ed recently that a Federal Bankruptcy court judge
ordered Bear Stearns, one of America’s top tier trading firms to
pay $160 million to investors who lost money with a hedge fund
that cleared through Bear Stearns. While doing stock research
on publicly traded brokerage corporations, we came across the
settlement. This spurred us on to thinking, what does this mean
for the everyday investor, and what does it mean for stock
research in general. Here’s the real story.
Hedge Fund’s Asset Base SKYROCKETS
Hedge funds have become a significant force in the investment
world. At the beginning of the 1990’s, hedge funds controlled
less than $40 billion in assets, less than Warren Buffett’s
personal investment portfolio. Today there are more than 9000
hedge funds controlling in excess of $1.1 trillion dollars of
assets.
Hedge funds also use leverage, averaging some six times their
asset base. This means the industry today controls investments
of about $7 trillion dollars. These investments are on both the
long and short side. The mutual fund industry can only go long,
and never on margin, which means no leverage.
Now leverage is a two-edge sword. When things are going your
way, it creates excessive returns or alpha. When trades go
against you however, it can wipe out your investment in
lightning like fashion. The hedge fund borrows money on its
asset base from prime brokers, and other lending institutions.
The lender always charges a fee, and the fees are big. For the
brokerage firms involved, these fees may make up the vast bulk
of their bottom line depending upon the firm involved.
Hedge funds must clear through clearing firms that are referred
to as prime brokers. The prime broker sees every trade the hedge
fund does, unless the hedge fund employs multiple prime brokers.
Now lets say, the hedge fund lays on a massive trade using
margin borrowed from the prime broker, and the trade goes
against you, meaning paper losses are sustained. What happens
next?
The hedge fund has to make a decision as to whether to close
out the trade or not. Some funds believing that the momentum
will turn, will double down, or increase the investment. The
success of this transaction lies in whether or not the momentum
is in fact changing at the time of the double down. If not, than
the second investment will be under water as well.
Now a prime broker will never allow a hedge fund’s trades in
total to be under water. This would mean that the hedge fund
has gone negative equity, and the prime broker would be at
risk. The prime broker never wants to be at risk, nor will it
allow itself to be.
Enter the Manhattan Investment Fund
What happened with the fraud we mentioned in the title of this
article is that a hedge fund called the Manhattan Investment
Fund clearing through Bear Stearns lost nearly $400 million of
their assets. These assets belonged to rich investors, and the
fund’s managers made the wrong bets on Internet stocks in the
late 1990’s. Apparently Manhattan Investment Fund sought to
cover up or delay the inevitable consequences of its trading
activities by issuing FALSE reports to its investors.
This led to the creation of an inflated track record, which
allowed the hedge fund to bring in even more money, which in
turn allowed them to pay off early investors with money from
new investors. In other words a classic Ponzi scheme began.
Bear Stearns probably caught onto the scheme when one of its
managing directors met an investor in the Manhattan Investment
Fund at a party, and the investor talked about how his reports
from the hedge fund showed a 20% return. The managing director
understood from internal knowledge at the firm that the actual
trades going through Bear Stearns were in conflict with what
the investor was reporting.
Bear Stearns did follow up with the hedge fund’s manager
Michael Berger who is now a fugitive at large. Berger got out
of the problem by telling Bear Stearns that Bear Stearns was
one of only 8 or 9 prime brokers that the hedge fund was doing
business with. In other words, we’re losing money with you as a
prime broker, but not with the other prime brokers we deal with.
It’s a great story, and even makes sense, but apparently Bear
Stearns did not check out the story by calling the other prime
brokers to see if it was true that the hedge fund was doing
business with them as well.
Somebody at Bear Stearns figured something was amiss because
months later, Bear asked the hedge fund to put up additional
margin or cash in order to raise the margin requirement to 50%
from 35%. The fund sent over another $141 million as margin
payments. When the fund went out of business subsequently, Bear
Stearns was secure, and did not suffer a loss.
Judge orders Bear Stearns to PAY
The bankruptcy judge controlling this case has ordered Bear
Stearns to pay $160 million to the investors in the hedge fund.
The judge’s ruling stated that Bear Stearns as prime broker,
failed to properly supervise the fund’s activities prior to the
2000 collapse of the Manhattan Investment Fund.
This ruling is going to be appealed because to allow it to
stand would create much greater risk for the prime brokerage
industry than the industry feels it is being properly paid to
manage. Bear Stearns only made $2.4 million in profits from the
hedge fund’s activities, and now it is faced with a $160 million
judgment.
What you the Investor need to know – Diversification?
If you are an investor in hedge funds, what you need to know is
that any hedge fund can go belly up. That’s right, any of them.
You cannot outthink someone who while running a hedge fund, is
trying to defraud you. The only answer is DIVERSIFICATION in
your personal investment structure. You must own an assortment
of hedge funds if that is your investment vehicle choice, and
not just one. Your funds should also use different investment
strategies, and not just be equities long, or domestic, or any
other classification.
Since you are searching for the elusive alpha (outsize
returns), it your responsibility as an investor to be aware
that fraud exists. Even just plain bad investment strategies
can result in the loss of all your capital since these funds
are using 6 to 1 leverage in the attempt to create performance.
You might also want to consider a FUND OF FUNDS vehicle. This
is when you invest your money with a fund manager who makes no
direct investments himself, but instead selects other hedge
funds for you to be invested in. This involves a double
layering of fees. If the returns are there for you year after
year, than it doesn’t matter, but be careful, fraud does exist,
and so do poor investment managers.
Goodbye and Good Luck
Richard Stoyeck
About The Author: Richard Stoyeck’s background includes being a
limited partner at Bear Stearns, Senior VP at Lehman Brothers,
Kuhn Loeb, Arthur Andersen, and KPMG. Educated at Pace
University, NYU, and Harvard University, today he runs
Rockefeller Capital Partners and http://StocksAtBottom.com
http://www.stocksatbottom.com/ez.html
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