Hedge funds are named after the practice of "hedging your bets," or betting on both sides of a wager. But what happens when the unexpected occurs and the whole wager goes sour? Both sides lose, but the guys who borrowed money to hedge their bets--to bet on both sides of the deal--lose the most. That's exactly what happened to Long Term Capital Management two weeks ago.

LTCM had nearly $1 trillion in bad investments, but only $2 billion in assets that it could sell to pay off its debts. Its borrowing in the past year alone averaged between 50 and 100 times its asset base, and it borrowed from the biggest of banks and brokerage houses in the world, thereby endangering a banking system already rocked by losses in Russia and the Far East. Last week, more news leaked out about this highly secretive fund and other funds just like it.

Cerulli Associates, a Boston consulting firm which is preparing a report on hedge funds, estimates that there are roughly 4,500 of these funds with an estimated $300 billion in assets. That's not counting all the money these funds have borrowed to make highly risky investments. About 81 percent of the funds borrow, and most borrow just under 5 times their asset base. Imagine being able to take out a mortgage for 5 times the value of your home; no bank would do it--yet they do it for hedge funds. Why?

In the case of LTCM, the fund was managed by a few "big names" on Wall Street, including three former Salomon Brothers brokers and two Nobel Prize-winning economists, Robert Merton and Myron Scholes. They had the gloss of "expertise" to help them fleece major banks and brokerage firms, and take investment money from not just a few wealthy people, but also a bunch of "institutional investors" that were looking for wildly high returns: pension funds, endowments, and foundations--whose investments now account for about 80 percent of the total assets of all hedge funds today.

How do hedge funds work? In the case of LTCM, it bought mostly derivatives--paper contracts that wager on the movements of markets. Derivatives have no underlying value, are not based on any asset that can be sold to recoup losses, and have no market of their own like stocks or bonds do, so they're highly "illiquid" (i.e., they can't be easily traded or sold, like stocks on the New York Stock Exchange). In short, derivatives can be summed up in two words: running numbers. Although the risk is very high, if you bet correctly, derivatives can pay off big-time--if the markets remain stable. But the global markets have deflated, and hedge funds are taking a big hit.

For example, LTCM's investments consisted of bets in the global bond markets. Not content just to own bonds and collect interest on them, it "hedged its bets" by betting that bonds with credit risk (i.e., emerging market bonds and junk bonds) would gain in price against European government bonds and U.S. Treasuries. It then "hedged its bets" again by buying stocks in emerging markets. Stocks usually rise when bond prices go down--either way, LTCM sought to make a profit. But when the Asian financial crisis hit, emerging market stocks lost much of their value. When Russia defaulted on its domestic debt, emerging market bond prices also fell against U.S. and European bonds, so LTCM lost both ways. And LTCM is not alone: last week, Everest Capital Ltd., based in Bermuda (to avoid paying U.S. taxes), reported that it had lost $1.3 billion--or 52% of its assets. Everest Capital's main investors include a number of U.S. university endowments.

Hedge funds first appeared in the late 1960s, but have gained in popularity only in the last ten years. They're considered private investments, so they're not regulated by the Security Exchange Commission, which regulates banks, brokerage houses, and mutual funds. They avoid public disclosure laws, so they remain highly secretive about their investments and operations. No precise legal definition exists of what a hedge fund is.

Many funds have set up their central offices in Caribbean tax havens to avoid paying U.S. capital gains taxes. Since 1992, when Congress attempted to regulate hedge funds, leading fund managers have poured money into Republican Party coffers to kill regulatory bills. And, since 1987, when banks were given the go-ahead to liberalize credit, hedge funds have found it much easier to borrow vast sums of money to leverage their investments.

Most large banks and brokerage houses now have investments in hedge funds. Merrill Lynch, which was one of the initial investors in LTCM, has $2.08 billion invested in hedge funds. Chase Manhattan has $3.2 billion. Bankers Trust has loaned $875 million to various hedge funds. Europe's biggest bank, UBS AG (which has already taken an enormous hit from loans made to Russian banks), says it will lose at least $700 million this quarter alone because of LTCM's problems. Italy's state bank invested $100 million in LTCM and loaned it another $150 million.

With LTCM's troubles, investors are beginning to flee hedge funds, but they're finding it difficult to get their money back. There's no formal market for derivatives and, when a fund can't quickly sell its investments to pay back investors, the fund risks collapse. Banks and brokerage firms have stepped in to prop up LTCM, but things will only get worse for hedge funds and for the banks that loaned them money. As Paul Roth of the American Bar Association's task force on hedge funds said: "Someone was asleep at the switch."

Well, it's wake-up time.