You can hear the nervous Nellies on Wall Street expressing worries that so many of us have raised for a long time about hedge funds and the private equity funds that operate outside the scrutiny of the government. Today’s front-page Wall Street Journal article is an expression of the concern:

 

The near-meltdown of two hedge funds at investment bank Bear Stearns Cos. last week underscored — and in some ways aggravated — a growing fear on Wall Street: that hard-to-trade investments may suddenly turn south and set off a broader market downturn.

 

The Bear Stearns funds, whose investors include wealthy individuals, other hedge funds and some of the firm’s own executives, are part of a recent boom in investment vehicles specializing in illiquid assets, such as exotic securities, highways and timber lands.

It’s pretty obvious that we’re playing with fire–The Journal even says that what motivates the investment is pure and simple: greed.

 

And the use of borrowed money is on the rise. In May, the sum investors borrowed from brokerage firms to buy stocks hit $317.99 billion, up about 14% from the previous record in March 2000, according to the New York Stock Exchange. Net borrowings by large bond-market dealers stood at about $1.33 trillion this month, up from $730 billion in 2003 and about $300 billion when the stock market peaked in 2000, according to Chicago market-research firm Bianco Research LLC.

 

More than anything, this borrowing represents a triumph of greed over fear. Investors use loans to juice up their bets without tying up much capital, and enjoy high-octane returns while holding seemingly conservative assets like mortgage bonds. The risk is that recently placid markets start to crack, turning these profitable leveraged bets into deepening losses. With funds that use leverage, it doesn’t take a sharp move in a market to create a sharp drop in a portfolio’s value.

 

The problem here is the old story of someone yelling fire in a crowded theater. The hedge fund investments are only as solid as the confidence people maintain in them–you just need one or two funds collapsing (as was the case with Long Term Capital Management in 1998) to trigger a wave of panic. And the losses could be stupendous before anyone even knew what was happening:

Moreover, hedge funds typically don’t keep investors abreast of the details of day-to-day trading. As a result, any losses the funds suffer may be significant by the time investors learn of them. That can be especially true for illiquid assets, which may not show much price movement for months and then dip sharply when confronted with the one-two punch of declining fundamentals and nervous investors.

This is important to watch–major pension funds, particularly those holding public employee pensions, are major investors in hedge funds because of the higher returns. But, what happens when historically low interest rates go up–which they inevitably will–and the flood of cash pouring in from countries with trade surpluses with the U.S. dies up–which could happen sooner than you think? A potential disaster if these hedge funds find themselves in a bind.