Barclays sues Bear Stearns over collapsed hedge funds

UK bank demands compensation and damages; Collapse of funds was first sign of mortgage
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Barclays has launched a $400m-plus legal action against Bear Stearns, accusing its Wall Street rival of fraud over the collapse of two hedge funds earlier this year.

The collapse of the funds in June was the first sign of the seriousness of the mortgage market crisis, but Barclays alleges that Bear Stearns was misrepresenting the health of its hedge fund business for more than nine months leading up to the disaster.

Barclays' possible losses on the funds, to which it advanced a string of multimillion-dollar loans, could amount to between $300m and $400m, and the company demanded compensation and damages in a lawsuit filed with a New York court last night.

The action adds to the legal problems swirling around Bear Stearns and the managers in charge of the two funds, whose collapse wiped out $20bn almost overnight. Last month, the US attorney in Massachusetts charged the company with improper trading activity, and it was reported earlier this week that Ralph Cioffi, the fund manager, was under investigation for moving $2m of his personal fortune out of one of the funds just a few weeks before its collapse.

Barclays' suit claims that Bear Stearns lured Barclays into supporting a highly leveraged fund for mortgage-related assets, in order to alleviate liquidity problems at an earlier fund that stretched back until at least September 2006. Mr Cioffi and another fund manager, Matthew Tannin, are named personally in the suit, alongside Bear Stearns and its subsidiaries.

The filing last night sets the stage for a bitter legal showdown between the two sides. A spokeswoman for Bear Stearns said the bank had not yet received the lawsuit but that it was certainly unmerited.

"While we do not like to see investors or counterparties lose money, we believe this lawsuit is an attempt by Barclays to avoid taking responsibility for its own actions," she said. "Barclays is a highly sophisticated financial institution with scores of analysts and economists capable of evaluating investment risk. It made its decisions based on its own assessment of the risk that did not anticipate what, in hindsight, turned out to be a historically difficult market."

The value of mortgage-related assets collapsed after American homeowners began defaulting on the underlying loans in record numbers this year.

The suit claims that Bear Stearns repeatedly misled Barclays about the performance of its highly leveraged fund known as the Enhanced Fund and that managers came up with a string of improbable excuses for why they could not hand Barclays regular performance statistics. In particular, Bear Stearns told it that February 2007 had been its "best month ever" and encouraged Barclays to invest further funds, when it turned out that the fund had in fact fallen in value that month.

Barclays further alleges that Bear Stearns used its hedge funds as a dumping ground for risky mortgage-related assets that it could not sell elsewhere, and took on $800m of the riskiest kinds of mortgage derivatives in contravention of their agreements.

"The defendants concealed the fund's falling net asset value from Barclays for as long as possible, instead of revealing the drop in value in, and increased risk to, the enhanced fund, and instead of taking immediate and effective corrective action," the lawsuit says. "This cover-up only caused greater losses and a more spectacular collapse of the enhanced fund."