NEW YORK (Reuters) - Bear Stearns on Friday said it would provide up to $3.2 billion in financing for a struggling hedge fund it manages, raising concern about other funds that invested in bonds linked to subprime mortgages.The biggest bailout since Wall Street's 1998 rescue of Long-Term Capital Management signalled that the funds' main investments — a type of bond known as a collateralised debt obligation (CDO) — may be riskier than previously reckoned.

"The big worry is: Are there other funds like this out there? Are whole markets going to seize up?" said James Ellman, president of financial services hedge fund Seacliff Capital, adding that he thought concerns were overblown.

Analysts said in the worst-case scenario, the stock market could broadly decline as companies could face higher borrowing costs and leveraged buyouts could grow less attractive.

Last Friday, investors sold stocks, driving the major averages down more than one percent, and bought safer US Treasury bonds. Bear Stearns' shares fell 1.4 percent, or $2.06, to close at $143.75 on the New York Stock Exchange.

Bear Stearns, the fifth-largest US investment bank, said it would provide secured financing to its High-Grade Structured Credit Strategies Fund so the fund can sell assets in an orderly fashion.

Bear also said a second fund that took greater risk is still working out a restructuring plan with creditors.

Jeff Marwil, a Chicago-based lawyer at Winston & Strawn who has overseen hedge fund liquidations, said the financing should buy Bear Stearns some time.

"When you're dealing with assets like these, it takes time to find a willing buyer and negotiate a sale," Marwil said. "If a trading partner knows you're desperate, that desperation will be reflected in what the partner offers."

Bear Stearns believes it will generate enough from selling assets to more than cover its exposure from the credit line, Chief Financial Officer Sam Molinaro said in a conference call.

The financing eliminates other banks' exposure to the fund. But many still have exposure to a sister fund, High-Grade Structured Credit Strategies Enhanced Leverage Fund, which is still negotiating with creditors. That process could take several months, Molinaro said.

The two funds melted down after rising US subprime mortgage defaults earlier this year depressed prices of CDOs, which were essentially repackaged portfolios of subprime home loans and were among the funds' main investments.

Fitch said Friday it may downgrade some CDOs linked to subprime mortgages. Moody's downgraded a series of subprime mortgage bonds earlier this week.

Bear Stearns' High-Grade Structured Credit Strategies Fund was down about five percent so far this year through the end of April, according to a source familiar with the matter.

The High-Grade Structured Credit Strategies Enhanced Leverage Fund, meanwhile, which borrowed more to magnify potential returns and potential risk, was down 23 percent over the same period. At their peak, the two funds controlled more than $20 billion of assets.

Bear Stearns said Monday it would add $1.5 billion of its own capital to the funds. Creditors rejected that offer. Merrill Lynch & Co. sold $100 million of assets from the funds.

Those securities are believed to have come from the High-Grade fund, while on Friday, dealers looked at selling assets from the Enhanced Leverage fund, sources said.

Investment bank and dealer Cantor Fitzgerald sold Bear Stearns hedge fund assets on Friday, and "did not lose a penny" from the sale, a spokesman said.

CDOs trade infrequently, making their valuation fiendishly difficult.

"It is hard to get a handle on how widespread this problem is, because when you ask around, no one owns this," said Mike Hennessy, managing director at Morgan Creek Capital. "But you know that everyone owns them."

If the prices of those securities broadly fall, Wall Street firms, hedge funds and other investors could suffer losses on their portfolios, cutting into profits.

Meanwhile, buyout funds that depend on the CDO market to help finance take-overs could have more trouble completing deals.