Hedge Fund Fraud: Playing Poker with People's Lives

New York, NYHedge fund fraud appears to be the new white-collar crime, if the latest spate of arrests and charges is any indication. Headlines are rife with words such as swindle and cheat, fraud and deception, as the piper that has been providing the soundtrack to the sub-prime mortgage mess is lining up to be paid.

Meanwhile a noted hedge fund manager who also happens to excel at playing poker and managed not to become caught up in the debacle, is saying 'I told you so…'

David Einhorn, writing in his book 'Fooling Some of the People All of the Time,' says "the authorities are good at cleaning up fraud after the money's gone…but they really don't know what to do about fraud when they discover it in progress." He makes the point that six years ago he recommended shorting Allied Capital, whom Einhorn was convinced was understating its loan losses. However, instead of getting support from the Securities and Exchange Commission, the SEC joined the financial media in accusing the hedge fund manager of attempting to drive down Allied's stock price.

Today, he feels vindicated given Allied's stock is off 50 percent from a year ago—and last October he was offering similar observations regarding Bear Stearns and Lehman Bros. However, instead of merely criticizing them for, in his view and those of others taking too many risks and disclosing too little, he walked the talk and sold their shares short.

If Wall Street is akin to a poker game, Einhorn—whose Greenlight Capital manages $6 billion—excels at that game too, winning over half a million dollars at the 2006 World Series of Poker.

Others haven't been so lucky, as recent arrests will attest. Many of the players have been attempting the game with too many cards up their sleeves and are now having to face the aftermath of their folly. The road beyond the failure of so many hedge funds is littered with the failed finances, and ruined lives of thousands of investors who were promised the moon, and shielded from the real risk.

Specifically, the two fund managers of the Bear Stearns High-Grade Structured Credit Strategies Fund, and Enhanced Leverage Fund are alleged to have deceived their own investors and certain institutional counterparties about the fund's growing difficulties, until the eventual and rapid collapse of the funds incurred losses of $1.8 billion.

Ralph Cioffi, who served as senior portfolio manager, along with Matthew Tannin as portfolio manager and chief operating officer, are alleged to have misrepresented the funds' deteriorating condition together with the number of redemption requests, all in an effort to attract new money and prevent investors from withdrawing capital.

Cioffi is accused of misrepresenting the funds' monthly performance for April of last year by releasing insufficiently qualified estimates, based only on a subset of the funds' portfolios that ultimately projected flat returns. Final returns later revealed actual losses of 5.09 percent for the High-Grade Structured Credit Strategies Fund and 18.97 percent for the High-Grade Structured credit Strategies Enhanced Leverage Fund.

It is also alleged that Cioffi and Tannin misrepresented their funds in subprime mortgage-backed securities. Monthly performance summaries highlighted direct subprime exposure as typically six, to eight percent of each fund's portfolio.

However, after the funds' collapse it was revealed that actual subprime exposure, both direct and indirect, amount to about 60 percent.

And here is a prime (not subprime) example of brokers playing mind games with investors. It is alleged that Cioffi and Tannin of Bear Stearns made a habit of exaggerating their own investments in the funds, while using their personal stake as a selling point for investors. Tannin is alleged to have articulated to investors, either personally or through his sales force, that he was personally adding to his stake in order to take advantage of the 'buying opportunity' presented by the losses—misrepresented as they were—incurred by the funds. In reality, however, Tannin is alleged to have never made that investment. At one point Tannin is accused of mocking an investor seeking to redeem, rather than increase the investment, accusing the investor of being 'silly' for not following Tannin's personal lead.

The SEC has brought various charges against the two, part of a much larger sting on the entire financial services industry. They, and some 400 others like them, will have their days in court.

Wronged investors will be hoping they do, too…