The Hedge Fund Collapse"......from "Portfolio"..(Bookmark this with "Death of Wall St." Ken Lewis

[KoKo]

Wall Street
The Hedge Fund Collapse
by Jesse Eisinger | See Archive



There’s an old joke on Wall Street in which an investor calls his broker every day to tell him to buy. After a couple of weeks of this, the stock is up. The investor calls the broker and tells him to sell. The broker says, "Okay. To whom?"

The joke was on Falcone. Take the case of a tiny biopharmaceutical company called Medivation. Falcone’s funds filed a notice that they had become a holder of more than 10 percent of the company in December 2007. After that, Falcone was an insider, required to file with the S.E.C. within two days each time he bought and sold the company’s stock. Everyone in the market could see every move he made in it, which meant he lost whatever competitive advantage he had.

Then there is the age-old problem of leverage. Equity hedge funds began using more and more leverage in the past decade. The rule in the U.S. on stock investing is that you cannot borrow more than half your position. But many long-short hedge funds had much more leverage than that, in part by running some of their money through affiliates in London, where regulation is weaker. Some equity funds would go to five or even six times.

The Fed has the responsibility of interpreting margin rules, and in theory, the S.E.C. enforces them. In reality, the rules have been interpreted to the point of meaninglessness. When he was Fed chairman, Alan Greenspan explained the central bank’s view, testifying in November 1995 that the Federal Reserve Board “continues to believe that self-regulatory organizations should be given greater responsibility for margin requirements.” In 1996, the Fed came out with an updated rule that allowed for American broker-dealers to “arrange” credit for their clients in other countries, if they couldn’t give it themselves. The result was that investors could shop around for jurisdictions that allowed as much leverage as they wanted. “That’s when our world changed from asking ourselves, ‘How levered can we be?’ to ‘How levered do we want to be?’ ” says one hedge fund veteran. Today, nobody knows precisely how much leverage is out there in the financial markets because no one attempts to keep track.

Investment banks’ prime brokerages would offer their clients “enhanced leverage,” according to hedge fund insiders, through their London affiliates, neutering the rules to the point of uselessness. When Lehman went down, everyone paid the price. Dozens of managers found that their money wasn’t held in separate, accessible accounts. Today, they are standing in line with everyone else, somewhere on the long list of Lehman creditors.

Smart investors will always be with us. They will continue to invest both long and (assuming that it remains legal) short. They will call themselves hedge funds unless they get smart and rebrand.

But the hedge fund business itself will not look anything like it did during its heyday. Washington clearly intends to declaw the industry. That will probably mean, among other things, that hedge funds (and private equity firms) will finally lose the argument about taxation. No longer will their income be taxed as capital gains but as regular income. The additional tax dodge of keeping money offshore to defer taxes for years should, and probably will, be closed.

http://www.portfolio.com/views/columns/wall-street/2008/11/11/Collapsing-Hedge-Fund-Industry#page3