Bloomberg – Bear Stearns Cos. didn’t investigate the financial health of a hedge-fund client that later collapsed because its claim of an annual 20 percent return on investment “made perfect sense,” a former executive at the firm said.

Bear Stearns was sued in 2001 by a bankruptcy trustee on behalf of creditors of the now-defunct Manhattan Investment Fund Ltd. U.S. Trustee Helen Gredd alleged New York-based Bear Stearns was liable in part for $400 million in investor losses because it didn’t properly inspect the fund’s books, according to a complaint originally filed in a Manhattan bankruptcy court.

A senior Bear Stearns executive learned in 1998 that the fund was claiming a 20 percent return when the securities firm’s records showed a $190 million loss, the trustee said in court papers. The executive, Fred Schilling, was head of prime brokerage sales in 1998 when an investor in the hedge fund praised its returns to him at a cocktail party, he said.

“With the information I had, that Ernst & Young was a third-party administrator, and there were other prime brokers involved, it made perfect sense,” Schilling, referring to the New York-based auditor, testified today during a trial of the case in Manhattan federal court. The executive said he learned an affiliate of the accounting firm aggregated losses and gains from other parties to arrive at the final return rate.

Under U.S. bankruptcy law, if Gredd can prove the securities firm failed to diligently investigate the fund, she can recover around $141 million on behalf of creditors.

Bear Stearns spokeswoman Elizabeth Ventura declined to comment.

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Bloomberg- Hedge funds may be forced to sell bonds and asset-backed debt amid tighter lending standards and poor returns, the European Central Bank said in its six-monthly Financial Stability Review.

Volatile financial markets, investor redemptions and difficulties meeting margin calls have resulted in a “challenging period” for the $1.9 trillion industry and that will continue, the ECB said in the report published today.

“Some leveraged credit-focused hedge funds have been particularly badly hit,” the ECB said. “Moreover, many hedge funds still remained vulnerable to tougher lending stances of prime brokers and a further deterioration in financial markets. Further de-leveraging and forced sales in credit and other asset markets cannot be excluded.”

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