Analysts lay much of the blame for the downturn on fears sparked by Bear Sterns' $3 billion bailout of one of its hedge funds that was in danger of collapse because large institutional clients wanted out.
"The investment banks who had lent money to the Bear Sterns hedge funds said, 'We want our money back. And if we can't get our money back right away, we may seize collateral and sell it,'" says Janet Tavakoli, president of Tavakoli Structured Finance.
The cause of the high-grade structured credit fund trouble was sub-prime mortgage loans — mortgages designed for people with poor credit histories. When borrowers began defaulting earlier this year, hedge fund managers were caught flatfooted.
"We've had more trouble in the sub-prime market than many of us expected. We've had default rates that are around 15 percent and climbing," says Tavakoli.
Although by definition, sub-prime loans are riskier investments, that's precisely why hedge fund managers poured money into them.
Hedge funds promise high returns for high risks, through the use of unconventional strategies. They're mostly unregulated and usually limited to wealthy investors. Tavokoli opposed Bear Sterns' bail out.
"These are sophisticated investors who know that they're supposed to be taking risk," says Tavokoli.
But you don't have to be a millionaire to be affected. According to the Securities and Exchange Commission, $72 billion in pension fund assets are in hedge funds.
Although other hedge funds may also have losses from the troubled sub-prime market, Tavokoli says pension holders should not be alarmed.
"Most pension funds have invested small portions of their funds in hedge funds, that would be their discretionary money," she says.
So far, Congress, which receives millions in campaign contributions from Wall Street, isn't pressing to regulate hedge funds. In March, Charles Grassley, the ranking member of the Senate Finance Committee proposed that large hedge funds be required to register with the Securities and Exchange Commission. The motion failed.