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Scoundrel Hedge Funds? Don’t Just Stop There

Posted by Larry Doyle on May 11, 2009 6:40 AM |

Hedge funds are bad guys, right? Greedy, unethical, opaque, right? Well, hedge funds are largely opaque and that needs to be addressed in order to make sure that trading and investment activity occurs in an ethical fashion. That said, hedge funds are like any other industry; there are some bad seeds mixed in with plenty of outstanding individuals. Do the bad seeds warrant an industrywide assault? I don’t think so, but that is what we are seeing from the Obama administration on the heels of the Chrysler bankruptcy.

I see the issues in the hedge fund as follows:

1.  This industry should be required to pay taxes on income generated at ordinary income tax rates instead of as carried interest and thus at long term capital gains rates. The Obama administration has looked to implement this change in their budget. This move is long overdue. 

2.  The industry should be regulated and/or regularly monitored. Why regular oversight did not occur after Long Term Capital Management imploded in 1998 is beyond the life of me. Who may monitor them? A division within the SEC. (for those interested in the topic of hedge funds and Wall Street oversight, a must read is When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein)

The collapse of LTCM in 1998, a mere 5 years after its founding, exposed many of the problems within the hedge fund industry. Although the principals in LTCM were not bailed out, the process of unwinding that firm was viewed as a Fed orchestrated takeover. Many moral hazards were violated. Many shoddy business practices were exposed. Very few real regulatory changes were implemented. There is no doubt in my mind that the manner in which LTCM was handled set the precedent for many of the problems of the last few years. (I wrote extensively about this topic in my March 18th piece: “AIG and LTCM“)

 It has always been widely speculated that many Wall Street firms profited handsomely from the LTCM debacle. How so? Representatives from each firm were involved in a committee that took over the LTCM operations. In the process, firms became aware of the vulnerability of market sectors in which LTCM had significant exposure. Traders at firms drove markets in one direction or another to further LTCM’s pain. There is no doubt we have experienced similar scenarios recently. Goldman Sachs, rightly or wrongly, is typically the firm implicated for this activity.      

3.  Hedge funds are the most active traders in the marketplace. A large number of traders within hedge funds came from Wall Street banks and maintain close relationships at the banks. Additionally, hedge funds also have close relationships amongst themselves.  Dare I say, without aggressive oversight, the system allows and effectively engenders coordinated if not collusive trading activity. This is not a new development. 

4.  Often traders from hedge funds transact business directly with traders at Wall Street banks without a salesman involved to act as an intermediary. This type of business is a compliance violation.  Hedge funds want access to information from traders rather than salespeople who filter it or do not fully understand it. 

5.  I am very suspect that there are still a number of unexposed Ponzi schemes disguised as hedge funds. The fact that so many funds suspended redemptions is a sign the “flow of oxygen” to continue the scam had stopped. In fact, I would strongly suspect that a number of hedge funds farmed money to Bernie Madoff knowing full well the nature of Bernie’s business.

Are all these points an indictment of the entire industry? NO! As with any industry, there are plenty of unsavory and unethical charlatans. I could write a similar scathing review of illicit activities in banking, insurance, asset management, technology, politics (that would be a long one), and regulatory bodies.

The simple fact is hedge funds, in general, and the unsavory firms in particular, pushed the envelope because they were allowed. In fact, given the massive amounts of contributions which Washington politicians effectively commanded from them, it is not a stretch to propose that hedge funds were buying their own cover and protection.

In so many words, though, haven’t the large banks been operated as massive hedge funds as well? The banks utilized massive leverage, off balance sheet vehicles, active trading, and proprietary models to run their businesses. The banks also contributed massively to Washington coffers. Additionally, the banks funded their own regulatory oversight in the name of FINRA.

If banks operated as hedge funds, did the SRO (self-regulatroy oversight) FINRA also operate as a hedge fund? No, FINRA merely invested hundreds of millions of their OWN dollars in hedge funds and fund of funds. FINRA should be compelled to release the names of those funds. The circle is complete.

If Obama wants to castigate the hedge fund industry (WSJ reports Hedge Funds Are Piqued by White House) as being scoundrels and attempt to curry political favor with his constituencies in the process, he is morally bankrupt if he does not also address the complicit nature of the banks, politicians, and regulators as well. 


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