Bear Stearns is proposing to rescue one of its struggling hedge funds by assuming $3.2 billion (£1.6 billion) of its debts in what would be the biggest bailout since the collapse of the Long Term Capital Management fund in 1998.

The hugely leveraged fund has run into trouble as the value of bonds backed by high-risk mortgages, which make up the bulk of its investments, has plummeted in the face of rising defaults on American home loans.

Under Bear Stearns’s proposal, the bank would repay the loans to some creditors from its own balance sheet.

This is a high-risk move for Bear Stearns, since the value of the so-called High Grade Structured Credit Strategies fund is likely to continue to fall as defaults on sub-prime mortgages mount. Creditors such as Deutsche Bank and JPMorgan had threatened to seize assets from the fund and to sell them in an attempt to minimise their losses. Since these auctions would have flooded the market with mortgage bonds and driven their price even lower, Bear Stearns concluded that it would be better to keep the fund afloat and sell the bonds off slowly.

Merrill Lynch, one of the fund’s main creditors, followed through with its threat to sell some of its assets on Wednesday when it put $850 million of bonds up for auction. Demand was weak and the bank managed to sell only about $100 million-worth before it ended the auction. The auction raised fears in the industry that appetite for high-risk mortgage bonds could be even weaker than had been thought and it increased the chance that investment firms may need to substantially write down the value of these kind of securities on their books.

Bear Stearns is negotiating individual agreements with the hedge fund’s lenders. The terms of the each deal may vary.

The fund had borrowed about $9 billion from banks such as Lehman Brothers, Goldman Sachs, Citigroup, Bank of America and Barclays, according to Bloomberg News, which first reported the discussions.

The proposed bailout would be the biggest since 14 lenders extended an additional $3.625 billion to Long Term Capital Management after the hedge fund lost $4.6 billion.

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