Jan 5, 2009
How Bernie Madoff screwed me – II:The Ponzi Scheme in Every Hedge Fund – TIME
Now comes the murkier part: Many assets — particularly those that unregulated hedge funds can trade — are not as liquid as stocks, and so they do not always have a definite price on the market. Since a fund reports unrealized gains, it could easily get away with inflating profits. More specifically, the fund could use the most optimistic models to price its illiquid assets, which include mortgage-backed securities and other swaps. After all, economists disagree about how to value these assets, so the fund is not necessarily dishonest in its assessment.
Madoff never even came close to realizing the gains he reported and paid out to some investors. Yet even funds with fairly accurate estimates of unrealized gains are guilty of engaging in similar Ponzi practices in the short term. Heres why:
Suppose some investors decide to withdraw their money from a hedge fund. The fund must liquidate the appropriate amount of its assets to pay these investors. Say the fund holds large positions in illiquid assets. The fund cannot immediately sell these assets, except at a fatal loss, so it would sell its more liquid assets. Given that the fund is more likely to inflate its estimation of the illiquid assets, it would seem that investors who withdraw early get the better returns over that time period. Sounds a bit like a Ponzi scheme, right?
Even in the most vanilla of trading, liquidation can impact the market price. With lightly traded securities, this can be magnified. For example, a fund might corner some asset by buying and buying and buying, and then report a huge unrealized gain. But the moment the fund tries to sell and realize the gain perhaps to pay off its last few investors, demand disappears, and the asset crashes.
via The Ponzi Scheme in Every Hedge Fund – TIME.
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