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Out of fear that a cleanup of bad loans would trigger widespread defaults, Japanese banks got themselves deeper and deeper into trouble by hushing up the problems. We are talking about the crisis at Bear Sterns’ subprime hedge fund. The crisis shows that major adjustments on how the market prices risks are overdue; this may have negative implications for stocks, bonds, and commodities, as well as the US dollar.

Bear Sterns is a leading provider of services to hedge funds; it is also one of the largest originators of subprime-backed collateralized debt obligations. CDOs are what their name implies: a security backed by collateral. CDOs are created when mortgages with various risk profiles are grouped into different tranches or segments. Among others, Bear Sterns would create a CDO in a bundle according to a client’s specifications. Indeed, Bear Sterns would work with a rating agency, such as Moody’s, to obtain the desired rating (a practice likely to face more scrutiny as some allege that Moody’s no longer acts as an independent rating agency, but as a syndicator in the offering).

The explosive demand in this sector has attracted ever more creative structures. Investors should have grown concerned when dealmakers started suggesting that one can create a higher-grade security by grouping together a couple of lower-grade securities; it is rare that 1 + 1 = 3. As these instruments have grown more complex, the clients buying these instruments often do not have a full understanding of what they buy.

How do you make a best-seller better? You introduce leverage. Not only can leverage be introduced in the credit derivatives that define some of these securities, but brokers eager to attract hedge-fund business may also accept CDOs as collateral to lend money. The hedge fund now attracting so much attention is Bear Sterns’ High Grade Structured Credit Strategies Enhanced Leverage Fund, launched only 10 months ago. It shall be noted that Bear Sterns did not put much of its own money into the fund, but supplied many of the CDOs. A total of US$600 million in invested capital was boosted with borrowings of about $6 billion.

The collateral provided by the fund had the highest ratings by Moody’s. However, a high rating does not ensure that the CDOs are liquid, ie, that they can be sold off on short notice. This became painfully clear as bets of the fund were creating heavy losses and some lenders asked for more collateral for the loans extended. In the industry this is called a margin call. Bear Sterns told other lenders, including Merrill Lynch, JPMorgan and Citigroup, that the fund was unable to provide more collateral. On a side note, it is rather grotesque that Merrill, JPMorgan and Citigroup are among the larger investors in a fund managed by Bear Sterns. The company put little of its own money into the fund.

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As Merrill went public with its plan to auction off the collateral, others tried to rescue the fund. There was talk that Citigroup would inject $500 million and Bear Sterns might inject $1 billion. And the Blackstone Group was very interested in supplying much-needed capital. Blackstone’s offer required the brokers to abstain from further margin calls for 12 months. Such restrictions may be common in the private-equity world that Blackstone is active in, but was not acceptable to Merrill.

As the rescue plan fell through, Merrill stated that it would go ahead with its auction yet again. In the meantime, JPMorgan was front-running Merrill by trying to unload collateral it held for the Bear Sterns fund. When all was said and done, it wasn’t clear how much which broker was able to sell, but the sales were halted once again, and the parties seem to have agreed on an “orderly unwinding” of the positions.

This had the hallmark of the biggest financial crisis since the bailout of Long Term Capital Management. In 1998, the US Federal Reserve coordinated a bailout that led to the orderly unwinding of a fund that threatened the stability of the financial system. But this time is different: the instruments involved are so complex that journalists have had difficulty relaying the issues to the public, but the multiple calling and canceling of auctions by Merrill highlight the behind-the-scenes maneuvering to avoid fallout to the rest of the industry and beyond.