With record losses from the subprime and credit crisis veering towards the $400 bn mark, here come the market police.

In the crosshairs: Hedge funds, including the indictments of the two Bear Stearns hedge fund managers.

A senior law enforcement official said in an interview that hedge funds now sit at the top of the hit list of federal investigations into the subprime crisis, including at the Department of Justice and the Federal Bureau of Investigation. Expect more announcements of hedge fund indictments in coming days, sources say.

Federal authorities say Ralph Cioffi and Matthew Tannin, ex-managers of two now defunct hedge funds at Bear Stearns that at one point were worth a total of $20 bn, have surrendered in New York City. The hedge funds ran aground in June of last year, costing investors an estimated $1.6 bn and kicking off the credit crisis. The two are alleged to have misled investors about the health of the hedge funds, which invested in risky subprime and credit securities. Bear Stearns lent one of the funds about $1.6 bn, and the loan was never fully paid back. The investment firm never recovered, and was eventually subject to a Federal Reserve-orchestrated shotgun marriage with JPMorgan Chase.

Because of the record losses from the subprime and credit crisis, "regulators are under terrific pressure to look into hedge funds," says Michael R. Young, a top securities lawyer at Willkie Farr & Gallagher, a white shoe law firm in New York City.

The two Bear Stearns hedge fund managers would be the highest level Wall Street executives to be charged in connection with the subprime and credit crisis to date. Details of the indictment are expected later today. A New York City grand jury is expected to return sealed indictments. The U.S. Attorney's office in Brooklyn declined comment.  The FBI did not return a call for comment.

Federal and state regulators have stepped up a nationwide probe into companies that allegedly committed wrongdoing in the subprime collapse, which includes investigations into hedge funds. The investigations are being run by the Department of Justice, the FBI and the Internal Revenue Service, sources say. The investigators are looking into disclosure issues, including whether market players intentionally misled and deceived investors about the value of subprime securitizations, among other things, sources say.

Hedge funds made hundreds of billions of dollars in trades of hard-to-value subprime and credit assets that do not always carry market prices. Because hedge funds annually pay their managers as much as 20% of investment gains each year, the fear is that they helped overestimate the values of these securities to line their own pockets at the expense of investors.

Despite managing assets that range into the trillions of dollars, hedge funds operate under a self-regulatory structure and fall outside of the regulatory purview of the Securities and Exchange Commission. They are not required to file quarterly or annual financial reports, for example.

With the subprime and credit crisis, a growing number of Congressional, federal and Wall Street officials are debating that they should make such filings, as such disclosures would provide much needed transparency into their portfolios, leverage ratios and potentially their trades, sources say.

In a January 2008 report, federal auditors at the Government Accountability Office called for stepped up vigilance over hedge fund activities, citing the fact that because the funds use multiple prime brokers as service providers, no single broker has enough independent information about a fund's total leverage.

After the collapse of Bear Stearns, the SEC began probing a dramatic rise in trading on option contracts which would benefit buyers if the company's stock declined quickly and dramatically.

Earlier, the SEC had launched a subprime working group in the spring of 2007, which now has about three dozen open investigations covering a broad range of potential wrongdoing, including at hedge funds, ranging from the origination process, to the securitization and retail sales of mortgage-backed securities, as well as insider trading, sources say.

The SEC is also looking at fraud and breaches of fiduciary duty in the creation of collateralized debt obligations, including valuation problems, sources say.  The FBI is also conducting probes of hedge funds, as well as companies involved in the housing mess such as subprime lenders, numbering as many as 19, sources say.  

And the SEC has been probing how hedge funds account for illiquid assets, sources say. For example, when hedge fund managers are unable to value assets, they have the option of moving them to "side pockets," where they are not included in calculations of a fund's net asset value.

Hedge funds can park bad assets in these "side pockets" in order to hide losses from investors. In turn, hedge fund managers don't disclose to investors the percentage of the fund's portfolio in a side pocket or what standards they used to determine which assets would be stuck there, according to a report from Wolters Kluwer Financial Services.

Private equity companies, pension funds, and portfolio managers are also hiring forensic accountants in an attempt to try and claw back their losses on subprime securities and structured products by proving hedge funds and other players knowingly committed fraud in their valuations of these securities, sources say. To do that, they need to prove that these individuals knew these securities had a higher chance of flopping than what they were telling clients.

Similarly, federal prosecutors may have a hard time proving their case against the Bear Stearns hedge fund managers.

At the crux of these cases sits a legal principle called "scienter," (a Latin word meaning knowledge), whereby prosecutors would have to prove the hedge fund managers, including Cioffi and Tannin, deliberately or knowingly knew their actions were illegal in order to prove they were legally responsible at the time of the alleged crime. Scienter is notoriously difficult to prove, prosecutors literally having to be sitting in an alleged criminal's lap to prove a crime, which is why they tend to rely on emails to prove their case, as in the Bear Stearns matter.

"High profile meltdowns almost always create pressure for regulatory probes," Young says. "Sometimes they're justified, sometimes not."

Separately, the relatively new Financial Industry Regulatory Authority, launched in July 2007 through the merger of the National Association of Securities Dealers and certain functions of the New York Stock Exchange, is also conducting probes. The probe reportedly includes hedge funds.

FINRA can fine, suspend or expel from the industry companies which violate FINRA rules, federal securities laws, or rules enacted by the Municipal Securities Rulemaking Board.

FINRA, which tends to focus on abuses of senior investors, has sent letters to as many as two dozen companies that sell collateralized mortgage obligations requesting detailed information about sales, marketing, review processes, and consumer complaints. These widely marketed products are often targeted at seniors and are difficult to understand.

Some major hedge fund players are being swept up in the dragnet.

The SEC has been investigating the $5 bn hedge fund DB Zwirn, which ran a high-yield bond portfolio. The commission is requesting information about how the hedge fund valued its assets, sources say. DB Zwirn is winding down its fund after colossal redemptions. The fund had specialized in purchasing corporate loans and other illiquid credits.

The fund had raised the valuation issue itself in a letter to investors last year that said a fund manager who left in 2005 had failed to "follow a systematic pricing methodology" for a portfolio of high-yield bonds, according to reports.

However, DB Zwirn said its lawyers and auditors uncovered "no conclusive evidence that the portfolio was overvalued" but found that by using one pricing methodology, "the portfolio may have been marginally overvalued," reports indicate, and returned to investors a sum equal to the management fees on the discrepancy, $818,398.