In the competitive world of hedge funds, it’s all about numbers, games, and strategy. But most recently, hedge funds seem to be about crisis. The risky investing by Bear Stearns rogue traders, which skirted established practices and hid true intent from investors, precipitated the global credit crisis and subprime mortgage collapse of late. It has affected families across America whose dream of buying a home came crashing down—entire blocks of towns and suburbs have emptied out.
But the scandal is hitting home for Bear Stearns executives as well. Co-Chief Operating Officer Warren Spector has been fired, and the reputation of the bank may never recover. Yet Ralph Cioffi, the trader who set up these funds, is still on the payroll as an adviser.
Cioffi was able to set up two hedge funds on an extremely shaky foundation because they were getting results. It was a structure that was doomed to crash in any minor downturn in the market, as it was leveraged to the hilt with almost eight times as much money borrowed against what was invested, including $275 million in capital from Barclays. This meant that Barclays had the power to pull its capital from the funds at any time, which would collapse the structure. On top of that, only one percent of the total investment was kept as reserve cash, compared to the usual ten percent that hedge funds keep around for emergencies.
The devastating results of rogue traders are compounded when they are not recognized as such. When they hide under the legitimacy of a major investment bank, the stakes are higher because they are seen as trustworthy and they have more resources at their disposal. If this crash is going to teach traders anything, it should be that their actions resonate beyond the world of the market, their bank, and themselves.