When Wall Street genius fails

• No new trades.

Some of Wall Street's largest and most successful hedge funds have suffered big losses this year. So far the list includes Bear Stearns (BSC, news, msgs), Goldman Sachs (GS, news, msgs), Macquarie Bank (MQBKY, news, msgs), Renaissance Institutional Equities Fund and BNP Paribas (BNPQY, news, msgs).

The Wall Street Journal reported that assets in Macquarie's portfolios fell by 4% in June and may have fallen an additional 20% to 25% in July. Goldman Sachs' $9 billion Global Alpha fund is reported to be down 27% this year.

What many of these funds have in common is that they are "quant" funds that try to exploit anomalies from the historical relationships between a wide range of securities. These funds have been enormously successful. For example, the Medallion fund (managed by Renaissance) has averaged roughly 36% a year since 1988, according Alpha Magazine, an industry publication.

What went wrong?

For the most part, the price discrepancies these funds exploit are small and fleeting. In order to generate such eye-popping returns from small and fleeting opportunities, you have to use a lot of leverage and act quickly; there is no time to do any research to figure out if the price discrepancy is justified.

Generally, the trading of these funds themselves helps to restore things to normal, making the profits predicted by their models almost a self-fulfilling prophecy. However, once in a while, what starts out looking like an anomaly turns out to be the first indication that something has fundamentally changed. When this is the case, the highly leveraged quick trading of these funds can lead rapidly to big losses.

What changed?

People who took out mortgages to buy real estate that is now worth less than the amount of the mortgages have reached the entirely rational conclusion that their best course of action is to default. But mortgage default rates are not reported daily, so when the value of securitized baskets of these mortgages first started to fall, it must have looked to the quant funds like a price anomaly that would be quickly corrected.

When the value of these securitized baskets of mortgages fell further, the banks that loaned the hedge funds the money to leverage their portfolios asked for additional collateral. In order to meet what are essentially margin calls, the most highly leveraged hedge funds started to sell their holdings of these securities. This drove prices down still further and put more hedge funds in the same situation.

Who gets hurt?

The people who are most directly hurt are the investors in these hedge funds. For the most part, they are large institutional investors who presumably understood the risks.

Last week, there was a chance that the damage could spread beyond the hedge funds and their investors when banks almost stopped making overnight loans to each other out of fear of lending to the bank that drops the next bombshell. The Federal Reserve effectively defused this threat by stepping in as the lender of last resort, so banks that did not trust each other could borrow from the Fed.

What else could the Fed do?

If the Federal Reserve started cutting interest rates, fewer people would default on their mortgages and the value of securitized baskets of mortgages would rise, putting an end to the immediate problem facing the hedge funds and their investors. However, the economy is already growing at about the rate that capacity can be added. Cutting interest rates could stimulate faster economic growth than what can be matched by increasing production -- in other words, inflation.

Continued: How big is the problem?

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