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In first quarter 2008, hedge funds reported their worst performance in nearly two decades according to Hedge Fund Research, Inc.36 Even those numbers may not represent reality because the lack of reporting controls tempt hedge fund managers to inflate their performance. Some academic studies “suggest hedge funds have been routinely dishonest, or at least economical with the truth.”37 Investment banks tightened credit terms for hedge funds. By the beginning of August 2008, year-to-date hedge fund performance was down 3.5 percent. Hans Hufschmid, a first-hand witness to LTCM’s financing crisis, observed it was “much worse” than in 1998 when LTCM collapsed, because “hedge funds live on credit and leverage and the ability to finance esoteric positions for a long time.”38 I would have added that some hedge funds seem to extend their lives because of the ability to set the prices on their own esoteric positions.

Academics seem late to wake up to this. Warren Buffett and Charlie Munger have publicly criticized (mis)representations of hedge funds for decades. Forbes has published article after article about hedge fund problems. Some hedge funds simply make things up. Even “legitimate” reporting is often materially misleading. In 2004, Forbes said: “Fakery aside, hedge funds have returned less than stocks and bonds.”39 If you took away various ways of plumping up performance such as creation bias (and a variety of other shenanigans) a Reality Check study showed: “TASS [the largest hedge fund tracking service] net returns drop from 10.7 percent to 6.4 percent annually for the six years through 2002.That compares with a 6.9 percent annual return for the S&P 500 and 7.5 percent for Lehman Brothers’ intermediate bond index.”40 Yet, poor relative average performance did not deter investors. Money continued to pour into hedge funds.

Most hedge funds rely on borrowed money. Goldman Sachs, Credit Suisse First Boston, Merrill Lynch, Morgan Stanley and others lend money through hedge fund umbilical cords called prime brokers.Then they trade with the hedge funds and often supply research and other helpful information. Most of the time, the information sharing is legal.

If a hedge fund uses borrowed money to buy securities, it backs the loan with the assets it “bought” plus collateral (margin). For example, if a prime broker lends $100 million to a hedge fund to buy securities that the prime broker’s investment bank is selling, it may ask a hedge fund to put up $10 million or 10 percent as additional collateral against the $100 million loan (so the assets plus margin are $110 million or 110 percent of the amount the hedge fund owes). That way, if the price of the securities falls a little (not more than 10 percent), the investment bank will have a cushion to make sure it gets back its money. If the price of the securities drops by 5 percent, or $5 million, the investment bank will ask the hedge fund to put up more money (approximately $5 million) to keep the percentage of margin roughly constant. When the investment bank calls for more collateral, it is known as a margin call. One would think that investment banks only accepted cash or a cash equivalent such as a T-bill as margin (collateral). But sometimes they accept something very illiquid (while asking for a bit more of the illiquid stuff). Investment banks try not to think about the possibility that the value of the securities will drop by say, 50 percent, or that the hedge fund will not be able come up with the margin when asked (perhaps because everyone is asking at the same time). That would probably mean the hedge fund is going bust. Prime brokers (affiliates of banks and investment banks) avoid thinking about this horrific scenario by comforting themselves with the thought of the high fees they charge the hedge funds.

Investment bank prime brokers will even help spawn hedge funds. Typical of most investment banks, Bear Stearns Asset Management (BSAM) offered a “turnkey” program, essentially a 50-50 economic