As the hedge fund world becomes bigger and bigger as more and more hot money seeks the elusive alpha of maximum performance, it is becoming apparent that more and more newspaper space will be devoted to hedge funds, and private equity. Recent news has taken us into the inner sanctum of Bear Stearns, truly a dominant investment firm in the world today. It might be argued that Bear Stearns is the best managed Wall Street firm in existence. Some might say Goldman Sach's. In any event Bear Stearns would have to be on the short list.

Investment firms for almost a decade sat by and watched hedge funds form, and amass vast investment capital pools while successfully charging 2% management fees, and 20% of the profits. Some of these hedge funds in a few years, have grown to possess capital bases equal to that of investment banking firms that have been around for generations. Taking some of the risks that were involved to achieve this performance is now coming home to roost.

Bear Stearns is the latest firm to stub its toe in the hedge fund industry. The firm is FAMOUS for quantifying and judging RISK before making its bets. This time however it seems that Bear Stearns threw its usual caution to the wind in embracing the formation of two hedge funds over the last year or so.

The second hedge fund was considered a more highly-leveraged version of Bear's High –Grade structured Credit Strategies fund which was formed last year. Both funds were managed by Ralph Cioffi, who up until recent events took hold, had the reputation of being a MASTER at this game, and the game is the subprime mortgage bond business.

Most people are not aware of it but Bear Stearns is the finest fixed income trading firm on the planet bar none, and this has been true for several generations. This makes recent events even more perplexing to understand.

Jimmy Cayne who is Bear's CEO is embarrassed at the very least, and certainly upset enough that there will be major changes in the leadership of the units responsible for the pain being inflected on the firm's reputation. This should not have happened at Bear Stearns, that's the point.

Actions Taken and Implications

Mr. Cayne has made the decision to inject $3.2 billion of Bear Stearns capital into a bail-out of the older fund. Bear is also negotiating with the banks that put up the credit facility for the other fund, the highly leveraged High-Grade Enhanced Leveraged fund. What Bear is trying to prevent is the forced sale of the debt obligations underlying the fund's investments. These issues trade by appointment as they say, which means they rarely trade at all. Bear knows the Street smells blood, and will take advantage of any weakness that Bear shows.

So what are the implications of this latest hedge fund debacle? It clearly shows that the most sophisticated investors on the planet who put their money into hedge funds may in fact have NO IDEA what they are investing in. Instead, they are betting on the institutional reputation of the firms standing in back of the hedge funds. In this case nobody knew more about this market segment than Bear Stearns, yet they caught in a terrible position.

This is not Cayne's fault, but as CEO, it is always his responsibility. I believe him to be the finest Wall Street executive of his generation. Nevertheless, his underlings certainly let him down, and they are among the highest paid people in the world today. Some of these industry veterans are drawing $10 million dollar annual incomes. Let the investor beware is the rule of the day, especially when it comes to hedge funds.

But Wait – There's More

The average hedge fund uses about six to one leverage in order to obtain the performance success we have become accustomed to seeing in the hedge fund world. Investors in Bear Stearns' fund called Enhanced Leverage put up about $638 million of their own money. The fund was then able to borrow about 10 times that amount. They used repo-financing and a credit facility at the Barclay's Bank.

Enhanced Leverage then went out and invested about $11.5 billion in both bonds and various and assorted bank debts on the long side. On the short side, they had about $4.5 billion through credit default swaps. These transactions were originated on the ABX Index, all of which were tied into subprime mortgage bonds.

I know you are asking how it all came undone. What happened is that the underlying bonds of the whole market segment are what you could call the subprime market came undone. Back in February, this hurt Bear's two funds. The funds and the hedges laid on by Bear went under water in March simultaneously. The hedges should have performed when the market worsened, and they didn't. That was the killer. The hedges did not do what they were supposed to do.

In late May, Bear knew they had to do something. What Bear chose to do was close down the redemption process. In other words, not allow any investors to withdraw their remaining funds, which would create a run on the hedge fund. This is similar to Franklin Roosevelt closing down the banks in 1933, to prevent a run on the banks from taking place.

The banks who lent the money to the Bear Stearns sponsored funds quickly began selling down the securities in the funds in an attempt to back into some kind of positive equity balance. This was all the result of margin calls brought about the funds' poorly performing, and now distressed investments. Bear finally agreed to a bail-out of one of the funds injecting $3 plus billion dollars into the fund. The firm as of now will not rescue the other fund, known as Enhanced Leverage.

In our opinion, Bear will not be the last firm to experience problems with hedge funds, and investors are in for a further rude awakening as the hedge fund industry continues along its under-regulated path of seeking maximum investment performance. Many hedge funds are overextending, and frankly have no idea as to their actual open positions in the financial world.

Bear and nobody is better than Bear says it will be another week or two before it knows the extent of the losses of its investors in these two funds. If that is true of the best managed risk taking firm in the world today, how much confidence can you have in the hundreds of other hedge funds out there that are poorly managed compared to the legendary Bear Stearns.?

The answer is you'd better sleep with your pants on, if you think your money is safe in the hedge fund world. You think you're sleeping on a nice warm bed. What you don't realize is that the bed is sitting on a railroad track with a 100 mile per hour train bearing down on you. The problem with hedge funds is the leverage. Six to one is normal, and then you get the ones that go crazy and start approaching 10 to 1 leverage in the race for performance. It's great when the market is on your side, but when the market goes against you; these entities literally go out of business.

Warren Buffett has always talked about being able to sleep at night with your investments. He also talks about what would happen if you wound up in a coma, and woke up 10 years later? Would the investments you made ten years ago still be good, or not? Would you like to wake up from a coma, owning hedge fund investments for the previous ten years, maybe yes, maybe no, but as an investor, you better be able to answer that question?