Hedge funds that imploded because of investments in collateralized debt obligations (CDOs) containing sub-prime mortgages are blaming the rating agencies for granting AAA or Aaa ratings to what is now viewed as toxic waste. Even though hedge funds -- including those managed by Bear Stearns Asset Management -- invested in the highest-rated tranches, they still experienced heavy losses.

The episode is raising serious questions about the structure of the CDOs and how the AAA rated layers ended up holding junk paper.

A CDO is an investment-grade product that exposes investors to a pool of mortgages and other bonds that are sliced into different layers or tranches based on their credit worthiness. The top-rated layer, known as the senior tranche, contains AAA or Aaa rated mortgages or bonds; the middle layer, known as the mezzanine tranche, contains AA to A rated instruments; and the lower tranches contain Bbb, Bb and B rated mortgages or bonds, explains Virginia Parker, founder of Parker Global Strategies, a fund of funds manager in Stamford, Conn.

The bottom tranche pays the highest return because if there's a default, it's the first to get hit with losses. "The highest-rated tranche gets paid first and then the next one, and whatever is left goes to the bottom tranche -- and the bottom tranche, called the equity tranche, gets the highest return since they're the last to get paid," explains Ed Rombach, derivatives market analyst at Thomson Financial. Hedge funds that held the AAA rated tranches, however, assumed they would get paid even if some homeowners defaulted on their mortgages.

But as delinquencies on sub-prime mortgage loans began to rise, the AAA and AA rated tranches offered little protection to investors because the lower-rated equity tranches didn't absorb all the losses. If the losses wipe out the bottom tranches, then they start to eat into the next highest tranche, Rombach relates.

The problem, according to Parker Global Strategies' Parker, was that the equity tranche represented only about 7 percent of the entire CDO structure. "That's not much equity when you have a structure full of junk," she says.

As a result, even though the hedge funds managed by Bear Stearns Asset Management were invested in the higher-rated tranches, they were not spared losses. "The Funds' reported performance, in part, reflects the unprecedented declines in the valuations of a number of highly rated (AA and AAA) securities," the firm said in a letter to investors.