Making a Million Bucks an Hour: How Hedge Funds Get Away With Siphoning Off America's Wealth
The following is an excerpt from Les Leopold's new book, How to Make a Million Dollars an Hour: Why Hedge Funds Get Away with Siphoning Off America's Wealth (Wiley Books, 2013).
You may be asking, “Do you really have to cheat in order to make it into the million-an-hour club?” Well, it depends on what you mean by cheat and have to.
You absolutely don ’t have to—no, no, no, hedge-fund supporters assure us. There are only a few rotten apples in the hedgefund barrel, writes the ever optimistic journalist Sebastian Mallaby:
An industry of around 9,000 hedge funds is indeed bound to harbor some criminals. But insider trading is already illegal, and prosecutors have the tools to go after offenders in hedge funds without new regulations. The number of fraud cases suggests that regulators are not shy about using these powers, and hedge funds regularly experience inquiries from the SEC when they happen to trade heavily in a stock ahead of a price-moving announcement. 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.
You’ve got to admire how far Mallaby will go to exonerate hedge funds—golly, they ’re not really bad crooks. They ’re not the “chief offenders.” They only drive the getaway cars! But how many getaway drivers are there? How does Mallaby or anyone else know that hedge-fund cheating is not widespread? And how, for that matter, would we prove the opposing view—that foul play is endemic in the hedge-fund industry? In fact, until a lot of “accomplices” are wiretapped or tell all, it ’s virtually impossible for outsiders to really know the extent of the cheating.
We need to hear from an informed insider, someone who has run a major hedge fund, someone who hasn’t been nabbed and isn’t just talking to cop a plea. Yet what hedge-fund manager in his right mind would dare to tell all about the lawless world of hedge funds?
Enter Jim Cramer, the frenetic star of the highly successful CNBC show Mad Money. Before he became a TV star, Cramer made tens of millions of dollars running his own hedge fund, one of the most successful ever. After a decade in the business, Cramer knows a thing or two about hedge funds. Yet unlike others in this famously mysterious fi eld, Cramer talks about it in his entertaining autobiography, Confessions of a Street Addict.
In 2002, Cramer drew a gory picture of the cutthroat tactics required for hedge-fund survival. Five years later, in an interview on TheStreet.com (a website he cofounded and still co-owns), Cramer admitted that the industry actually pushes people, including himself, out to the ethical edge—and beyond.
James Cramer, a good Jewish boy from a middle-class home in Philadelphia, grew up smart and quirky. While other kids pored over baseball cards, young Jim was obsessed with stock market quotes. He tried to keep up with as many companies as possible and engineered make-believe trades. Fantasy market-playing became part of his peppery persona long before fantasy baseball came along.
As he plowed his way through Harvard (where he was president of the Harvard Crimson ) and then Harvard Law School, Cramer continued to feed his obsession with the stock market. He started picking and investing in stocks as a student, and when he graduated, he began to manage money for one of his professors, Marty Peretz, the publisher of the New Republic.
Instead of a summer internship with a law firm, Cramer nailed a job at Goldman Sachs and then put in four years on its sales force. With his energy and charm, he was a budding star with a knack for landing big accounts. Yet his real passion was still playing the markets himself. He soon found the means to set up a hedge fund with his wife, Karen—aka “The Trading Goddess.”
During the late 1980s and the 1990s, he traded like a wild man— and became exceedingly rich in the process.
In his Confessions , Cramer shows all the signs of the “good Jewish boy” genetic program (believe me, I know): he presents himself as a walking disaster. In contrast, his wife, Karen, is shrewd, brilliant, and always right. She never makes a bad trade or a bad hire. Meanwhile, poor Jim combines bad judgment with a psychosis Woody Allen would be proud of, as he stumbles his way toward riches. After their kids are born, Karen becomes the calm, caring stay-at-home mom, while Jim is consumed by work, blowing off family and school events left and right. When things go awry, Jim panics, screams and yells, and generally acts like someone who desperately needs to be scolded by a good Jewish mother, which, of course, Karen is.
Jim Cramer was a man possessed and obsessed, outworking everyone, all of the time. And he absolutely detested losing money. In an industry of alpha males reaping alpha profi ts, he had to have A-pluses on all of his report cards. He drove himself to make the highest returns, year after year, beating all of the biggest names every time. He was ablaze with energy:
I simply couldn’t stay asleep past three. No matter what I did, no matter how late I went to bed, no matter what I took, Sominex, cabernet, Bombay and tonic, didn ’t matter, I would sit up, eerily awake every night at 3:00 am, sweat pouring from every pore. Jeez it ’s dark at that hour. And nobody to talk to at all. Once up, all I could do was lie there and be paralyzed by the poor trades I had made the day before or the potential for great trades I could make the next day. I would roll on my stomach, press my head to the pillow, and think about the money I had lost if I had traded poorly, or the positions that had gone against me even if I had traded well. What good would it do to go over the good trades? That couldn’t make you money.
Eventually, after a ritual hour of bogus attempts to fall back asleep, at 4:20 am I would give up and fi nd myself on the treadmill in the basement. Bleak existence. (Cramer 2002, 103) Then someone invented the Internet—and made it go live on Wall Street—so that Jim could work even harder: Now I knew what to do when I couldn ’t sleep. I would get up and read and enter message boards, go to the Web sites of all of the newspapers around the world, and plan what our Web site would look like. I would spend from 3:30 until dawn working on designs for what would be TheStreet.com and then shift to my day job of trading until 4:00 pm, when I would once again start working online, taking a break for dinner before reimmersing myself in a night of e-mail and planning. (103)
On his way to work from suburban New Jersey (in his chauffeured Mercedes 500), he would read hundreds of reports, write blogs, and talk to his key traders and the press.
Cramer clearly wanted us to understand that he made his millions by working harder than everyone else in the universe—and millions he made. For a full decade starting in 1987, Cramer and Company (later renamed Cramer-Berkowitz) averaged a 23 percent return per year . That means, if you invested $1 million with Cramer, in ten years it would be worth $6.4 million. (Would that our 401k ’s followed that trajectory.) In one good year, the value of Cramer ’s hedge fund went from $300 million to $400 million. While Cramer took 1 percent of the assets as his administrative fee (staff salaries and such), he and his wife took 20 percent of the profits, too. That ’s a tidy $20 million in one year—in addition to the $4 million Cramer was paid to run the offi ce. (Today, most hedge-fund managers continue to skim 20 percent of the profits, while administrative costs are usually 2 percent or more of the assets under management.)
Yet there ’s a catch: You get your 20 percent only when your returns take the fund over what ’s called the “high-water mark.” If you lose money, then you won ’t collect another 20 percent until you make up those losses and bring your fund back past the last high-water mark. So you can never afford to lose money. Then there are those dreaded redemptions. That ’s when the fund ’s investors decide to take their money and run. Each year, hedge funds offer investors a window of time—perhaps a few days, two or three times a year—when they can take out some or all of their funds. If your fund is losing money, your investors may run for the hills, which makes it nearly impossible to get back to your high-water mark. You risk going into a rapid death spiral, as more and more investors flee. Suddenly, you ’re toast. It ’s not uncommon, and it can happen very quickly.
Jim Cramer was desperate to avoid such a dismal outcome. At stake was not only his huge hedge fund, but also his growing media presence, including his regular appearances on shows such as CNBC ’s Squawk Box . Jim did a lot of squawking, offering controversial, rapid-fi re opinions on all things financial. He loved to let it rip on the air. His cachet and credibility were entirely built on his day-to-day life as a top kick-ass hedge-fund manager—the ultimate insider (and the only hedge-fund honcho who regularly shared his thinking with the everyday investor). If his hedge fund failed, his entire media persona would crumble as well. He had more to lose than money.
In his book, Cramer does a masterful job of setting us up for a fall. We know it ’s coming, we just don’t know when or how.
• • •
The year was 1998. That ’s when Long-Term Capital Management (LTCM) (a hedge fund run by Nobel laureates that was leveraged 100 to 1) nearly took down the entire economy, forcing the New York Federal Reserve to engineer a private bailout. LTCM ’s collapse tore the heart out of many hedge funds, because so many of them had mimicked its strategies.
Cramer began the year with what he calls “hubris.” Going into 1998, he said,
I could recite the litany of my greatness in my sleep: Never had a down year. In cash for the crash of ’87. Made money in the minicrash of ’89. Weathered 1990 and 1994 better than most; two years that closed lots of funds for awful performance. Coined money on national TV in the Asian contagion. By 1998 I figured I had the money making process down pat. I knew that if I came to work every day with just my wits, made my calls, looked at my stocks, looked at the tape, the procession of stocks crossing the ticker, checked in with my sources and my analysts, I could make $400,000 in 12 hours. I could beat my trends line. Everybody would love me no matter what, even if I had an off period because I had been so darned good. What a dope I was. (183)
Then came the crisis at Long-Term Capital Management, and Cramer learned some facts of life about hedge-fund capitalism:
This is money we are talking about, not love and not a home sports team. Money ’s fungible and molten. It fl ows to wherever the hottest hand might be and it departs cold hands as quickly as someone might change the channel on a boring television show. There ’s no loyalty with money, even after years of outperformance. Which is why 1998 leaves the most bitter taste in my mouth even now, four years after the debacle.
Cramer ’s hedge fund lost 10, 20, 30 percent of its value in a matter of days. In the middle of it all, the fund entered an unexpected redemption period. According to Cramer, it happened because his good friend Eliot Spitzer, an investor, needed to take his money out so that he could run for New York State Attorney General. Cramer had made a pledge that if he let one person pull money from the fund, he ’d let everyone do it. So Cramer opened up the fund just at the peak of the LTCM crash. Many of his dearest friends took their money and ran.
In three excruciating chapters, Cramer shares his pain. We feel his anger and disappointment at those who fl ed his fund. We feel his despair, his loss, his failure. He has us sweating along with him, as everything he tries fails and every move he makes backfires.
I’ve read many accounts of how hedge funds fail, and Cramer ’s strikes me as remarkably realistic. Because of the fund’s loss of value and lack of cash, Cramer had to borrow tens of millions to pay off the investors who were leaving. Eventually, he even had to break margin rules to borrow more than he was allowed to, hoping against hope that his broker bank, Goldman Sachs, wouldn ’t catch him and liquidate his collateral. Cramer was on the verge of losing his shirt, along with his entire wardrobe.
It got so bad that his beloved Trading Goddess found a babysitter for the kids so she could focus on scoring a few trades that might keep the fund from folding.
Meanwhile, word was spreading among reporters and talk show hosts. Jim Cramer was in trouble. Cramer had to go on TV and admit that times were tough—though the hedge fund, he insisted, was not about to go belly-up.
That didn’t keep other hedge-fund sharks from circling in for the kill, betting against Cramer ’s positions to force him to liquidate. (Remember, this is a key part of the million-an-hour strategy: if you think something could die, bet it will die, and then kill it.) Cramer desperately defended his key positions by buying more and bluffing. It was a battle of wills and money. Somehow Cramer managed to keep the sharks at bay, at least for a few days.
Then things got really grim. Cramer ’s good friend Larry took his money out of the fund and called Cramer a loser. Cramer hit bottom:
For someone whose only security came from fi nishing fi rst, the words stung so deeply I might as well have been told to kill myself. For a moment I thought, that ’s why those people jumped in ’29. They jumped because they should have jumped. They jumped because they had just lost a lot of money and were losers delivering loser performances, and people wanted that money back. They jumped because it was rational. Because it was right. Because it was, yeah, the honorable thing to do. Because it was quicker than hiding or disappearing. (215)
Cramer still had the Trading Goddess, though. She just happened to be running the trading desk at the moment when the market finally bottomed out. There were only hours to go before the Cramer fund had to pay out the redemption requests and close its doors for good.
“How can you be so sure it is the bottom?” I said, trying to divine what she saw as I stood watching the markets rise on eight screens in front of us at the top of the trading desk. “What makes you so certain? How do you know this bottom will hold? How do you know you will be right?”
“Simple.” She bent down and whispered to me so that others in the room could not hear. “Because at the bottom even the coolest, most hard-bitten pros blink. At the bottom, there is final capitulation.” She waited until it dawned on me who she was talking about. “At the bottom, Jimmy, you capitulated. At the bottom you gave up. That ’s how I know it ’s the bottom.” (245)
Then, by chance, at the eleventh hour, the Cramers were saved: Fed chair Alan Greenspan slashed interest rates, and the markets bounced back.
For the last quarter of the year, the Cramer fund made up all of its losses and then some. The Cramers again went back to presiding over a booming hedge fund, and maybe Jim Cramer matured a bit. After a few more years, he decided to quit the firm to save his health. He became a full-time writer and media personality.
Despite its title, Cramer ’s book is not his real confession. Yet he is brutally honest about a number of things—especially the trauma of failure. He doesn’t even pretend that the hedge-fund industry is socially useful or that hedge-fund managers such as him are really worth all that they earn. He admits that he only cares about winning because he was someone “whose only security came from finishing first.”
Cramer ’s real confession came in his truly remarkable interview for TheStreet.com years later, in 2007.
• • •
“It ’s just fiction and fiction and fiction,” says Jim Cramer.
When Jim Cramer ’s interview with Aaron Task of TheStreet .com spread to YouTube in March 2007, it kicked up such a storm that the website pulled the piece and told everyone else to pull it as well. (As of this writing, however, you can still find the interview on YouTube and transcripts on Antisocialmedia.net.) Note that all extracts quoting the transcript in this chapter are from Antisocialmedia.net.
TheStreet.com was not exactly hostile territory for Cramer, because he’d cofounded it with Marty Peretz. When the site went public, Cramer ’s shares were worth millions.
The last thing Aaron Task wanted to do was to score a blockbuster incriminating interview with a man who was essentially his boss. He just wanted Cramer to talk about recent market gyrations. Yet Cramer seized on Task ’s first innocuous question to boast about how he had cheated:
Cramer: A lot of times, when I was short at my hedge fund and I was positioned short, meaning I needed it down, I would create a level of activity beforehand that could drive the futures. It doesn’t take much money. Or if I were long and I would want to make things a little bit rosy, I would go in and take a bunch of stocks and make sure that they ’re higher, maybe commit $5 million in capital to do it, and I could affect it.
This is not exactly what they teach you in business school. Hedge funds are supposedly betting on the movement of markets, not manipulating those movements to ensure a winning hand. Yet Cramer was confessing that when he was betting against stocks— going short—he temporarily drove the market down, and when he was long, he drove the market up. After this brief manipulation, Cramer collected on his bet, scoring a nice a profit, and got out.
Cramer: But it ’s a fun game and it ’s a lucrative game. You can move it up and then fade it. That often creates a very negative feel. So let ’s say you take a longer-term view intraday and you say, “Listen I’m gonna boost the futures, and then when the real sellers come in, when the real market comes in they ’re gonna knock it down and it ’s gonna create a negative view.”
That ’s a strategy very worth doing when you ’re evaluating on a day-to-day basis. I would encourage anyone who ’s in a hedge fund to do it, because it ’s legal.
It ’s a very quick way to make money, and very satisfying. By the way, no one else in the world would ever admit that, but I don ’t care.
After this startling confession from his subject, Aaron Task was dumbfounded. Apparently hoping to give his boss time to pull his pants back on, Task quickly changed the subject by asking how the growth in hedge funds affected hedge-fund strategies.
Cramer blithely ignored Task, however, and continued the exposÃ© himself. He explained that the goal of his market manipulation was to ensure that by the end of each quarter, his fund was up—“because that ’s your payday.” For Cramer, the pressure not to fail is overwhelming. You just can ’t afford to let your guard down for a minute.
Cramer explained that his eye was always glued to the key stocks, including Apple and Research in Motion (RIM), the maker of the BlackBerry, because when they move, they take the entire market with them (or so they did in 2007). According to Cramer, if you ’re betting short, you’ve got to take matters into your own hands.
Cramer: You really gotta control the market. You can ’t let it lift. When you get a Research in Motion, it ’s really important to use a lot of your fi repower to knock that down ’cause it ’s the fulcrum of the market today.
Aaron Task stumbled to keep up as Cramer took complete control of the interview.
Cramer: So let ’s say I were short. What I would do is I would hit a lot of guys with RIM. Now you can ’t foment. That ’s a violation of . . .
Cramer: Yeah, you can ’t foment—
Cramer: You can ’t create yourself an impression that a stock ’s down. But you do it anyway ’cause the SEC doesn ’t understand it. That ’s the only sense that I would say this is illegal. But a hedge fund that ’s not up a lot really has to do a lot now to save itself. This is different from what I was talking about at the beginning [when he was using his money to buy certain instruments that would eventually move down the price of RIM].
And what makes it so different?
Cramer: This is just actually blatantly illegal. But when you have six days and your company may be in doubt because you ’re down, I think it ’s really important to foment, if I were one of these guys. Foment an impression that Research in Motion isn’t any good, because Research in Motion is the key.
Listen carefully to Cramer ’s words: “when your company may be in doubt”; and “if I were one of these guys.”
Cramer ’s company was in doubt. He was one of those guys. So, was Cramer himself doing those things he described as “blatantly illegal”?
And what exactly did he mean by “illegal fomenting”?
Apparently, he meant manipulating the press, spreading rumors—and breaking the law.
So, what ’s the law? According to the Securities and Exchange Commission, rumormongering is defined as “the intentional spread of false information intended to manipulate securities prices.” The prosecution would have to show that “fi rst, the rumor was inaccurate; second, the market was impacted by the rumor; and third, the defendant knew or should have known that the rumor was inaccurate” (Marshall 2009).
Did Cramer go too far?
Cramer: Again, when your company ’s in survival mode it ’s really important to defeat Research in Motion. You get the Pisanis of the world and the people talking about it as if there ’s something wrong with RIM.
Cramer was admitting that he fed bogus information on Research in Motion to financial reporters such as CNBC ’s Bob Pisani. Quite an admission—especially since Cramer actually worked for CNBC at the time. Pisani was a colleague. Yet Cramer was using him to gain personal profits.
Cramer: Then you would call the [ Wall Street ] Journal and you get the bozo reporter on Research in Motion, and you would feed that Palm ’s got a killer it ’s gonna give away. [PalmPilot was then a key BlackBerry rival.]
These are all the things you must do on a day like today. And if you ’re not, maybe you shouldn ’t be in the game.
Say that again? According to Jim Cramer, if you don’t engage in illegal rumor-mongering to manipulate the market, then you shouldn ’t be running a hedge fund . Maybe Cramer was simply justifying his own behavior by using that classic children ’s defense “But everyone else is doing it!” Or maybe he was accurately describing the cutthroat game as it really is played, with stakes in the tens of millions of dollars.
Back to the interview, though, and poor Aaron Task, who was still trying to change the subject by asking what role Apple plays in the markets. Cramer ignored the obvious lifeline and proceeded to offer a tutorial on how to illegally beat down Apple ’s share price!
Cramer: Apple ’s very important to spread the rumor that both Verizon and ATT have decided they don ’t like the phone [iPhone]. It ’s a very easy one to do because it ’s also you want to spread the rumor that it ’s [the iPhone] is not gonna be ready for Macworld [the big trade conference]. This is very easy because the people who write about Apple want that story, and you can claim that it ’s credible because you spoke to someone at Apple. . .
Task: They ’re not gonna comment [meaning that Apple never comments on rumors so you can get away with starting one].
Just in case we didn’t understand how to manipulate Apple, Cramer ran through it again:
Cramer: Again, if I were short Apple, I would be working very hard today to get that. The way you would do that is you pick up the phone and you call six trading desks and say, “Listen, I just got off the phone with my contact at Verizon and he has already said, Listen, we ’re a Lucky G house [LG phones]. We ’re a Samsung house. We ’re a Motorola house. There ’s no room for Apple. They want too much. We ’re not gonna let them in. We ’re not gonna let them do what they did to music.” I think that ’s a very effective way to keep a stock down. . . . You kind of create an image that there ’s gonna be news next week, and that ’s gonna frighten everybody.
. . . Then they call Pisani again. You have to use those guys and say, “Listen, I see a big buyer of puts [a fi nancial instrument that protects a hedge fund if the price goes down] and I ’m told that it’s SAC [a very large hedge fund with lots of buying power].” You would do that, too. These are all what ’s really going on under that market that you don ’t see.
You bet you don ’t see it. If you did (and if Cramer was right), all of the top hedge funds would be under investigation.
Flat-out lying , Cramer went on to say, is the only way to win. And you’ve got to win, because otherwise you face the trauma of failure, the fear of seeing investors leave your fund:
Cramer: But what ’s important when you ’re in that hedge fund mode is to not do a thing remotely truthful because the truth is so against your view that it ’s important to create a new truth—to develop a fi ction. The fi ction is developed by almost anybody who ’s down 2 percent, up 6 percent a year. You can ’t take any chances. You can ’t have the market up more than it is if you ’re up six because starting Jan 2 you ’ll have all your money come out.
And here comes the indirect admission that when he was in big trouble in 1998, he cheated:
Cramer: What would you do if you were in that situation and you felt like you ’re desperate? You would do these actions.
Aaron Task scrambled to frame Cramer ’s bald admission of lawbreaking into a perfectly normal conversation about “market mechanics” and “fundamentals,” but Cramer would have none of it:
Cramer: Who cares about fundamentals! . . . But look what people can do. I mean that ’s a fabulous thing. The great thing about the market is it has nothing to do with the actual stocks. Now, look, over maybe two weeks from now the buyers will come to their senses and realize that everything they heard was a lie. . . .
It ’s just fiction and fiction and fiction. I think it ’s important for people to recognize that the way that the market really works is to have that nexus hit the brokerage houses with a series of orders that can push it down, and we get to the press and get it on CNBC. That ’s very important. Then ya have kind of a vicious cycle down. It ’s a pretty good game and it can be played—it can pay for a percent or two.
Task tried to yank Cramer away from the confessional once again by asking him about investing in the cell phone market. And once again, Cramer ignored the safe haven and went on to describe yet another classic illegal maneuver—price fixing: Cramer: The problem with the cell phone market, frankly, is that these guys are all killing each other. Someone has to take a dive. Motorola and Nokia have to get in the room and just fix price. They’ve been reluctant to do that because of the various justice departments.
Task, however, pointed out that price fixing is illegal. Cramer snapped back, “Well, that hasn’t stopped a lot of other companies.” Task then finally succeeded in getting Cramer to talk about something that wouldn’t incriminate him—some chitchat about Fed policy and Ford versus GM.
But Cramer had the last word, and it was a whopper. After just explaining with crystal clarity that you ’ve got to lie to the media about stock prospects to make a profi t on your short bets, he emphasized that it was absolutely imperative for hedge funds to bring down Research in Motion before the quarter ended, even though the company was doing really well and should be going up in market price:
Cramer: It ’s Friday. You [hedge funds] have fi ve more days to make your quarter. Can you really risk having them [Research in Motion] up this much? I don ’t think you can.
• • •
What do we make of Cramer ’s confessions? Are they credible? After all, the guy has just boasted that when you ’re in “hedge fund mode,” you ’ve got to be sure “not to do a thing that is remotely truthful.” So how can we trust him when he tells us that this time he is telling the truth?
In Confessions of a Street Addict , Cramer never mentions any form of stock manipulation. (I ’m sure his lawyers made sure of that.) He never hints that he illegally used the media—including his own colleagues at CNBC—to twist the truth. Yet five years later, in the interview with Task, Cramer argues that if your hedge fund isn’t manipulating markets, “maybe you shouldn’t be in the game.”
To know for sure whether Cramer cheated, the SEC would have to go back through his records to look for signs of “fomenting”: was Cramer really able to affect the prices of the stocks he was playing? But that investigation won ’t happen because Cramer has been out of the business for more than a decade.
Unless Cramer is schizophrenic, on top of being a charming nut, the odds are that Cramer ’s two confessions are deeply linked. You can ’t read Confessions of a Street Addict without sensing the emotional upheaval Cramer experienced when his fund came within minutes of going under. It ’s the heart of his book and maybe the main reason he wrote it. To me, it feels as if he needed to exorcise the demons of failure. I believe him when he said that his entire identity was based on winning and the adoration that came with it. You don ’t make it to the top of Harvard Law School and Goldman Sachs unless you are competitive to your core. Smart is not good enough.
Then, in Cramer ’s second confession, he kept returning to how unbearable it felt when there were only a few days to go till the quarter ended, and when you knew that if you didn ’t post good numbers, your investors would walk out on you. “ What would you do if you were in that situation and you feel like you ’re desperate? You would do these actions.”
In his Hedge Fund Fraud Casebook , author Bruce Johnson compiles one hundred hedge-fund fraud cases and tries to understand what conditions and structures were most likely to produce fraud. (If you have lots of money and are into psychotropic drugs, you might want to drop $95 on this book. Its flow charts and spinning diagrams are like Woodstock for Wall Street.)
Hedge-fund fraud doesn’t usually happen because certain evil people consciously set up a Ponzi scheme to cheat investors, Johnson concludes. Instead, hedge funds usually resort to fraud only when they ’re in danger of collapse—precisely the predicament Cramer faced in 1998.
It ’s no mystery what happens when a hedge fund “blows up”— say, when a rogue trader makes a billion-dollar blunder or when someone ’s Ponzi scheme is outed: the fund goes on immediate life support and usually shuts its doors in a matter of weeks, at most.
Yet when a hedge fund ’s survival—and the manager ’s performance fees—are at risk for less spectacular reasons, things get complicated. If there ’s still room and time to maneuver, the hedge-fund manager has options—and might just try them all. With the aid of his psychedelic diagrams, Johnson describes these “mortality calculations.” They include “cutting overheads and drawing upon retained earnings or other partnership resources.” Or a manager might “shift to higher volatility strategies or increase leverage” to improve the odds of getting a performance fee. Another, “darker practice,” he says, is to “obtain illiquid assets where the value can more easily be overstated” (Johnson 2010, 24).
The most serious cases of fraud, however, come when all of these maneuvers fail. That ’s when hedge-fund managers begin to consider more powerful forms of cheating.
[A] substantial proportion of frauds and perhaps those most dangerous to investors begin as legitimate businesses. These “funds gone bad” have likely had managers that made similar fund mortality calculations. But they did not limit their choices to the business alternatives outlined thus far and allowed themselves to consider unconventional solutions that included criminal behavior. (25–26)
Bernie Madoff ’s “success” is criminal from the get-go. Simon Lack, in his book The Hedge Fund Mirage , describes a meeting he had with Fairfi eld Greenwich, a large feeder fund that provided billions of investor money to Madoff. Lack was trying to understand how Madoff made such “remarkably consistent” high returns (Lack 2012, 133). He reports being told that Madoff operated two businesses—a brokerage that executed trades for clients and a hedge fund that executed its own trades. The message was clear. Fairfield Greenwich was implying that Madoff made lots of money by using information he gleaned from making trades for his brokerage clients and then would illegally front run those trades with his hedge-fund money. Lack wrote,
Although the Fairfi eld marketers never used the term frontrunning and didn’t suggest anything illegal was taking place, it occurred to me that this was probably what they themselves believed was supporting the consistently successful results of Madoff ’s hedge fund. Madoff ’s investors, including those brought in by Fairfield Greenwich, were profi ting at the expense of the brokerage clients. The further attraction of such a scheme to a hedge fund investor could be that they ’d be the passive beneficiary of such activity, with no liability for doing anything illegal yet still able to profit from it. (133)
So, some very savvy investors probably suspected that Madoff was doing something illegal, but of a kind that was palatable. That was fine with all concerned, as long as the returns kept coming . What ’s a little front-running among friends? Yet when it turned out that Madoff was running a classic Ponzi scheme, all bets were off, because the returns could not and did not keep coming. How many rotten apples are there in a hedge-fund barrel? Johnson tries to give us an estimate in his hedge-fund-fraud casebook:
In its most simple terms . . . an investor with a hypothetical of 100 hedge funds might be likely to experience one fraud per year. A more realistic hedge fund, or fund-offunds portfolio of 20 funds, could be expected to encounter a fraud about once in fi ve years. (Johnson 2010, 253) So, for every hundred hedge-fund apples, Johnson ’s careful and cautious account claims that at a bare minimum, one hedge fund is rotten enough to get caught.
• • •
Is there a connection between Type A1 personalities and widespread hedge-fund cheating? Because such highly competitive personalities populate nearly all of the hedge-fund industry, is cheating endemic as well—despite Johnson ’s one-in-a-hundred estimate?
Lynn Stout, the Paul Hastings Professor of Corporate and Securities Law at the UCLA School of Law, wrote an extremely provocative blog post in the Harvard Business Review in December 2010 titled “How Hedge Funds Create Criminals.”
The recent hedge-fund scandals, she claims, “raise suspicion that some hedge fund trades may have succeeded at beating the market not through careful research and original analysis but allegedly by breaking the law.” She goes on to ask this carefully parsed question: “Why does a portion of the hedge fund industry stand accused of succumbing to illegal behavior?”
Stout ’s answer is a slap in the face to the hedge-fund industry: “from a behavioral perspective,” she wrote, “my research suggests that hedge funds are ‘criminogenic’ environments.” (And she didn ’t invent that word.)
Professor Stout isn’t claiming that all people are naturally poised “to break the law or exploit others when it serves their material interests.” She maintains that behavioral science has conclusively disproved this claim. In truth, she says, “people often act ‘prosocially’— unselfishly sacrificing opportunities for personal gain to help others or to follow the rules. Few people steal their neighbor ’s newspapers or shake down kindergartners for lunch money.”
It ’s all about the circumstances, Stout posits: some circumstances promote prosocial behavior, others don ’t—such as hedge funds. Stout says that hedge funds, “both individually and as a group, can send at least three powerful social signals that have been repeatedly shown in formal experiments to suppress prosocial behavior.” They are:
Signal 1: Authority Doesn ’t Care about Ethics . Since the days of Stanley Milgram ’s notorious electric shock experiments, science has shown that people do what they are instructed to do. Hedge-fund traders are routinely instructed by their managers and investors to focus on maximizing portfolio returns. Thus, it should come as no surprise that not all hedge-fund traders put obeying federal securities laws at the top of their to-do lists.
Signal 2: Other Traders Aren’t Acting Ethically . Behavioral experiments also routinely fi nd that people are most likely to “follow their conscience” when they think others are also acting prosocially. Yet in the hedge-fund environment, traders are more likely to brag about their superior results than [about] their willingness to sacrifi ce those results to preserve their ethics.
Signal 3: Unethical Behavior Isn’t Harmful . Finally, experiments show that people act less selfi shly when they understand how their selfishness harms others. This poses special problems for enforcing laws against insider trading, which is often perceived as a “victimless” crime that may even contribute to social welfare by producing more accurate market prices. Of course, insider trading isn’t really victimless: for every trader who reaps a gain using insider information, some investor on the other side of the trade must lose. But because the losing investor is distant and anonymous, it’s easy to mistakenly feel that insider trading isn ’t really doing harm. (Stout 2010)
All three signals are flashing away in Jim Cramer ’s confessional:
1. Cramer definitely does not think that hedge funds “put obeying federal securities laws at the top of their to-do lists,” as Stout puts it. Cramer openly disdains authority, in the form of the SEC. He “foments” with impunity, even though he knows it ’s illegal: “You do it anyway ’cause the SEC doesn ’t understand it.”
2. Cramer is quite certain that other traders aren’t acting ethically. In fact, he believes that any trader who does act ethically (by not “fomenting”) “shouldn’t be in the game.”
3. Cramer clearly doesn’t think that his rule breaking hurts others. In his view, if you don’t play fast and loose with the rules, you ’re hurting yourself, suffering the most humiliating defeat possible.
A blogging colleague who works in the financial industry has come up with his own one-word description of the ultra-competitive world of hedge funds: “Sociopathic.”
Do ’s and Don ’ts • Don’t ever admit to the media that you manipulated the media for fun and profit.
• Do remember to move markets up and down whenever you need to. “It’s a fun game and it’s a lucrative game.”
• Do understand that you can always move the ethical edge out a little further.
• Do look your criminogenic best when they take your mug shot.
Published with permission from the author, all rights reserved. Copyright, 2013, Wiley Press.