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7 Ways Hedge Funds Lie, Cheat and Steal

The billionaire head of the Galleon hedge fund was found guilty of 14 counts of securities fraud and conspiracy, but he's not just an isolated "bad apple."

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3. Ponzi Schemes:

Madoff isn’t the only one. Hedge funds and Ponzi schemes are made for each other since the funds are designed to evade so many disclosure regulations. It's virtually a sure thing that every new year will reveal another Ponzi scheme through which a hedge fund steals money from investors and then uses new investor money to pay returns to the old investors. It’s so easy to do when no one is watching.  

But the Ponzi problem is much bigger. The entire housing bubble was kept alive with a barely legal Ponzi perfected by the Megatar hedge fund. Pulitzer Prize winning reporters Jesse Eisinger and Jake Bernstein at ProPublica.org uncovered how Megatar created giant CDOs based on junk mortgages (even after the housing scam was unraveling) for the sole purpose of betting that they would fail. When they couldn’t sell the crap, they stuck it into the next CDO, sliced it, diced it, got top ratings and then sold it again. And when that crap couldn’t get sold, it went in to the next CDO and so forth.  

The Financial Crisis Inquiry Commission Report revealed a similar patterns where hedge funds and banks would trade the junk bank and forth among themselves in order to keep the production line going. If these aren’t Ponzi schemes then the word has no meaning. These “innovative” Ponzi schemes were far more damaging than Bernie’s. 

4. Front-running trades:

With their high-speed trading systems and algorithms that sense ever so slight 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 is also worried that brokers leak information about large trades by institutional investors to hedge funds so that favored hedge funds can pull off the trade just a split second sooner, thereby earning a quick, easy and illegal profit.  

With superfast computers, hedge funds may not even need insider information to cheat the system. Their computers can sense what large mutual funds and pension funds are doing and them beat them to it. While the mutual fund is pulling off a large trade, a hedge fund computer in nanoseconds might buy the stock, for example, and then sell it to the mutual fund at a slightly higher price, pocketing the difference. This scam, which should be outlawed, raises an important question: Where do all those billions in hedge fund profits really come from?  Some of it comes from draining the trades that are made for our 401ks, investment accounts and pension funds.

5. Late Trading:

When Eliot Spitzer was New York Attorney General (and earned the handle, "Sheriff of Wall Street"), he uncovered hedge funds maneuvering around trading rules like a Ferrari speeding around the hapless shmoes stuck in midtown traffic. In violation of all rules, hedge funds were allowed by mutual fund managers 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.  

6. Accounting Irregularities:

Boring stuff, but the stuff of big money. 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 – bend their books. You can get away with a great deal if you avoid internal audits. 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.