge funds as financiers for this debt, investment banks and lenders were able to make massive loans to freewheeling borrowers and feel less impact from the risk during the boom of the past few years.

As a result, the banks were able to offer mortgages to people with questionable credit. The business of borrowing billions of dollars to buy troubled companies boomed. Backed by hedge funds, insurance companies offered coverage to homeowners in New Orleans after Hurricane Katrina.

These kinds of transactions have now all but shut down. And if more hedge funds end up closing, the markets could lose some of their liquidity, a term that refers to the free flow of money through the financial system.

"Right now I think it's a pig in a poke, and I think people are paralyzed and probably rightfully so," said Peter Kaufman, president and head of restructuring and distressed mergers and acquisitions at Gordian Group, a New York-based investment bank. "This is a brave, new, ugly world."