The WSJ this morning ran a front page article on how the managers of the two Bear Sterns Hedge funds that lead to the collapse of Bear Sterns and were the front of the credit crunch wave may face indictments. At issue is whether the managers, Ralph Cioffi and Matthew Tannin, mislead investors. I don’t know if there is fire here, but there is definitely smoke. Here is a timeline of the 2007 events leading up to the issue.

March: three months before Cioffi’s riskier fund goes belly up, Cioffi takes out $2 million of his $6 million personal investment in the fund.

April: Cioffi exchanges emails with colleagues expressing concerns about the credit markets and the potential negative impact on his funds. Then, he turns around and tells investors in an April 25 call he is “cautiously optimistic” about his and Mr. Tannin’s ability to hedge their portfolio.

May: Cioffi and Tannin sell billions of dollars in bonds to keep the riskier fund viable. Some investors hear about this and desperately try to get their money out, but Coffi and Tannin refuse redemption requests.

June: Cioffi and Tannin leave the riskier fund to die, saddled with unrecoverable margin calls and notices of default.

To be blunt, hedge funds bug me. They are not an asset class. They are a compensation scheme. And the compensation scheme creates incentives for fund managers to engage in risky behaviors not aligned with investors expectations or interests.

In another post I will describe the mechanics, but suffice it to say the typical hedge fund compensation scheme creates unbalanced incentives. There is a huge upside financial incentive to take big risks and swing for the fences (this is how you become a billionaire hedge fund manager). However the incentives to avoid the downside are not nearly so great. If your hedge fund goes under (a more and more common occurance), you can take some of your money out (e.g. Cioffi) and then wait a year or two and just start another one.

If Cioffi and Tannin are found not guilty, I would bet big money they are leading another giant hedge fund in a year or two.

The feedback loops are broken in the hedge fund world, creating an ethical pressure cooker of temptation.

Tags: BearSterns, ethics, ethics for the real world, clint korver, hedge funds

You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.