It starts with a good idea that yields spectacular returns, attracts much money and generates great wealth for those at the top. With so many people doing the same thing, investment returns decline, as do ethics and the quality of financial reports. Then come the scandals, the lawsuits and the rush for the exits, followed at times by convictions or regulatory settlements.
We've seen it before with railroad stocks, junk bonds, third-world debt and tech stocks. Now it's happening again -- with hedge funds.
Start with Bayou Management, which used made-up financial statements to lure $450 million from investors. In fact, Bayou managed to lose money every year since 1997. Now all that's left is about $100 million, seized after bank employees inquired after suspicious wire transfers.
Then there's John Whittier, who raised several hundred million dollars for Wood River Capital even after informing investors he had no particular investment strategy. After promising not to put more than 10 percent of the fund in any one investment, Whittier poured two-thirds of it into two small wireless companies that -- surprise -- have since lost three-quarters of their value.
Next there's the former chief operating officer of Durus Capital Management who has pleaded guilty to charges that he artificially boosted returns by buying up two thinly traded stocks in an effort to inflate the share price and earn a big bonus. When word got out, the stock plunged, reducing the value of the fund by more than $300 million, according to the Securities and Exchange Commission.
The SEC is also looking into the collapse of Philadelphia Alternative Asset Management, run by Paul Eustace of Ontario, Canada. Eustace allegedly invented funds with fictitious returns, then mingled the investments with his personal funds. Regulators say he hid $175 million in losses from investors by stashing them in brokerage accounts run by another giant hedge fund, Man Group.
And finally there is Refco, a major commodities broker that profited by borrowing and lending securities for hedge funds. Prosecutors say one of those funds, Liberty Corner Capital, engaged in offsetting transactions at the end of each quarter, and the beginning of the next, allowing Refco chief executive Phil R. Bennett to keep up to $545 million in bad debt off the company's books. The shell game allegedly went on for years, eluding detection by auditors and overpaid bankers who peddled the company to investors. Now Refco has filed for bankruptcy protection, and Bennett faces criminal charges.
There's no coincidence that all this is emerging just when the returns from hedge funds are about to turn negative and the flow of funds into them has dramatically slowed.
Nor should it be surprising that such scams went undetected. Hedge funds are notoriously secretive, fending off regulations with the argument that they deal only with wealthy and sophisticated investors.
If you need more proof that the hedge fund bubble is about to burst, consider that last year, fund manager Eddie Lampert reportedly broke through the billion-dollar annual compensation mark -- apparently for his brilliant idea of combining Kmart and Sears into one giant retail failure.
Former SEC chairman William Donaldson could see this coming but was able to push through only modest regulatory oversight of hedge funds. His successor, Christopher Cox, must show his mettle.
At a minimum, hedge funds should be required to send audited, quarterly statements to investors and the SEC. With college endowments, insurance companies, pensions and mutual funds now so heavily invested in hedge funds, this has gone well beyond protecting rich investors.
With $1 trillion in assets, hedge funds have become a dominant force in capital markets, accounting for as much as half the daily trading on the stock market, hundreds of billions of dollars in bank loans and a healthy chunk of the profits of Wall Street brokerages. Federal regulators cannot guard against systemic risk to global markets if they don't know what hedge funds are doing.
This is not a case of a few rotten apples. It's a case of an industry that has become so rich and arrogant -- and so littered with charlatans and con men -- that government must step in to protect the public interest.
Steven Pearlstein will host an online discussion at 11 a.m. today at washingtonpost.com. He can be reached at firstname.lastname@example.org.
A broker sympathizes with a Refco colleague. Scandal hit the commodities broker last week.