Bear Stearns hedge fund trouble should be a warning to investors!

This is bound to send a shiver down the spine of hedge fund investors in the region, and not before time.

The Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Fund had leveraged $600 million in invested capital to invest in $6 billion of sub-prime mortgage debt in what are known as Collaterallized Debt Obligations, or securitized mortgage bonds.

With the US housing market in general in a state of crisis and the sub-prime mortgage lending market in particular in serious difficulty, perhaps this sort of contagion is to be expected. In this case the quality of the asset bought by the hedge fund has been hit, and this effect is amplified by the leverage it has applied to the investment.

The Bank of America has warned that this is the 'tip of the iceberg' as far as hedge funds are concerned. It would indeed be surprising if this hedge fund proved to be an isolated example, and Bear Stearns is a blue-chip Wall Street firm, not a cowboy operator.

LTCM precedent

Indeed, Bear Stearns was one of the 14 lenders who injected $3.6 billion to bailout Long-Term Capital Management, the hedge fund that collapsed in 1998 during the Asian Financial Crisis. At the moment the Bear Stearns hedge fund does not seem to present anything like such a big problem as LTCM.

However, it may prove to be the case that Wall Street has seriously underestimated the contagion effect of the US housing crash. The US real estate and construction sector is responsible for around a quarter of activity in the world's largest economy.

That means that the impact of the US housing crisis could surely be far bigger than the dot-com crash or even the Asian Financial Crisis, which was largely an ex-Japan phenomenon.

Bonds tighten

The tightening of the US bond market also signals a new mood of concern in capital markets, and at the same time is starting to choke off the supply of cheap finance to the hedge funds, which in time could prove even more significant in their undoing than sub-prime mortgage securities.

For hedge fund investors often forget that their above average rate of return comes at a price of increased risk, and that increased risk does also include the possibility of a complete implosion and loss of capital.

This is the so-called 'Black Swan' event. It is unlikely but when it happens it is devastating. Now for hedge fund investors sat mulling over their portfolio this summer the conclusion ought to be obvious: get out of this asset class while you still can!

Just ask yourself, what is the residual value of a hedge fund? This is not like a house, gold or shares, you can be left with nothing, and why take that risk?