Japan's Nikkei share average plunged 10.6 percent on Tuesday, posting the worst two-day rout since 1987, as hedge funds bailed out after reports of rising radiation near Tokyo. ~ Reuters, March 15, 2011
While it's far too early to assess the full impact of the Japanese disaster on markets around the globe -- let alone on the Japanese people -- we do know that hedge funds are already busy trying to profit from the misery. They make no apologies for operating in an ethics-free zone. Their business is to rapidly move money in and out of distressed markets. That's just what they do.
But as we're learning from the trial of billionaire Raj Rajaratnam, head of the Galleon hedge fund, an ethics-free zone can easily become a crime scene. The Raj is charged with enough counts of insider trading to spend 20 years in the hoosegow. And he's not the only one on trial. As the case unfolds, Wall Street as a whole may find itself in the dock, facing the question it dreads most: Just how much of Wall Street's wealth is built upon criminal activity?
Of all the rich and worried people on Wall Street right now, the hedge fund managers are the richest and maybe the most worried. After all, they've got a lot to lose. A LOT. Just to name one example, in 2010, the top hedge fund manager, John Paulson, netted -- for himself personally -- $2.4 million an HOUR. Forbes reports that in 2009, Rajaratnam was the 236th richest American, with an estimated net worth of $1.8 billion. That's more than 12,000 times the median US family's net worth (which was $98,997 in 2009).
Sebastian Mallaby, the financial author, offers a spirited defense of the hedge fund industry, arguing that, yes, there may be a few truly rotten apples, but insider trading is really no big deal. (See "Hands Off Hedge Funds" May 2007)
An industry of around 9,000 hedge funds is indeed bound to harbor some criminals....Moreover, some of what politicians and journalists label 'hedge-fund abuses' involve leaks of inside information from investment banks rather than from hedge funds, making the hedge-fund managers who receive the leaks accomplices rather than the chief offenders.
But federal prosecutors beg to differ: They say the Raj's hedge fund is the prime mover of the insider conspiracy, not a lowly accomplice to the crime. "Greed and corruption -- that's what this case is all about," said the the lead prosecutor in his opening statement. Rajaratnam "knew tomorrow's business news today and traded on it. ....One crucial thing he didn't know. He didn't know the FBI was listening."
What goes on when the F.B.I. isn't listening?
The defense team, led by John Dowd, argues that the Raj is just a smart guy who made his fortune through "shoe-leather research, diligence and hard work" and who "conducted the best research in the business." You see, says Dowd, the Raj used the "mosaic" method of investing: He collected from many sources a compendium of unconnected facts about a company to form a mosaic of its true worth. And that mosaic told him whether to go long, short, both, or stay away. Constructing these gorgeous mosaics turned the Raj into the billionaire he is today.
Mosaic method? Okay, let's give it a try. How about constructing a mosaic of hedge fund illegalities over the past decade or so? There are so many colorful tiles to choose from. Here are a few.
Insider Trading: Hedge funds of all kinds rely on "expert networks" who link together consultants who gather information about companies. In the process, bits of illegal information find their way into and around the network and then into the bottom lines. The Raj investigation already has upended several hedge funds that benefited from this common phenomenon.
Tax Evasion: Swiss banker Rudolf M. Elmer has blown the whistle on an international web of rich investors, banks and hedge funds that evade taxes by illegally shifting money to low-tax jurisdictions. There's something extra-slimy about tax dodging by hedge funds, given that they already pay less taxes than anyone else. Due to an egregious IRS loophole, hedge fund managers pay a top tax rate of 15 percent instead of the 35 percent normal wealthy people are supposed to pay. That these under-taxed fat cats feel entitled to top it off by engaging in this blatantly illegal form of tax evasion is galling. These guys seem unable to resist piling up more money, even if it means taking the law into their own hands.
Ponzi Schemes: When we think Ponzi, we think Bernie. Hedge funds like Madoff's are ideally suited for this kind of scam since they are designed to evade so many disclosure regulations. But Bernie's isn't the only game in town. There's a whole other kind of Ponzi scheme that has largely escaped media attention. You can find a description of this seriously twisted strategem buried deep in the bowels of the Financial Crisis Inquiry Commission Report. To construct and market exotic and highly profitable CDOs based on toxic subprime assets, investment banks had to be able sell the lower tranches (where a good deal of the junk assets lived). But that got harder towards the end of the housing boom.
So to keep the production line going, the banks sold the junk to each other: Entity A sold to Entity B who then sold back to Entity A. This game of hot potato was even played by different departments within one large investment bank. Hedge funds were always there to suck up the lowest level, highest yield "equity" tranches -- while often shorting other pieces. The potato toss had to continue or the entire game was lost. According to the Financial Crisis Inquiry Report, "heading into 2007 there was a Streetwide gentleman's agreement: you buy my BBB tranch and I'll buy yours." (p. 278) This scheme would have gone nowhere without hundreds of hedge fund players lapping up the equity tranches and buying the credit default swaps that allowed the deals to be constructed in the first place. How many financial billionaires were minted in this process, I wonder?
Front-running trades: With their high-speed trading computers and algorithms that sense market moves, the biggest hedge funds and banks are able to trade just a fraction of a second before the rest of us do. The SEC has been investigating this practice, known as front-running, for several years. The agency is worried that brokers leaked information about large trades by institutional investors to hedge funds so they could pull off the trade just a split second before the large trade took place thereby earning a quick, easy and illegal profit.
Timing and Late Trading: When Eliot Spitzer was New York Attorney General (and earned the handle Sheriff of Wall Street), he uncovered how hedge funds were maneuvering around trading rules like a Ferrari speeding around the hapless shmoes stuck in midtown traffic. Hedge funds were allowed to jump in and out of mutual funds many more times than normal investors, enabling them to score high returns at the expense of regular mutual fund customers. They even got away with booking trades hours after the market closed for the day -- a real perk, since market-moving announcements often are made right after closing. You don't need to go to Wharton to make big bucks on this one: All you do is wait a few hours to judge the impact of the after-closing news, then book your trades at the 4 pm price. Spitzer forced the guilty parties to pay several billion dollars in fines.
Accounting Irregularities: This is the catch-all biggie: Hedge funds and banks cook the books to avoid showing losses and to artificially inflate profits. Hedge funds are also deeply involved in helping other companies -- like Enron and WorldCom -- cook their books. According to a study by Bing Liang at the University of Massachusetts, as of 2004, 35 percent of all hedge funds cited no dates for their last audit. Hmmm.
Setting up bets that can't fail: Goldman Sachs had to pay $550 million for not telling its investors about its questionable deal with a hedge fund: The bank allowed the hedge fund to pick the most shaky underlying mortgage securities to be used in creating a synthetic CDO -- so that the hedge fund could then turn around and bet against it. It was a winning bet for the hedge fund -- it bagged a billion. Unfortunately, the investors lost a billion. Goldman Sachs did pretty well with its deal to pay only the $550 million SEC fine. After all, the company was bailed out by taxpayers to the tune of $12 billion: We paid them 100 cents on the dollar for credit default swap insurance that AIG could not pay. Incredibly, the hedge fund was in the clear. It couldn't even be charged, since it neither bought nor sold the securities in question. At the moment, there's no law against encouraging someone else to rig a bet for you -- except at the racetrack.
These are just a few of the many tiles for our hedge fund mosaic of cheating. As Neil Weinberg and Bernard Condon wrote in Forbes back in 2004 ("The Sleaziest Show On Earth"):
Hedge funds exist in a lawless and risky realm, exempt from the rules governing mutual funds, equities and most other investments. Hedge funds aren't even required to keep audited books -- and many don't. These risky funds often are guilty of inadequate disclosure of costs, overvaluation of holdings to goose reported performance and manager pay, and cozy ties between funds and brokers that often shortchange investors.
Of course, none of this proves that any given hedge fund billionaire is a cheat or even ethically challenged. But it does offer an unflattering picture of an industry that is at this very moment trying to milk money from Japan's roiling markets, once again profiting from the misery of others.
There's got to be a better way.
Les Leopold is the author of The Looting of America: How Wall Street's Game of Fantasy Finance destroyed our Jobs, Pensions and Prosperity, and What We Can Do About It Chelsea Green Publishing, June 2009. He is currently working on a new book, How to Earn a Million an HOUR: The Dubious Contribution of Wall Street Billionaires to the American Economy(hopefully to be published in 2011).