Jonathan D. Iseson made his first, and only, appearance in the New York Times on June 1, 1999, when the Metropolitan section portrayed him as an example of the chichi financier who was giving the Hamptons their style and grace despite much recent lampooning and degradation by the big-hair set. “The money floats in on private helicopters and corporate jets and gleaming white yachts,” the Times reported. “‘I just got it yesterday,’ said Jonathan D. Iseson, a 42-year-old hedge fund manager from Manhasset, N.Y., docking his 48-foot cruiser at the Sag Harbor Yacht Club. He downsized from a 55-footer. ‘I got rid of the wife, so I didn’t need the space,’ he explained.”
A great wit too! And there was better to come. The hedge fund that the forty-two-year-old yacht-docker and wife-divorcer was piloting was the Blue Water Fund Ltd. In the months that followed the Times piece, the Blue Water Fund Ltd. sailed over the bounding waves. There is an old saw that goes something along the lines of “Where are the customers’ yachts?” but it did not apply to Iseson or Blue Water. They had plenty of solid bucks coming their way, in the manner in which solid bucks are often last seen before they sink below the waves—on paper. In the first quarter of the new millennium, Blue Water was at the very top ranking of hedge funds tracked by MAR/Hedge, a leading hedge fund database, with a 140 percent gain. The problem was that this gain had resulted from one stock that was dominant in the Blue Water portfolio—dominant as in 55 percent of its net assets. That one stock was an Internet company called Netsol, and Blue Water’s purchases of that stock had driven up its price and, thus, the value of Blue Water. A good strategy, but a little—maybe just a bit risky or overconcentrated, wouldn’t you say?
Well, it all became public and the lawsuits came and lots of people got upset. The lawsuits, which charged fraud and stock manipulation—allegations very much denied by Iseson—were settled after the usual legal sturm und drang. Blue Water sailed over the horizon, and the publicity was mild enough that Iseson was able to move on to other fields of endeavor, doing convertible bond deals at a brokerage that doesn’t like to publicize his Blue Water dalliance, and who can blame it? The regulators did nothing, so obviously nothing bad had happened.
Quite a story, Blue Water—and there are so many of them too: hedge funds that are bold and brave, and that may cut corners now and then, not always to the benefit of their clients and not always with a Katrina-sized gust of negative publicity.
All this is by way of saying that the portrayal of hedge funds in this book has been badly skewed, in the sense of being too gentle. We’ve only scratched the surface of how adventurous hedge funds have become. We haven’t explored the Blue Waters of hedge-fund-land. We haven’t explored the many mini-Askins and the hedge funds that are having even more fun with your money, the phony-baloneys and criminals and scamsters who screw investors using hedge funds.
We haven’t delved into an even worse element that has been introduced into the equation—increasing numbers of hedge funds, including some gloriously underperforming funds-of-funds, that are sponsored by Wall Street megafirms and mutual funds. The perpetrators of this latest glory upon the investing public include every major brokerage house, from Merrill Lynch to Salomon Smith Barney, and big fund groups such as Wellington Management, Alliance Capital, and Invesco. Nowadays your “financial advisor” and mutual fund have plenty of nice, high-fee house hedge funds, including plenty of fee-upon-fee funds-of-funds, to add to the list of merchandise they can sell you.
We also haven’t gotten to the cute little tricks that hedge funds perform, in addition to the not-so-cute, not-so-small tricks enumerated previously.
One of the more public-spirited hedge fund managers, an ex-newsman-turned-fund-manager named Harry Strunk, has compiled a list of the various ways hedge funds screw investors. Harry is widely known for an index that tracks short-sellers, and he also runs Treflie Capital Management LLC, in West Palm Beach. Here’s a sampling from Harry’s list:
Let’s see what the self-regulatory pyramid is doing about this stuff. The pyramid and its overseers in Congress, as well as the Federal Reserve Board of Governors, have all been toying with the idea of regulating (or, more precisely, toying with the idea of toying with the idea of regulating) hedge funds since the early 1990s. They really, really haven’t wanted to do any toying or even thinking about toying with hedge fund regulation. But then the funds started misbehaving, again and again. It was a real pain in the butt.
Scandals can be so annoying, so disruptive to the orderly flow of paperwork. Just when the leather armchair is feeling comfy, and the lure of the post-government job is intruding upon even the deepest of afternoon naps, along comes a scandal with reporters calling and editorials screaming, and one must make believe that one gives a damn about hedge funds. Such are the demands of government service.
The first whiff of potential hedge fund lousiness took place during the Salomon Brothers bond-trading scandal in 1991. While the Solly bond market scandal was not a “hedge fund scandal” per se, it was plain at the time that hedge funds were making money along with Salomon as the latter was cornering the government bond market. Just about every leading Superinvestor of the era—Julian Robertson and George Soros as well as Steinhardt and Kovner of Caxton Corp.—was getting sued and investigated for a supposed role in the scandal. Robertson and Soros were eventually cleared, but, as we’ve seen, Steinhardt and Kovner were pursued for some years and accused of helping Salomon rig the market.
Something new was at work here—a form of investment that was feckless, maybe a tad irresponsible, and capable of causing problems.
Officials of the SEC, Federal Reserve, and Treasury Department roused themselves to action via a Joint Report on the Government Securities Market in January 1992. The report was an intelligent document. Among its findings:
Events in the government securities market have shown that their capacity for leverage allows hedge funds to take large trading positions disproportionate to their capital base. Thus far, [hedge] fund managers have proved very adept at controlling their market risk, and their lending counterparties appear to consider them creditworthy. However, the sheer size of the positions taken by hedge funds raises concerns about systemic risk that these funds may introduce into the financial markets.
The report did everything but use the name Askin in predicting the hedge fund failure that lay in wait, two years down the road.
Prescient as that was, when it came to hedge funds the SEC was at the very foot of an Everest-size learning curve. That was evident only a few months after the Joint Report was issued, when the SEC was forced to cope with one of the perennial annoyances of bureaucratic life—congressional meddling. On March 18, 1992, the head of the House Telecommunications and Finance Committee, a nosy Massachusetts Democrat named Edward J. Markey, sent a letter to the Bush I administration SEC chairman, Richard C. Breeden. Markey wanted to get some authoritative answers to some basic questions on the subject of hedge funds. Breeden put his staff right on it and, three months later, sent over to Markey a staff memo that laid out all the “facts,” such as they were. The study is interesting for what it reveals about the SEC’s knowledge of the hedge fund industry, which was pretty close to nothing.
Breeden began by making one thing perfectly clear: Appearances to the contrary notwithstanding, hedge funds were nothing to get all worked up about. “Since 1987,” he said in a letter to the Markey committee, “the Commission has apparently received no investor complaints and has instituted no enforcement actions against hedge funds.”
“Apparently”? Well, come now, you can’t expect the SEC to keep accurate records of investor complaints. In any event, this was about as clean a bill of health as the SEC could provide. The staff memo, attached to Breeden’s letter, picked up on that “stop worrying and go away” theme. It began by presenting a vaguely worded history of the hedge fund industry culled from press clips, apparently the SEC’s only source of info on hedge funds at the time, and moved headlong into a discussion of the here and now. The press clips were, alas, inadequate sources of data, particularly on such things as offshore funds, which the media wasn’t covering very much at the time.
Unbeknownst to most of the civilized world and the regulators thereof, offshore variations on hedge funds, such as the Soros funds, were about to explode on the scene. Just one of the Soros funds, Quantum, had $3.1 billion under management at the start of 1992. During the year, the Soros funds—which, as you’ll recall, were operated “off the shore” of the Lake at Central Park—would accumulate a massive short position in the British pound. Soros would cash out before the first golden leaves of autumn, causing teeth-gnashing throughout Europe and turning him into “the man who broke the Bank of England.”
The SEC report devoted all of four nonchalant paragraphs to the offshore phenomenon (though Soros’s Quantum Fund did appear in a list of hedge funds tacked on as an appendix, “taken from recent media articles from newspapers and periodicals”). The report observed that there were $250 billion in offshore funds—thereby making the whole discussion inane by lumping in ordinary non-U.S. mutual funds with U.S. hedge funds operated out of filing cabinets in the Caribbean. The SEC staff even had trouble finding elementary source materials. “According to media reports,” the report said in a footnote, “there does exist a privately published list of offshore funds. The staff, however, was unable to obtain a copy of this list.” That apparently is a reference to the U.S. Offshore Funds Directory, published by Antoine Bernheim, a pleasant gentleman whose phone number was, and is, listed in the Manhattan telephone directory.
The report went on to discuss the sources of cash for hedge funds, and did so in a way that would have completely misled any policymaker who made the mistake of believing it. The SEC staffers cast cold water on “media sources [that] recently have reported that some pension funds invest, or are considering investing, in hedge funds.” No, said the report. Not happening. A footnote said that “it appears that registered investment companies do not invest significant assets in hedge funds” because of provisions of the Investment Company Act that “prevent excessive layering of fees.” As those words were being written, pension funds were already becoming one of the hedge funds’ biggest sources of cash. In fact, the SEC’s 2003 study of the fund industry observed correctly that “pension funds were among the earliest hedge fund investors.”
Having downplayed or scoffed at all the major trends that would drive hedge funds in the years to come, the SEC’s 1992 study was no more useful as it turned to possible ways of riding herd over funds. For that, the study relied on an impending “large trader reporting system” that would supposedly put hedge funds under a microscope. The system had been in the works for a long time. It was not the SEC’s idea, but was rammed past the agency’s tonsils by Congress, in a law called the Market Reform Act of 1990. The system was designed to overcome information gaps that regulators encountered during the crash of October 1987 and a market downturn two years later. The aim was to help market overseers reconstruct and analyze trading activity, in the event that, God forbid, there should be another crash.
In the report, the “large trader reporting system” came in handy as something to which the staff could point, a thing that would deal with hedge fund secrecy and opacity. The Markey committee was assured that “the Commission will be able to gain considerable information regarding hedge funds that are large traders in the equity markets as a result of its proposed large trader reporting system.” Such a system “should provide the Commission with access to information that is more tailored to systemic risk concerns, without unduly burdening private investors.”
Now, at this point some of you may be thinking, “Gee, why haven’t I ever heard of such a thing?” The reason is that it doesn’t exist. Hedge funds didn’t like the idea, so it didn’t happen. Such is our self-regulatory pyramid in inaction, with the accent on self. Regulation with the consent of the regulated—has a Jeffersonian sound to it, don’t you think? In order for a regulatee (or, in this case, a putative nonregulatee) to exert the necessary muscle, it is necessary to have a full-fledged lobbying arm in Washington, and by the early 1990s that goal had been realized. Hedge funds now had their own lobbyists, some hired by individual hedge funds, and their own trade association, the Managed Funds Association. The MFA was founded in 1991, just in the nick of time, you might say, and proceeded, along with other hedge fund lobbyists, to help the SEC and other regulators come up with excuses to not regulate the hedge fund industry.
The large trader reporting system was quietly shelved in the time-tested Washington way—by doing nothing. Artie Levitt’s SEC simply never adopted implementing regulations. No reasons were given at the time. No reasons were necessary. Congress could pass the law, but it could not enforce it. As Stalin supposedly said in a similar situation, “The pope? How many divisions has he got?” The advantage of not doing something, as opposed to affirmatively saying no, is that one is rarely asked why one doesn’t do something. The hedge fund industry did not like this idea one bit—said it would be difficult to implement and maintain and also that there were other mechanisms out there able to monitor stock market activity—so it was not done. Besides, it might have actually done what it set out to do, and shed some light on hedge funds, at least as far as their stock dealings were concerned. That would never do.
Congress finally roused itself in the mid-1990s, slammed its fist on the table, and shouted, “Damn it! Time to do something about hedge funds!” Our legislators decided that it was high time to make it easier for hedge funds to bulk up on assets, and to reduce oversight of the funds.
It happened in 1996. Hedge funds were now a $200 billion industry, getting bigger, and desirous of getting bigger still. At the urging of the MFA and other hedge fund lobbyists, Congress decided that the time had come to improve the lifestyles of hedge fund managers. Thus was born the National Securities Markets Improvements Act of 1996. (Note the word improvements in the title of the bill, as in “improved hedge fund revenues.”) Previously hedge funds had a restriction of one hundred investors per fund. That went out the window, and the asset base (and resulting fees) of hedge funds were now “improved” fivefold, with the number of investors allowed per fund increasing from one hundred to five hundred, as long as each investor had up to $5 million worth of investments sitting in his portfolio.
The law also provided an additional “improvement” that made hedge fund managers everywhere stand tall: It greatly reduced state regulation of offers and sales of hedge fund securities. Just what hedge funds needed in the mid-1990s—less oversight!
In fairness to Congress, I should point out that all these wonderful improvements had no effect on the LTCM disaster one way or the other. However, hedge fund lobbyists really showed their stuff when it came to damage control after LTCM, ensuring that every single regulatory response to Meriwether & Co. was quietly but effectively shelved. Again, the swift sword of inaction was the fund industry’s most effective weapon.
In 2000, the Commodity Futures Trading Commission issued a proposal that would have gone a long way toward shedding light on the activities of the biggest hedge funds. What happened next was dazzling, probably the most impressive act of inaction to take place anywhere on the globe until a few years later, when the forces of evaporation caused the waters of Lake Powell to recede, exposing the glories of Glen Canyon. This time, the force of nature at work was the sheer power of bureaucratic entropy.
Acting as recommended by one of the numerous committees formed after LTCM, the CFTC proposed a rule requiring operators of large commodities-trading “pools” to report periodically to regulators on their finances and risk. These are not fecund bodies of water where cattle, swine, and other “commodities” come to drink, but actually regulator-speak for some of the biggest hedge funds. Many are considered commodity pools because they dabble globally in currencies and futures contracts. With such oxen unwilling to be gored, the rule came under attack from the MFA. The result was immediate, sustained, and, I might add, effective inaction.
In the absence of any strong interest group (such as the U.S. government) pushing in favor, the rule was allowed to evaporate. It sat on the CFTC’s Semi-annual Regulatory Agenda until late 2002, marked “Next action undetermined,” and was finally withdrawn in March 2003, a few weeks after its twilight-zone status was publicized in Business Week.
By 2003, the theory and practice of hedge fund inaction, which had begun under SEC chairman Richard Breeden and was refined by the stasis-loving Investor’s Champion Artie Levitt, was being further improved by Bill Donaldson. With the hedge fund industry now pressing up toward the trillion-dollar mark, there was work not to be done. Total inaction, the favored methodology during the Levitt era, now gave way to a Donaldson specialty—inaction disguised as action.
By now, Street firms were falling over themselves to get prime brokerage bucks from hedge funds—a particularly lucrative business in which Wall Street firms handle trades, paperwork, and other administrative tasks for hedge funds. Brokerages were pushing low-minimum funds of hedge funds with horse-choking fees. Donaldson, in one of several stern speeches on the subject, referred to this as the “retailization of hedge funds.”
A good example of this was being bestowed upon the lucky customers of Merrill Lynch in 2005. To invest, all you needed was a million bucks—“including the value of your home,” Merrill was careful to point out. Since real estate was engaged in a boom of an insanity not seen since the IPO mania in the late 1990s, that meant that pretty much anyone living in a Manhattan coop bigger than a peanut shell was now a millionaire. Whoopee! They could now prance around, rejoicing like James Dean covered with oil in Giant, and buy what Merrill had to offer. Its Multi-Strategy Hedge Opportunities fund of funds (minimum initial investment $25,000, minimum subsequent investment $10,000) was a doozy. Here’s how the charges stacked up:
That was it. Not too bad, huh? Total fees were being capped at 3 percent during 2005, as an extra added incentive. Of course, you have to tack on the fees skimmed off by the hedge funds, commodity pools, and so on in which this fund invests, which included management fees of 1 to 3 percent plus incentive fees of 15 to 25 percent of profits.
Bill Donaldson gave many speeches attacking “retailization” of hedge funds. When it came time for inaction, what he did was require, in a rule he pushed through the SEC in October 2004, that hedge funds register as investment advisors with the SEC. That’ll fix ’em! Not.
Instead of doing anything about the fee circus described above, or forcing funds to provide meaningful disclosure to regulators and protection for their investors, Donaldson’s rule did absolutely nothing to deal with any of the problems that have plagued hedge funds. Nothing was done to keep crooks from running hedge funds, or to stave off systemic risks from runaway leverage. In fact, 40 percent of hedge funds were already run by registered investment advisors, voluntarily. As for the 60 percent that were holdouts, the rule wouldn’t do much of anything that mattered to customers.
Not only did the rule fail to do anything about crooked funds—which tend to be too small to be affected by the rule anyway—it actually expanded the potential market for hedge funds. Since pension funds tend to invest only in hedge funds that are run by registered investment advisors, SEC commissioner Cynthia A. Glassman noted, “Mandatory registration of all advisers will expand the potential universe and thereby afford even more opportunities for investment in hedge funds.” Other critics said that the meaningless registration requirement would give a kind of “Good Housekeeping Seal of Approval” on hedge funds. This kind of sensible opposition to bureaucratic wheel-spinning, by the way, later caused Glassman to be snidely referred to in the media as one of the “two Republican commissioners” who voted against Donaldson and stood in the way of progress. I challenge anyone to find anything particularly Democratic or Republican about a regulation that won’t work.
Proponents of the rule noted that it would raise the wealth requirement for investors in those 60 percent of hedge funds that are not registered. That’s because there already was a rule requiring that investors in registered funds have a net worth of $1.5 million, or at least $750,000 under management with the investment advisor. That looks good, until you realize how easy it is for hedge funds to get around this limitation.
That brings us to the pièce de résistance, the Roach Motel Encouragement Rule that Donaldson enacted as part of his inane registration requirement. Remember those ridiculous lockups that we discussed earlier—such as the one that proved so horrendous for the people who bought into LTCM and Julian Robertson’s Ocelot fund? Lockups are so egregious, so downright disgusting, that you’d think that Bill Donaldson (whose old firm Donaldson, Lufkin & Jenrette marketed Ocelot to hapless investors in 1997) would come down hard on such things. Instead he actually encouraged lockups. He wrote into the rule a loophole that exempts funds with lockups of two years or more.
In other words, if a hedge fund manager is particularly greedy and grasping, he gets off the hook! He doesn’t have to bother registering his fund, and he’s not subject to that $1.5 million net worth limit. He gets a pass, thanks to the new Investor’s Champion, Bill Donaldson.
You’d have thought that Donaldson and the SEC would have noticed how dumb this rule truly was. However, to call it dumb assumes that Donaldson and the SEC really wanted to do something to curb hedge fund abuses. It wasn’t dumb if their intent, from Day One, was to do nothing. You’ve got to admit—as an act of nonregulation, it is a work of genius.