Photo Credit: Shutterstock.com/RDaniel
April 5, 2013 |
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).
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
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
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.
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
During the late 1980s and the 1990s, he traded like a wild man— and became exceedingly rich in the process.
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.
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
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.
• • •
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,
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:
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.
’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.
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.
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
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.
things got really grim. Cramer ’s good friend Larry took his money out
of the fund and called Cramer a loser. Cramer hit bottom:
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)
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.
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?”
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
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
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.
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.
was not exactly hostile territory for Cramer, because he’d cofounded it
with Marty Peretz. When the site went public, Cramer ’s shares were
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.
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
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
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.
blithely ignored Task, however, and continued the exposé 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.
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—
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
And what makes it so different?
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
Listen carefully to Cramer ’s words: “when your company may be in doubt”; and “if I were one of these guys.”
’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.
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?
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.
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
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.
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.
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!
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:
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
. . . 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.
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
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.
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:
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.
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
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:
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
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.
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.”
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
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.
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
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.
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)
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)
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
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.
• • •
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?
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
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?”
’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
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
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:
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.
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.
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:
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.”
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.”
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.
blogging colleague who works in the financial industry has come up with
his own one-word description of the ultra-competitive world of hedge
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.
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