Investors Brace for Ripples from Hedge Fund Fallout

Investors following the near-collapse of two hedge funds managed by Bear Stearns might be a little bit like a homeowner watching the house down the block catch fire.

It is far enough away to think there's no immediate threat - but you still need to care about what the embers could do to your own roof. The worry is the same on Wall Street, where bankers are anxiously watching to see if the hemorrhaging at Bear Stearns will spread elsewhere.

Right now, individual investors are not yet seeing an impact in their 401Ks and stock portfolios. But, the situation might have wider implications as the nation's biggest financial institutions determine if their own hedge funds are at risk - and as U.S. regulators remain on high alert for a contagion that could rattle the economy.

"The investors in the hedge fund that goes down can be those ordinary Joes on the block," said Harvey J. Goldschmid, a former commissioner with the Securities and Exchange Commission who now is the Dwight Professor of Law at Columbia Law School.

"In theory, hedge funds are about wealthy people investing," he said. "But, by practice, pension funds, endowments, and other financial institutions invest in them, and a few big hedge funds going down can spread an awful lot of harm among real people."

Indeed, pension funds and other endowments had about $1 of every $10 sunk into alternative investments last year, such as hedge funds and private-equity funds, according to consulting firm Greenwich Associates. Similarly, large hedge funds get about 24 percent of their investments from endowments, foundations, and pension funds.

That might not sound much until you put it in perspective _ hedge funds manage about $1.5 trillion of assets, if not more, analysts said. And that has given the matter a sense of urgency for Wall Street's top players.

James Cayne, the longtime chairman and chief executive of Bear Stearns, is trying to stem the losses at the nation's fifth-largest investment bank. He has scrambled to salvage the two hedge funds, which were dragged down by investments tied to subprime mortgage debt.

He plans to pump in $3.2 billion to revive the healthier of the two funds. There has been speculation that the firm might dissolve the second fund, where investors' money has been cut by more than half.

The amount of money Bear Stearns is putting into the fund rescue represents the largest such bailout since Wall Street's investment banks bailed out Long-Term Capital Management in 1998 to avoid a collapse of the broader financial markets.

It is not alone in facing risk from its own hedge fund portfolio, either. Major financial institutions like Goldman Sachs Group, JPMorgan Chase, and Citigroup also manage tens of billions of dollars in hedge funds, according to Moody's Investors Service.

On Monday, researchers at Citigroup said subprime mortgage bonds issued last year by Goldman were being downgraded by rating agencies at a faster pace than any other issuer.

Defaults on mortgages to risky borrowers have risen to an all-time high, and that's done more than just hurt the long-suffering housing market. It has hurt the ability of banks to package mortgage loans as securities that can be traded - which is something many borrowers don't realize their lender even does.

"This is an unfolding story," said Dick Bove, an analyst with Punk Ziegel. "It might take months to see the effects on a whole range of areas. For banks, it means they'll be less likely to write loans, borrowing costs go up, and ultimately stocks could fall. It's like a wave crashing."

Beyond the effects on Wall Street proper, the economy could be set up for a shock if hedge funds begin to collapse. Without some kind of government intervention, a worsening environment for big investors could eventually trickle down to the little guy.

Though any real shakeup in the hedge fund world might be months or years away, some believe it might be a good thing for investors in the long run.

There has been continued criticism by regulators and politicians that hedge funds might be too leveraged to begin with _ and perhaps a shake-up will flush out the riskiest funds.

It also could accelerate a push on Capitol Hill for tougher regulation of hedge funds and private equity. But that might not happen until Wall Street feels the kind of squeeze that would hurt individual investors as well.

"If there's a downturn for a group of hedge funds, then there could be dramatic effects for the markets in general," Columbia's Goldschmid said.