The recent collapse of two hedge funds at Bear Stearns Asset Management raises two questions few people can answer. How did they lose so much money so quickly? And where else are similar problems buried? The unsatisfying answers illustrate why markets suddenly have become so volatile.

First, it has been widely reported that the Bear Stearns hedge funds lost money on highly rated derivative securities based on subprime mortgages. Essentially, these securities, known as collateralised debt obligations (CDOs), were complex bets on how many people would repay the money they borrowed to buy homes. Although Bear Stearns has not yet admitted which versions of these derivatives it held, one can glean some characteristics from letters the funds sent to investors months ago.

On May 15, the newer of the two funds reported it was down 6.5 per cent for the year. By contrast, the value of many subprime-linked securities had been sliced in half as early as February. In other words, the fund was not simply tracking the subprime markets: it was doing better, presumably because it was buying highly rated securities. Still, many investors in both funds were nervous about the losses and asked to redeem their investments. The funds said No.

On June 7, losses climbed to 19 per cent. Investors asked how the newer fund lost so much money, when the subprime markets were rebounding and many commentators, including Ben Bernanke, the Federal Reserve chairman, suggested a crisis had been avoided. Indeed, as the markets bubbled with optimism at the time, Everquest Financial, a new firm that had purchased most of its $700m of assets from the two Bear Stearns funds, filed for an initial public offering. This timing was baffling: why did the two funds fall while the markets rose?

Then came the whopper: on July 18, Bear Stearns admitted it could not figure out how much money it had lost. It said: “A team at BSAM [Bear Stearns Asset Management] has been working diligently to calculate the 2007 month-end performance for both May and June for the funds.” The funds refused to answer investors’ questions. Less than two weeks later, they filed for bankruptcy protection.

This is not the first time smart people have bought complex derivatives and later said they could not calculate their losses. Bankers Trust, the most sophisticated derivatives firm of the 1990s, made similar mistakes. In 2001, the chief executive of American Express shocked investors when he admitted the company “did not comprehend the risk” when it lost $826m on CDOs. Freddie Mac and Fannie Mae have taken years to value derivatives losses, as did Enron.

As in those cases, the Bear Stearns funds did not lose money in the manner most people think. If the funds lost most of their money in May and June, they must have held positions other than highly rated CDOs. Some experts say the funds also made lower-rated subprime bets that were designed to hedge risk by moving in the opposite direction. Unfortunately, they did not. The Bear Stearns funds held opposing positions that unexpectedly moved in the same direction. As many traders say, the only perfect hedge is in a Japan­ese garden.

Anyone looking for clues to buried subprime losses elsewhere also should understand that many institutions do not “mark to market” complex derivatives to reflect changes in value over time. Many pension funds and insurance companies hold subprime-linked derivatives, but have not yet recorded losses. Others have recorded some, but not all, losses. Indeed, it is possible the Bear Stearns funds lost money during February, but did not record those losses until months later.

Some institutions argue that accounting rules permit them to hold derivatives at cost. Others say they need not reflect a loss until there is compelling evidence of a decline in value, such as a downgrade of the investments’ credit rating. As a result, it is virtually impossible for investors to understand how much exposure an institution really has to the subprime markets.

The common denominator of derivatives fiascos such as that of the Bear Stearns funds is that the answer to the above questions is: “No one knows.” Subprime exposure can remain buried and unexplained for months.

Now that investors seem to understand this, the markets are swinging wildly. Volatility is highest when people realise they cannot figure out what investments are worth.

The writer is an author and law professor at the University of San Diego

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