BusinessWeek – Ralph R. Cioffi seemed as cool and confident as ever. The market for subprime mortgages was crumbling, but the 51-year-old manager of two Bear Stearns ( BSC ) hedge funds offered nothing but reassurances to investors. “We’re going to make money on this,” he promised his wealthy patrons in February. “We don’t believe what the markets are saying.”
He should have known otherwise. The hedge funds were built so they were virtually guaranteed to implode if market conditions turned south, according to a BusinessWeek analysis of confidential financial statements for both funds and interviews with forensic accounting experts, traders, and analysts.
The funds had another potentially fatal flaw: an unusual arrangement with Barclays (BCS ) that gave the giant British bank the power to yank the plug–a deal that ran counter to the interests of other investors, many of whom didn’t even know about it.
The documents also cast serious doubt on the funds’ supposedly strong performance before their July bankruptcies. More than 60% of their net worth was tied up in exotic securities whose reported value was estimated by Cioffi’s own team–something the funds’ auditor, Deloitte & Touche, warned investors of in its 2006 report, released in May, 2007. What emerges from the records is a portrait of a cash-starved portfolio piled high with debt and managers all too eager to add to the heap.
The revelations shed new light on the murky dealings inside the booming $1.3 trillion hedge fund industry, which now accounts for up to a third of all daily trading on Wall Street. They seem to underscore critics’ biggest complaint: that many hedge funds use astonishing amounts of leverage, or borrowed money, in sometimes reckless ways.
The risks of “fair value” accounting, the practice that allows money managers to estimate the values of securities for which they can’t find true market prices, are thrown into sharper focus as well. Coming soon, for better or worse: louder calls in Washington for more oversight of the largely unregulated hedge fund industry.
