The Cockroach Theory says that when you see one cockroach, you have to assume there are a bunch more hiding in the walls waiting to come out. Tonight Bear Stearns is notifying investors that it has a third hedge fund that is in trouble and it is halting redemptions. Unlike the other two devastated funds, the $850 million Asset-Backed Securities Fund is unhedged and they say it will not suffer from forced liquidations or seized collateral, by lenders or investors.

However, the damage is potentially worse for the markets for the same reasons that it is being spun as not as bad. First, halting redemptions to stabilize a fund indicates to me that investors have lost confidence in Bear Stearns - a leading financial institution. So you may think that halting will prevent a meltdown by selling assets into a weak market, but the desire to pull out is very concerning. More importantly, the fund supposedly has only a small percentage of exposure to subprime - as low as 1% of the fund assets. That may make you feel better if you myopically focus on this as a subprime issue. But taking the bigger picture, you have to wonder how could a fund focused on Alt-A and prime mortgages be in trouble. The “containment crowd” has been denying the mortgage crisis by trying to isolate this as solely a subprime issue. I cannot count how many times brilliant people have said that subprime problems will not or is not migrating to higher quality borrowers. How many cockroaches do you need to see before you question that belief? AHM was one creepy-crawly-critter today. CFC was another prehistoric pest last week. I suspect tonight’s BSC disclosure will put this myth to rest.

And what is the remedy? When we first acknowledged the problem with subprime, Congress contemplated a bailout. Lenders were encouraged to restructure loans and be nice to the borrowers who supposedly were taken advantage of by predatory lenders. Congress also put the pressure on the Fed for their failure to prevent this mess. If we finally admit that this is bigger than subprime, then what do we do? It’s hard to contain cockroaches and it’s hard to prevent them and it’s hard to crush them.