The problems facing two Bear Stearns hedge funds were triggered by a small markdown in some of the funds' holdings, which became amplified because of the funds' massive borrowing, market sources have told CNBC.
The markdowns, reflecting bad bets on subprime loans, reduced the value of some of the funds' holdings to 96 cents on the dollar from 100 cents, a 4% decline, these sources said. That small decline was the catalyst for the recent plunge in the value of the hedge funds, which are now on the brink of collapse.
Like many hedge funds, the Bear Stearns managers borrowed heavily in the hopes of producing outsized returns. But being so heavily indebted, or leveraged, also can produce outsized losses with only a minor downturn in the value of the holdings, as was the case here.
A spokesman for Bear Stearns declined to comment, and Bear Stearns officials have never said publicly how much they marked down the fund to reflect the deteriorating conditions in the subprime market.
But investors are worried that if a small price decline can cause such a huge upheaval, the worst might not be over for the subprime market--or the Wall Street firms that have minted money in recent years from the subprime market.
There is also worry that Bear Stearns may have to mark down its funds even more than the 4% already taken. That could cause a ripple effect: As Bear Stearns reduces prices, Wall Street firms must do the same not just in the hedge funds they created but also if they are holding subprime debt on their balance sheets.
No Rescue for Second Fund
Separately, Bear Stearns said Tuesday that it needs to invest only half of the $3.2 billion it initially pledged to rescue one of its ailing hedge funds, and does not expect to rescue a second troubled fund.
The investment bank said it will provide about $1.6 billion in secured financing to its Bear Stearns High-Grade Structured Credit Fund after the fund sold some assets to partially mollify lenders.
"By providing this secured financing facility we believe we have helped stabilize and reduce uncertainty in the marketplace," Bear Stearns CEO James Cayne said in a statement.
Meanwhile, Everquest Financial, which has ties to troubled hedge funds run by BearStearns, officially called off a planned initial public offering.
The decision, which was first reported last Thursday by CNBC, was announced in a regulatory filing with the Securities and Exchange Commission.
Everquest was formed in May by several Bear Stearns executives and it filed for a IPO shortly afterward.
"(Everquest) has some of the same money managers as the hedge funds, and this company was essentially investing in a lot of the same instruments as those hedge funds," Gasparino reported last week.