Two former Bear Stearns hedge fund managers were arrested and charged by US authorities Thursday, accused of conspiracy and securities fraud. Ralph Cioffi and Matthew Tannin both entered not guilty pleas and were released on bail (Cioffi - $4m and Tannin $1.5m).

Authorities claim that the two hedge fund professionals continued to pitch the Bear Stearns High-Grade Structured Strategies Enhanced Leverage Master Fund and the High-Grade Structured Credit Strategies Master Fund to investors, even as they knew that the funds, which were linked to subprime lending-related investments, were in trouble. (When they eventually failed last August, the funds became the first casualties of the credit crisis').

Prosecutors are confident that the have the two hedgies bang to rights, as they have uncovered e-mail evidence that appears to implicate them in wrongdoing. Reuters reports that the indictment by a New York federal grand jury quotes Cioffi informing Tannin that 'the worry for me is that subprime losses will be far worse than anything people have modeled'. Both fund managers are said to have still pitched the two funds to investors as buying opportunities, even though they had personal doubts about the market. Tannin is said to have told one investor that he was adding to his investment in the funds, but never did, whilst Cioffi is said to have actually withdrawn $2m of his $6m personal investment. In one e-mail, Tannin is alleged to have boasted: 'believe it or not - I've been able to convince people to add more money'.

Another e-mail Tannin sent to Cioffi said: 'If we believe the (CDO report) is anywhere close to accurate I think we should close the funds now. The reason for this is that if (the CDO report) is correct, then the entire subprime market is toast. If AAA bonds are systematically downgraded, then there is simply no way for us to make money - ever....Caution would lead us to conclude the (CDO report) is right - and we are in bad shape'. Nevertheless, even after this mail was sent, the two guys are alleged to have assured investors that the funds had sufficient liquidity to survive.

Bloomberg quotes Steven Caruso, an attorney representing investors who have filed arbitration claims against Bear Stearns, who said: 'the arrests are appropriate given the magnitude and the egregiousness of their alleged misconduct'.

Cioffi's lawyer Edward Little, from Hughes Hubbard & Reed, said in a statement: 'The subprime crisis took everyone by surprise, including the Fed and Treasury, and dozens of the largest financial institutions have lost over $300bn to date on the same investments. Ralph Cioffi's funds lost money in exactly the same way. Because his funds were the first to lose might make him an easy target, but doesn't mean he did anything wrong'.

Tannin's attorney, Susan Brune from Brune & Richard LLP, said: 'Matt Tannin is innocent. He is being made a scapegoat for a widespread market crisis. He looks forward to his acquittal'.

The US Justice department has confirmed that it is investigating 19 firms, including investment banks and hedge funds, in a wide-ranging mortgage-fraud probe. 400 individuals are said to have been criminally charged in connection with the probe, with 60 arrested on Wednesday alone.

Comment from our Highly Placed Professional:

'It was only a matter of time before the US authorities started to go fishing for the big boys. Over 400 individuals charged, 19 firms under investigation, and some headline arrests with former high-ups being carted off in handcuffs. That's the rule of law US-style. But what's happening over in the UK ? Is anyone investigating mortgage mis-selling ? Are any firms being probed for mis-stating assets such as mortgage portfolios ? It doesn't look like it. No wonder Joe Public appears to have very little confidence in the integrity of our banking system'.

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