March 19 (Bloomberg) -- Hedge fund manager Steve Moyer joined 4,000 realtors and bargain hunters at a five-hour Southern California housing auction in February. As the tuxedoed barker peddled foreclosed homes for hundreds of thousands of dollars below their previous sale prices, Moyer took notes -- research that may help him make money from the biggest housing collapse in 26 years.

Moyer, who helps oversee $7 billion at Tennenbaum Capital Partners LLC, is part of the rush of more than 70 hedge funds -- including those run by Blackstone Group LP and Goldman Sachs Group Inc. -- to snap up distressed mortgages and securities from banks battered by the subprime meltdown.

``The risk is getting in too soon, before all the losses are flushed out,'' says Moyer of Santa Monica, California-based Tennenbaum, which is considering investments in securities linked to the housing market. ``It's really just hard to call the bottom.''

Hedge funds are taking this gamble as the slate of money- making strategies shrinks and profits vanish. Their returns fell 0.5 percent in the first two months of 2008, according to Hedge Fund Research Inc.'s composite index. Managers who specialize in stocks were among the hardest hit as equities markets worldwide tumbled on concern the U.S. economy might be in a recession.

In 2007, the funds gained 10 percent on average, almost double the performance of the Standard & Poor's 500 Index.

``Every couple of years, we go through a cleansing where we flush out some of the weaker hands,'' says Marc Freed, managing director at Lyster Watson Management, an investment advisory firm in New York that specializes in hedge funds and oversees about $2.5 billion. ``This may be one of those years.''

Goldman, PIMCO

Hedge funds have raised at least $20 billion to take advantage of the housing recession. Goldman Sachs, whose $10 billion Global Alpha fund fell about 40 percent last year, created two distressed-debt pools with a combined $4.5 billion in assets. Pacific Investment Management Co., manager of the world's biggest bond fund, has raised $3 billion.

Even Bear Stearns Cos., the U.S. securities firm that had two mortgage-related hedge funds blow up last year, tried to get its hand in the pot. The firm hosted a Feb. 14 conference in New York at which 11 firms looking to buy mortgage-related debt made pitches to about 150 potential investors.

Last week, Bear Stearns itself became a distressed asset. Clients withdrew $17 billion from accounts at the firm on concern it might run short of cash, and investors became reluctant to place new trades with it. JPMorgan Chase & Co. on March 16 agreed to scoop up Bear Stearns for $2 a share, 90 percent less than its market value two days prior.

For hedge funds pursuing mortgage-backed securities, raising money is proving to be easier than spending it.

Fair Prices

Most banks haven't begun to dump the securities because they can't get prices they consider fair, says Dan Castro, chief credit officer of the structured-finance business at GSC Group, a Florham Park, New Jersey-based hedge fund firm with $22 billion under management. It's raising $500 million for distressed debt.

Some hedge funds won't buy until prices fall enough to provide returns of as much as 30 percent, Castro says, while others may pay more to avoid sitting on investors' cash.

U.S. home prices, which declined in 2007 for the first time on a year-over-year basis since the Great Depression, may determine when the market for securities takes off. Lehman Brothers Holdings Inc. economists say home prices in the 20 biggest metropolitan areas will fall 20 percent from their 2006 peak through the trough at the end of 2009.

$200 Billion in Writedowns

For Citigroup Inc., Merrill Lynch & Co. and other banks that have already taken more than $200 billion in writedowns and credit losses, additional housing woes would likely inflict more pain and prompt a sell-off of the securities to raise cash, says Louis Gargour, chief investment officer of London-based hedge fund firm LNG Capital LLP.

``There's an enormous amount of mortgage debt that will be washing around secondary credit markets in the next 12 months,'' says Malcolm Perry, chief executive officer of London-based Prytania Group, which manages about $500 million and started a new fund for distressed credit. ``This represents a tremendous opportunity if you can tell the difference between the baby and the bath water.''

HFH Group LLC is now trying to do just that. The New York- based $1.8 billion hedge fund firm hired three Ph.D.'s to spend a year plugging formulas into spreadsheets to simulate how home loans perform under various economic and market conditions. The software program, which runs on 12 servers, takes an hour to analyze the 5,000 loans in a single mortgage bond.

``A lot of the new money is not going to have the discipline to sift through what is really happening,'' says Paul Ullman, CEO of HFH, who started trading mortgages in 1982 at Salomon Brothers. ``Drilling into individual loans is critical to the task of, one, avoiding loss and, two, making serious money.''

Spider and Fly

Nigel Blanshard, a founding partner at London-based fund- of-funds manager Culross Global Management Ltd., has already made money off mortgage securities. The firm invested with Paulson & Co., which earned at least $2 billion last year from predicting the subprime market's collapse.

Blanshard isn't ready to lock up money with funds waiting for prices of securities to hit bottom. ``I have no interest in putting money in a pool that's going to sit like a spider waiting for the fly to arrive,'' he says.

Hedge funds started the year with their worst performance since 1990. Many of them may have little choice other than to bet on the fly.

To contact the reporters on this story: Bradley Keoun in New York at bkeoun@bloomberg.netTom Cahill in London at tcahill@bloomberg.net

Last Updated: March 19, 2008 00:01 EDT