I want to give you an overview of the entire situation surrounding the "credit crunch crisis," so that you don't become confused by all the bits and pieces you may hear in the media.

Collateralized Mortgage Obligations (CMOs) have been around for decades. They have blown up like this before--first in the early 1980s, and then in the early 1990s. In fact, I bet that this crisis will strike again in another decade or so, after a new generation of inexperienced fixed-income traders emerge on Wall Street. The fact that Bear Stearns' hedge funds and other hedge funds leveraged these CMOs to get higher yields and subsequently blew up is, well...too bad for those investors. They obviously did not assess the risks in their quest to get a higher yield. However, now that the CMO credit crisis has hit big European banks, too, the pain is obviously hurting other investors.

Complicating matters this time around is a newer high-yield debt instrument, the Collateralized Debt Obligation (CDO). These are risky new high-yield investments that were packaged to boost yields. Structured CDO products totaled $3.3 trillion last year! Hedge funds struggling with lower returns leveraged themselves deeply in these CDOs in an attempt to get higher returns.

Sadly though, the resale market for CDOs has now collapsed, due to the fact that no one trusts any CDO until they break it apart to see what's inside. In fact, the Securities & Exchange Commission (SEC) is now investigating whether major Wall Street brokerage firms are using consistent methods to calculate the value of their CMOs and CDOs, as well as the assets they hold for large customers, such as hedge funds. If it turns out that some firms are valuing these assets differently, you can kiss the hedge fund industry goodbye! The SEC demands full disclosure and transparency, so if you cannot properly price a security, then chaos will reign. In the interim, help may be coming, since Goldman Sachs and other smart players are nibbling at the subprime and high-yield investments, when they can get a big enough discount, so some CMOs and CDOs actually have a consistent "bid" price. At least, that is what the Wall Street firms (and probably the SEC) are hoping to see.

In the interim, chaos will continue to reign for a few weeks. Treasury Secretary Hank Paulsen (former head of Goldman Sachs) and Fed Chairman Ben Bernanke are mandated to protect our standard fixed-income investments, such as Treasuries and certificates of deposits (i.e., CDs) at banks. Now that the U.S. banking industry is at risk for investing in CMOs and CDOs, potentially putting your CDs at risk as well, the Fed had to intervene last week to reassure everybody that it would be "providing liquidity to facilitate the orderly functioning of financial markets."

However, the situation got more complicated last week, as the hedge fund meltdown spread more widely. Specifically, many equity hedge funds, especially those that short stocks, were squeezed on August 6, when the Dow Industrials staged their biggest one-day rally this year, led by the battered financial stocks. This short-covering rally, combined with excessive stock market volatility (the Dow's swings averaged 400 points a day - much wider than usual), caused great confusion among some "market-neutral" hedge fund managers. Black Mesa Capital, for instance, has a hedge fund with about $1.9 billion in long positions and $1.9 billion sold short. But they told investors that market-neutral hedge funds had suffered losses of 5% to 15% so far in August.

According to The Wall Street Journal, a hedge fund run by Goldman Sachs - the North American Equity Opportunities market-neutral fund, with $767 million invested - was down 15% year-to-date through July 27th and has sold some of its positions recently. Goldman Sachs' largest hedge fund, the Global Alpha fund, suffered potentially bigger losses and may also be selling positions, according to other published reports. According to John Mauldin's August 11th weekly e-letter, Goldman Sach's $8 billion Global Alpha fund "has been losing money for two years, is down 26% for the year and down almost 40% since the end of July." On Saturday, MarketWatch said that the Global Alpha fund has "fallen 26% so far this year." These depressing performance reports only add to the chaos. No wonder Goldman Sachs is being hit with redemptions!

Another hedge fund, the $29 billion Renaissance Institutional Equities Fund, led by a famous mathematics professor, also reported significant losses in August as their computer models were overwhelmed by the wide stock price swings. Many such "quant" funds analyze the historical relationships between related securities and trade when those relationships get out of alignment. Unfortunately, trading ranges have since widened, throwing their models off kilter.

This is what happens when Wall Street lets the math professors play with the money, instead of letting the finance guys run the show! I cannot tell you how many knock-down drag-out fights I have had with some pretty big players on Wall Street who no longer believe in fundamental analysis, like I use each week on ProfolioGrader Pro. These math wizards were not trained in finance. This is what happened to Long-Term Capital Management (LTCM) in 1998 when some Nobel Prize-winning mathematicians profited from the "normal" trading ranges, then along came an abnormal move (devaluation) in the Russian ruble, and they had no idea how to stop the bleeding.

The use of leverage turns a small, normal loss into a massive loss that threatens bankruptcy in a hedge fund. Some of these hedge funds also have permissive redemption periods, allowing their investors to take their money out every month, with 30 days' notice or less, which exaggerates the selling pressure. Naturally, this puts more pressure on selected securities, such as financial stocks, and escalates the losses at other hedge funds that made the same bet through a chain reaction.

I'd say the current situation is best described as "the blind leading the blind." Too many hedge funds made the same bet and ended up on the wrong side of the trade. Back in 1998, the giant LTCM made bets on the relationship between the prices of government securities from around the world. When Russia defaulted and devalued its currency, there was a flight to quality that caused the prices of U.S. Treasuries to spike up and the Japanese yen to jump 12%, causing a massive financial earthquake around the globe. The LTCM collapse caused the Fed to intervene and bail out several of the world's largest investment banks. From last week's actions by the Fed and other central banks, we may be in the process of repeating the 1998-style bailout.