hedge funds testimony (28.6.06, update 30.9.07)

Thinking Things Over (#21)
Private, national & common wealth in the post-socialism/capitalism era
Bewildered by what's been happening, both nationally and globally, in the wake of the fall of the Berlin Wall?
I.e. where the unwittingly weakened nation-state - formerly a bulwark against plain-levelling & globalization -
no longer tempers the social, economic & other pitfalls foreseen by Marx, Gramsci, Minsky, McCulley,etc.
Where - as the Laffer & Rider Curves illustrate in the tax & the social fields - excessive poor/rich gradients
are upsetting the delicate social fabric, thus washing away fertility factors with uncontrolled erosive powers.
Where indeed, as Patrick Martin pointed out, monopolistic capitalism and the associated reckless greed
are no longer kept in check by Adam Smith' invisible hand, i.e. by the balance of contradictory interests.
And where the capacity for self-correction is increasingly inhibited by loss of freedom, mooring & orientation
which led to market frenzies & false alpha birds feeding on hype & bubbles, reminiscent of the Roaring 20s.
IMF & FATF estimate black funds (drugs, tax evasion etc) to be 2-5% of world's GDP (2006: $960-2400bn).
An IMF Report indicates these funds to be increasingly chased under anti-terrorism & ever flimsier pretexts.
Courtesy by the IV Reich's Secret Service, the world has indeed been made hostage of ill-considered rules
which impede more legitimate business than crime. For big time money laundering, the US Treasury set the
standard in 2001 with its 31% confiscatory backup withholding tax on unidentified investors in US securities,
turning foreign bankers from trustees of clients into IRS agents (qualified intermediaries) subject to US laws.
Private equity & hedge funds thus found a government-sponsored access to black funds, while the latters'
entry into subprime markets was also eased by the Internet. Results: predatory lending & systemic risks.
Society's organization needs re-thinking with Plato, Gottlieb Duttweiler, José María Arizmendiarrieta etc.
For man's evolution may only be stressed by technological leaps but not accelerated beyond natural limits.
Also: return on investment rates above productivity gains & organic growth are predatory & not sustainable.
If driven by managers, lawyers & funds on the back of other stakeholders, M&As are thus Ponzi schemes
where shareholder value adepts can maraud with stacked Monopoly cards, helped by micro-economic laws.
Like compulsory social insurance systems whose doom is delayed or obscured only by inflation, war, etc.
And where the cunniest operators are state-supported by myopic magistrates hood-winked into fiscal deals.
Gary J. Aguirre's US Senate testimony details fraud & market mechanics which were at work before 1929,
e.g. Ponzi structures, unregulated pools of money, siphoning from unsuspecting mutual fund investors, and
abuse-prone market dominance: hedge funds' $1.5 trillion drive half of the $28 trillion NYSE's daily trading.
Tongue-in-cheek, Warren Buffet famously opined: "derivatives are financial weapons of mass destruction";
yet, under increasing performance & compliance pressures, some bankers still see a future in fee hunting.
Society wised up against churning of accounts by undelicate trustees, but not yet against macro-parasitism
which feasts on ignorance, sucks & devours a firm's life-preserving substance, & weakens society's pillars.
Which turns economic rat races into societal tailspins with early burn-outs & senior citizens being wasted,
& instills values causing youth to be educated out of sync, resulting in drug, violence & €1000 generations.
With profit-driven quarterly thinking & cost-cuttings also eroding due infrastructure maintenance & renewal,
& democracy's promises ridiculed by Fatf, EU & UN bureaucratic lawmaking as if Berlin Wall fell eastwards.
So why not thinking things over & “Revisiting Das Kapital while some dance on the Titanic”? Iconoclast

     United States Senate
     Committee on the Judiciary
     224 Dirksen Senate Office Building
     Washington, D.C. 20510

The subject of your Committee’s hearing today (Hedge Funds and Independent Analysts: How Independent Are Their Relationships?) is the most recent variant of a stubborn question that keeps popping at Senate committee hearings: is federal law enforcement adequately protecting the nation’s capital markets and their participants from the risk of manipulation and fraud by the nation’s 11,500 hedge funds? The answer is no.

And the answer is no whatever facts you consider. It is no when the Securities and Exchange Commission ("SEC") fails to recognize any hedge fund fraud or manipulation against other market participants for a quarter century: from 1979 until 2004. It is no when the SEC fails to protect mutual fund investors when billions of dollars are siphoned from their accounts by hedge funds. It is no when you compare what the SEC is doing and saying about hedge funds with what its counterparts in Europe are doing and saying. It is no when the Department of Justice ("DOJ") merely shadows the SEC’s meager scrutiny of hedge funds. It is a deafening no when senior SEC officials throw a roadblock in the insider trading investigation of one of the nation’s largest hedge funds because the suspected tipper has powerful political connections, as they did with the investigation assigned to me.

From September 2004 through September 2005, I had primary responsibility for conducting an investigation by the Securities and Exchange Commission ("SEC") of suspected insider trading and market manipulation by one of the nation’s largest hedge funds, Pequot Capital Management ("PCM"). I worked long hours on the investigation with other equally committed staff. Among them was a thirty-year SEC veteran, then SEC’s most experienced and respected investigator of insider trading. His duties included teaching incoming Enforcement attorneys and foreign regulators how to conduct an insider trading investigation. At his retirement party, he told Enforcement Director, Linda Thomsen, in my presence that the PCM investigation was the most important one he had worked on in his thirty-year career with the SEC. Another seventeen-year veteran, who worked side by side with me, told me the same. His expertise was market manipulation and insider trading.

I believe the nation’s capital markets face a growing risk from unregulated pools of money--now called hedge funds--just as they did in the 1920s from unregulated pools of money--then called syndicates, trusts or pools. Those unregulated pools were instrumental in delivering the 1929 Crash. They were, among other things, skilled at using various devices to manipulate stock prices to trick the public. There is growing evidence that today’s unregulated pools--hedge funds--have advanced and refined the practice of manipulating and cheating other market participants.

One final introductory point: you may be curious why someone comes to the SEC after twenty-eight years as a trial attorney in private practice. I left the full-time practice of law in 1995. I had achieved my professional and economic goals and had no intention of returning to the full-time practice. Five years later, I looked back on that career that had missing chapter. Very little of it had been devoted to public service. I decided it was not too late to write that chapter and returned to law school to retool for that purpose. While at Georgetown, I decided my skills might be useful at the SEC.

Fixing the SEC so it can protect investors and capital markets from hedge fund abuse will not be an easy task. Powerful interests want the SEC to stay just the way it is or, better yet, to become even weaker. Those interests are not just the hedge funds. They include the financial industries that are receiving tens of billions of dollars in revenues for helping hedge funds cheat other market participants or close their eyes to the carnage. At the top of that list are the big investment banks, e.g., Goldman Sachs, Morgan Stanley, Merrill Lynch and Bear Stearns. Those interests know how to reward friends and punish perceived enemies. Their tentacles reach far. They stopped the hedge fund investigation I was assigned to conduct. They cost me my job.

Wall Street’s misuse of influence is nothing new. Ferdinand Pecora sensed this misuse of influence when he conducted the investigation in 1933 and 1934 on behalf of the Senate Banking Committee that led to the adoption of the securities acts and the creation of the SEC. His detailed cross-examination of powerful bankers, brokers, and industrialists revealed the ills the securities acts were designed to cure.

The first step in getting a handle on the risks posed by hedge funds is to separate and tag them. I believe there are three risks: (1) hedge fund conduct that cheats their own investors; (2) hedge fund conduct that randomly cheats everybody else, and (3) the systemic risks such as those that surfaced when Long Term Capital Management ("LTCM") collapsed. I will not address the LTCM class of risks because it is beyond my expertise and its solution appears to involve multiple federal agencies.

There are two different species of hedge fund fraud. They are easily distinguished because each has a different victim. One species victimizes the hedge fund’s own investors--wealthy individuals and institutions. The other species randomly victimizes everybody else.

Hedge Fund Fraud against Hedge Fund Investors

This species of fraud poses little risk of a severe crisis to the capital markets for multiple reasons. First, the incidence of fraud by hedge funds against their own investors is not disproportionately high. Further, when hedge funds do cheat their own investors, the character of fraud is not unique [viz TV's Big Brother Ponzi scam]. Put differently, a Ponzi scheme is a Ponzi scheme whether the investment vehicle is a corporation, an investment trust, or a hedge fund. That means the SEC has the experience to tackle this species of fraud. They have been doing it for decades. Indeed, through September 2003, all 38 enforcement actions the SEC brought against hedge funds over the prior four years were exclusively for this class of fraud - hedge funds victimizing their own investors.

Further, hedge fund investors, as a class, are not the easiest targets. They are wealthy individuals and institutions. They are more likely to become suspicious when the quarterly reports are a bit off. If they don’t get the right answers, they are prone to call their attorneys, who file lawsuits and call the SEC. Once again, the SEC knows how to investigate this kind of fraud.

Of course, wealthy individuals and institutions have entrusted $1.2 trillion to hedge funds. That is a big chunk of money, but it is only a tiny fraction of the total assets that individuals and institutions have invested in the capital markets. For example, mutual funds collectively manage $9.2 trillion. The bond and equity markets are more than $40 trillion. Globally, $90 trillion of financial assets are under management. Thus, by any measure, hedge funds have significant assets, but by no means dominate the capital markets. No amount of fraud by hedge funds against their own investors could cripple the capital markets. It is too little money.

From these facts, the hedge fund industry and others contend that hedge funds need no special attention. Why shackle an industry that does so much good for our capital markets, e.g., liquidity or risk transfer? Though the comments are valid when applied to the first species of hedge fund fraud, they are off the mark when applied to the second species discussed next.

Hedge Fund Fraud against Other Market Participants

This species of fraud has an easier target and a far greater potential to disrupt the capital markets. Its victims have no connection with the hedge fund. They are random victims. Much like the victims of a sniper, they never knew what hit them. For example, the millions of mutual fund investors had no clue that billions of dollars were being siphoned from their investment accounts each year by hundreds of hedge funds, as it happened in the recent mutual fund scandal. Likewise, the value investor has no clue that an attractively priced small cap is on its way to bankruptcy via the naked shorting of an $8 billion hedge fund. Similarly, the most sophisticated institutional investor will not second guess the expensive computer model when it begins blinking sell on XYZ stock because it has become overpriced. How could that investor know several hedge funds are buying up XYZ stock because they have been tipped by an investment bank executive that Google will make a tender offer for XYZ at a 50% premium to its current stock price?

The use of invisible fraud and manipulation is nothing new. It was just as invisible in the 1920s when banks and brokers employed the same devices to cheat the public. Pecora described why the public could not detect this type of fraud in the 1920s in words that ring true today:

It also works the other way. A hedge fund manager may find his investors heading for the door. The profits at rival funds are a couple points higher. Rumors circulate that the competition found a way to siphon funds from mutual fund accounts. To survive, a hedge fund must learn to siphon. One after another, hedge funds learn the trick. Fortune Magazine offers this colorful and insightful account how market timing and late trading spread like a virus from one hedge fund to another until it infected more than 400:

Hedge funds’ Dominance of the Capital Markets Creates the Power to Abuse Them

The potential harm that hedge funds can inflict on other market participants has no real limits. Hedge fund trading now dominates the nation’s capital markets. The $1.2 trillion under hedge fund management are on steroids. They recycle at high velocity through the markets. With that $1.2 trillion, hedge funds execute up to fifty percent of the daily trading on the $21 trillion New York Stock Exchange. They also do seventy percent of the trading in the US distressed debt market, US exchange-traded fund market and the convertible bond market. The same picture is emerging in the derivative markets. Patrick Parkinson of the Federal Reserve recently testified at a Senate hearing:
"The active trading by hedge funds has contributed significantly to the extraordinary growth in past years in the market for derivatives (emphasis added)." So far, hedge funds have dominated these markets with only $1.2 trillion under management. But that is changing too. The SEC projects the hedge fund asset base will increase from $1.2 trillion to $6 trillion by 2015.

Hedge fund trading generates huge commissions and fees to investment banks and brokers. That revenue flow gives hedge funds influence with both brokers and investment banks. The Economist examined this growing influence in an article last year:

The United Kingdom’s Financial Services Authority ("FSA") expressed concern in June 2005 that hedge funds were getting more from investment banks than their contracts specified. According to the FSA, "insider trading is now institutionalized" because of the flow of tips from investment banks to hedge funds. The FSA "had uncovered signs of insider dealing at almost a third of British M&A deals, with possible culprits including traders at hedge funds and investment banks." That same month, the FSA also observed that hedge funds were "testing the boundaries of acceptable practice with respect to insider trading and market manipulation."

The illegal flow of insider information from investment banks to hedge funds was the primary focus of the hedge fund investigation I headed. Senior SEC officials halted the investigation, as I was told, because the suspected tipper had powerful political connections. Indeed, he does at the highest level. When I raised the propriety of that decision with the most senior Enforcement officials, they fired me. When I apprised Chairman Cox of these events, he did not lift a finger.

How Influence Peddlers Stopped a Critical Hedge Fund Investigation in Its Tracks

The investigation was two-pronged. The insider trading prong involved the securities of twenty public companies. On eighteen occasions, a Self Regulated Organization ("SRO") had referred the suspected insider trading matter to the SEC after conducting its own investigation. In each case, the hedge fund traded shortly before a public announcement sharply increased the value of its new holding. In all but two cases, the hedge fund made at least $1 million. Some referrals involved much larger profits. In two cases, evidence suggested the tip may have come from court personnel. In five cases, the hedge fund made highly profitable trades shortly before public announcements of acquisitions. In two of these cases, evidence indicated the tip had come from an investment bank.

The second prong of the investigation--market manipulation--involved two classes of suspected violations: wash sales and naked shorts. Some of my colleagues believed this prong held a greater potential to severely injure the capital markets. Evidence indicated that hedge funds used wash sales to spike stock prices just as unregulated pools used wash sales to spike stock prices in the 1920s. The investigation of both wash sales and naked shorts led to the hedge fund’s prime broker, a large investment bank.

By May 2005, one of the insider trading matters dwarfed all others: the hedge fund’s trading in two companies just before the announcement of a cash tender offer by one for the other at a 50% premium over the last trading price. The hedge fund profited by $18 million in 30 days. The evidence suggested that the hedge fund’s CEO acted on an unlawful tip in directing the hedge fund’s trades. But the question remained: who tipped him? In May 2005, Branch Chief Robert Hanson, directed me to spend all my time on the one matter and focus on finding the tipper. Accordingly, beginning in May 2005, I searched through millions of emails and other records for clues indicating who tipped the hedge fund CEO and, in June 2005, questioned the hedge fund’s CEO--the suspected tippee--on this issue.

By mid-June, growing evidence pointed to one person: the former CEO of a large investment bank. The suspected tipper likely knew about the tender offer, spoke with the hedge fund’s CEO just before he began to trade, profited by the trades, and had other personal and financial motives for tipping the hedge fund’s CEO. The two suspects trusted each other, did financial favors for each other, and exchanged stock tips. The evidence yielded no other viable candidates.

My supervisors enthusiastically endorsed this factual theory of the evidence. On June 14, I briefed Branch Chief Hanson and Assistant Director Kreitman for one hour on the insider trading investigation, including the evidence that pointed to the suspect as the likely tipper. After which, they authorized me to present this same factual theory and evidence to the FBI and the US Attorney’s office in New York, as the first step toward a possible criminal proceeding against both suspects. Accordingly, at a meeting the next day, I presented the information to an Assistant US Attorney and two FBI agents.

A few days after the meeting, I informed Branch Chief Hanson that I intended to issue subpoenas for the suspected tipper’s examination and key documents. He first reacted positively to the suggestion. But a few days later, to my surprise, Hanson abruptly reversed course. Hanson blocked the issuance of subpoenas for the suspected tipper’s testimony and records, stating that it would be difficult to obtain the authority to issue the subpoenas because the suspected tipper had powerful political connections.

Immediately after Hanson’s comment, external interference with the investigation became evident. A high-powered attorney, Mary Jo White, bypassed the normal protocol of discussing the investigation with the assigned staff attorney. Instead, she went directly to Enforcement Director Linda Thomsen, despite the fact Director Thomsen had no prior involvement in the case. For the first time, senior staff left me out of meetings when they discussed the case. Associate Director Paul Berger--who had very limited knowledge of the facts--emphatically stated in my presence that no case would be filed against the suspected tipper, but gave no reason or clue for his decision. Emails between the suspected tipper and tippee that I had subpoenaed from investment banks were delivered by Mary Jo White to Director Thomsen. That had never happened before in the other 100 subpoenas I had issued. My supervisors, who had strongly supported the case only two weeks before, became angry and defensive when I tried to discuss the issuance of the subpoenas.

Most confounding, I could not understand how senior SEC officials would authorize me to meet with the FBI and the US Attorney to initiate a criminal investigation and then, two weeks later, block the issuance of civil subpoenas for the suspected tipper’s testimony and key documents. The only significant occurrence between those two events was the decision of the US Attorney and the FBI to begin looking into the matter.

From late June until September 2, 2005, I informed every link in the chain of command from my branch chief to the SEC Chairman in over thirty written communications of the special and favored treatment my supervisors were giving to the suspected tipper. By way of example, I enclose a redacted copy of the letter I faxed to Chairman Cox on September 2, 2005. It never got a response. Neither Chairman Cox, nor Director Thomsen, nor Associate Director Berger ever questioned why
the investigation was stopped.

If you wish to know more details how the SEC stopped the investigations, including supporting evidence, the identity of the suspected tipper and tippee, and the tipper’s political connections, you may find this information in the 42-page sworn statement and 46 supporting exhibits I provided Kathy Casey, Esq., Staff Director and Counsel for the Senate Banking Committee, in mid-March 2006.

Until I questioned the suspected tipper’s special treatment, my supervisors found my work met or exceeded all applicable SEC standards. They certified my performance met all applicable Enforcement standards for a staff attorney in June 2005. In mid-June 2005, Assistant Director Kreitman gave me his highest unofficial award for excellent work on the investigation. Later June, Branch Chief Hanson prepared his assessment of my 2004-2005 performance for a possible merit step increase. Just before the controversy over investigating the suspected tipper arose, Hanson praised my work on the hedge fund investigation, stating:

SEC’s Dismal Record Protecting Market Participants from Hedge Fund Fraud
How the SEC Learned Hedge Funds Cheat Others; the Mutual Fund Scandal

For twenty-five years, from 1979 to 2004, hedge fund fraud and manipulation operated under the SEC’s radar. The SEC brought no cases against hedge funds for manipulation, insider trading, or fraud directed against other market participants. During this period, the SEC recognized only one species of hedge fund fraud: that committed by a hedge fund against its own investors. The SEC first publicly recognized that there were two classes of hedge fund fraud in July 2004. Its proposed rule requiring hedge funds to register noted: "Since the staff report [of September 2003], a new species of hedge fund fraud has been uncovered (emphasis added)."

So, how did senior SEC officials figure out after twenty-five years that hedge funds were also cheating other market participants? Well, as a matter of fact, they did not. A state attorney general announced the settlement of the first case involving a pattern of hedge fund fraud on other market participants. It was the first hedge fund caught for pilfering mutual fund accounts, the investment vehicle of choice for tens of millions--the classic small investor. As for the SEC - "the cop on the street" - it caught nothing.

The total cost to mutual fund investors was staggering. According to Time Magazine, "Academics estimate that late trading costs investors $400 million a year and market timing $4 billion to $5 billion." According to The Wall Street Journal, "[H]edge funds …reaped the lion’s share of gains from the [unlawful] trading." In March 2005, the SEC was investigating 400 hedge funds for their participation in the scam.

The SEC Also Failed to Catch the Helpers--Yet Another Industry it Regulated.

Hedge funds could not have skimmed mutual fund accounts without help. That is just what they got from the brokers the SEC also regulates. "Thirty percent of the brokerage firms the SEC surveyed helped clients mask market-timing trades, either by breaking up big orders or creating special accounts to hide identities." On top of that, "70 percent of the brokers said they were aware that some of their customers were timing the market." They just looked the other way. The SEC survey showed that twenty-five percent of brokerage companies allowed late trading. Late trading occurs where a hedge fund puts in a trade after the funds’ 4 p.m. cutoff, but gets the pre-4 p.m. price. Some have likened it to betting on a horse race after it has been run. Some of those brokers who helped hedge funds pilfer mutual fund accounts were the brokerage arms of large investment banks like Bear, Stearns, & Company, Merrill Lynch & Company, and CIBC.

To sum up, the SEC was oblivious that hedge funds cheated other market participants for twenty-five years. The SEC somehow overlooked a hedge fund scam that cost mutual fund investors billions of dollars per year. The scam was executed for years with the participation of two industries the SEC also regulates: mutual funds and brokers. It would not listen to a whistleblower who was armed with the facts. Eventually, like the public, the SEC learned about the scandal when a state attorney general announced a $30 million settlement. How has the SEC done since then to detect hedge fund fraud that victimizes other market participants?

Over the past year, the SEC has brought three cases for a new type of hedge fund fraud that victimizes other market participants. All three involved a very specific form of insider trading. The facts follow the same pattern. A public company decides to raise money by making a private placement of its stock with the intent to register the stock a few months later. This is commonly known as a private investment in public equity or PIPE. A hedge fund agrees to purchase stock through the placement. The hedge fund also knows that the public announcement of the PIPE will depress the market price of the stock. Knowing that, the hedge fund shorts the company’s stock and covers it with the private placement for a quick and sure profit. In executing the short, the hedge fund acted on material nonpublic information and violated the securities laws.

Once again, the PIPE cases demonstrate the same old SEC enforcement patterns. The cop on the street--the SEC--did not detect this pattern of insider trading. Rather, it was detected by a $100 billion mutual fund and the evidence was then handed over to SEC officials.

In handling the PIPE cases, the SEC again wore blinders. The SEC has twenty-seven PIPE cases; it has filed three; it is investigating twenty-four others. Again, the PIPE cases demonstrate a pattern of insider trading by hedge funds. This pattern raises the obvious question: If hedge funds are willing to trade on nonpublic material information in one situation, might they not be doing the same in others? For example, are they getting tips from investment banks of pending acquisitions before they are publicly announced? Do hedge funds have techniques for obtaining tips, e.g., next quarter’s earnings from public companies before they are publicly announced?

The SEC should be able to check for this. It receives a constant flow of suspected insider trading referrals from SROs. The NASD, NYSE, and AMEX all have market surveillance units that track the market daily for suspicious trades, including insider trading. When their computers detect suspicious trading, the SRO’s staff does its own review and, if the trading appears suspicious, refers the matter to the SEC. Many of those referrals involve hedge funds suspected of insider trading.

But that system breaks down when it comes to referrals involving insider trading by hedge fund. Those referrals are rarely, if ever, investigated, unless they happen to meet the PIPEs cookie cutter mold. The investigation I conducted was an anomaly. The right person at intake found the right senior SEC official. That matter was assigned to me. I then found thirteen other insider trading referrals on the same hedge fund that had been gathering dust. None had been investigated other than a cursory review. No one had looked at the referrals collectively for any patterns.

The institutionalized form of insider trading by hedge funds insidiously erodes the integrity of the stock markets. The concept is best illustrated with an analogy. Imagine a sports arena with thousand small boxes organized in rows on the arena floor. Each box contains an egg: some are Faberge, others gold, others silver and on and on gradually to the rotten eggs. Egg buyers - some sophisticated; some not - carefully inspect the exterior of the boxes for clues to their contents. None may peak inside. The inspection ends at 5 p.m. All egg buyers exit the arena, notes in hand, ready for tomorrow’s auction. In the early hours, a security guard allows a team of egg buyers to enter the arena, open the boxes and survey their contents. The public auction of the boxes begins at 10 a.m. sharp. With their survey notes, the early morning team pays richly for the boxes containing the Faberge, gold and silver eggs and craftily avoids those with lesser value. The sophisticated egg buyers are puzzled why their boxes never contain the prized eggs.

My point is this: those that use insider trading cheat all investors--the most sophisticated institutional investor and the small investor alike. They cherry pick the market and, in so doing, undermine the integrity of the capital markets. They rig the game. One senior executive of a $97 billion mutual fund put it this way: "For the last five years, the hedge funds have gotten a free pass,...it’s damn well time that they're held accountable to the capital market rules, which were created to protect companies and investors to know that the game isn’t rigged." For the sophisticated investor, there are two options: continue to be victimized or join the early morning team.

The most recent testimony from the SEC on its efforts to police hedge fund abuse was given on May 16, 2006, before the Senate Subcommittee on Securities and Investment. Given the growing concern on this subject, this was a golden opportunity for a senior SEC official, perhaps from its Enforcement Division, to tell what new steps the SEC has implemented to protect market participants from hedge fund abuse. Instead, the SEC sent its Director of Investor Education, Susan Wyderko, as if to say that hedge fund abuse is merely a matter of educating investors. She was of course unable to give meaningful testimony or respond to the obvious questions.

Ms. Wyderko’s written testimony offered a ray of hope. It cited three "recent significant cases" to demonstrate the SEC "has taken appropriate remedial legal action" against hedge funds for "market abuse." Unfortunately, those cases merely confirm the analysis above that the SEC has no new thought for dealing with hedge funds. The first cited case is a classic market timing-late trading case. The second was a classic PIPE case.

That leaves the SEC’s handling of the third case, which would be funny, if the SEC were not offering it as an example how it is protecting market participants from hedge fund abuse. In that case, the media began detailing the transparent scheme of Scott Sacane and his hedge fund to manipulate two small biotech stocks in July 2003. The media continued to do so for more than two years until the SEC finally filed its enforcement action in October 2005. The SEC complaint borrowed allegations made by The Wall Street Journal two years earlier, but left out the humor. On July 30, 2003, the Wall Street Journal published this account of Mr. Sacane’s trading:

No new legislation or regulation can protect market participants from hedge fund abuse unless the SEC does its job. By any measure, it has not. The SEC failed to detect that hundreds of hedge funds were siphoning billions of dollars from mutual fund investors. It also failed to detect a second pattern of hedge fund abuse--the PIPE insider trading. Its conduct and words give no reason to believe it will detect other hedge fund abuses of market participants.

And then there is the obvious. One SEC investigation picked up the trail of several patterns of hedge fund market abuse. One prong included suspected insider trading in twenty public companies. The other found evidence of numerous wash sales and naked shorts. Both prongs led to the hedge fund’s connection with its prime broker. If the prime broker was involved in any of the violations, as appeared to be the case, the investigation would have had implications for the whole hedge fund industry. In sum, it was the only SEC investigation to put a high beam on the shadowy juncture where hedge funds and investment banks do their lucrative business.

Just after the SEC authorized the investigation to be presented to federal prosecutors and the FBI for possible criminal prosecution, senior SEC Enforcement officials blocked the issuance of civil subpoenas for the suspected tipper’s testimony and key documents. No insider trading case can be filed without proof of the source of the tip. Thus, stopping the investigation of the likely tipper stops the investigation. In so doing, the SEC has given hedge funds and investment banks notice that it will not police their joint activities. The SEC could do no greater disservice to other market participants and especially the small investor. This is not mere incompetence.

It is not surprising that the U.S. Office of Management and Budget (OMB) gave SEC Enforcement its lowest performance assessment: "Results Not Demonstrated." According to the OMB, "that rating indicates that [Enforcement] has not been able to develop acceptable performance goals or collect data to determine whether it is performing." In short, whether or not Enforcement performs is an unknown. And it is an unknown because it has no goals or data. That criticism is aimed at the top. No matter how committed and competent the SEC staff works the trenches, and that was my experience, they cannot achieve the SEC’s mission without leadership equally committed to that mission.

Is there more hedge fund abuse on the horizon? Logic says yes. In the mutual fund scandal, hedge funds broke legal and moral boundaries to make billions in profits at the expense of small investors. In doing so, hedge funds compromised two financial industries - mutual funds and brokers. It seems implausible that hedge funds would suddenly recognize those boundaries if other opportunities arose to make a fast dollar without getting caught. The PIPE cases are just one more example that hedge funds break the law in packs.

THE SOURCE OF MUCH OF THE RECENT TURMOIL in the stock market lies on Wall Street, and appropriately, the Street is paying the price.

It was the Street that helped enable the excesses in the subprime-mortgage business by packaging the loans into complex securities that were sold around the world to buyers who often knew little of the risks. It was the Street that extended copious credit for leveraged buyouts on overly generous terms. And it was highly paid Street rocket scientists working at places like Goldman Sachs who devised dubious quantitative equity-investment strategies that have backfired recently, roiling the stock market.

Stocks again grabbed the headlines last week as major indexes rose sharply from Monday through Wednesday, only to collapse Thursday in a session in which the Dow industrials fell 387 points. Stocks finished mixed on Friday after an ugly opening. The overall moves for the week were modest. The Dow industrials rose 57.6 points to 13,239.5, a 0.44% gain; the Standard & Poor's 500 index rose 1.45%, to 1453.64; and the Nasdaq increased 1.34%, to 2544.89. So far this year, the Dow is up 6.23%; the S&P 500, 2.49%; and Nasdaq, 5.37%.

Bank and brokerage stocks have been weak lately as investors rightly worry about the fallout from the mortgage and leveraged-buyout markets and whether the Street's profit cycle has peaked.

Takeover stocks continued to come under pressure last week, including a free-fall on Friday's opening that had some risk arbitrageurs making a comparison to 1987. Annualized returns in many takeover stocks like Clear Channel Communications (ticker: CCU) and First Data (FDC) are topping 30%, reflecting fears that pending LBOs won't get done or that private-equity firms will move to negotiate lower prices, as is being done by the group buying Home Depot's (HD) building-supply business.

It was a week of feasting for bears -- fed partly by the stumbling of "black-box" funds.
THE HEDGE-FUND INDUSTRY has suffered a black eye for the troubles among quantitative-equity, or "black-box" funds. Like most in the hedge-fund business, these funds sought to produce "alpha," which boils down to high returns with little risk. That's a tough game to play since only a few managers can truly add value, but the hedge-fund business pursues alpha anyway. Otherwise, why should investors pay high fees when they can buy a low-cost S&P 500 index fund that historically has produced ample annual returns?

The black-box funds sought to take the volatile human element out of investing by empowering computers to drive stock selections as well as buy and sell decisions. The managers generally have been loath to tell investors how the funds work, for fear of copycats.

These strategies, touted as "market-neutral," are designed to do well regardless of market direction. The largest and most famous of these funds is the $29 billion Renaissance Institutional Equities, run by the reclusive billionaire Jim Simons, that has generated consistently high returns and huge fees for Simons. Other black-box funds are operated by AQR Capital Management and Goldman Sachs, whose flagship is the $9 billion Global Alpha fund.

It turns out that many of these highly sophisticated, supposedly distinctive, computer-driven trading strategies actually were remarkably similar. The result is that the funds tended to crowd into similar stocks and to sell short similar issues.

With credit woes taking their toll on equities, the best bets are cash-rich companies, like Berkshire Hathaway and Loews, guided by smart investors.It may be an oversimplification, but the black-box funds appear to be value investors, buying stocks with low price/earnings ratios, low price/revenue ratios or low price/book value ratios while selling stocks with high-P/E, high-price/revenue and high-price/book ratios. Lately, the funds have suffered, with Renaissance down 8.7% in August and 7.4% so far this year, while the Goldman Alpha fund is off 26% in 2007, according to sources cited on Bloomberg.

THE LOSSES HAVE PILED UP lately because value investment strategies have fared poorly relative to growth strategies, and the funds have had to liquidate massive multibillion-dollar positions in volatile and sometimes illiquid markets. The funds often have suffered a double whammy as long positions have fallen and shorts have risen. Indeed, the talk on the Street Thursday was that the only stocks that rose in the market rout were those that had been shorted by the quant funds.

In a report Friday analyzing the plight of the quantitative funds, Citigroup Global Markets analyst Keith Miller noted that a strategy of buying the 100 stocks in the Russell 1000 index with the lowest price/sales ratio and selling those with the highest price/sales ratio would have generated a return of negative 5.6% in the first week of August. That may not sound like much, but these funds often use leverage of 5 to 1 or more.

"We have been caught in what appears to be a large wave of de-leveraging on the part of quantitative long/short hedge funds," Renaissance's Simons wrote to investors Thursday, according to Bloomberg.

ONE HEDGE-FUND MANAGER told Barron's that quant funds are in a bind. The valuation part of their models is telling them to stay invested because attractive situations are plentiful on the long and short side, especially among undervalued stocks. The risk side of the models, however, is telling them to liquidate positions because volatility is high. Lenders to these funds also are applying pressure to collapse the funds.

Some funds, including the Goldman Sachs Alpha, may not survive because of losses and likely investor pressure for redemptions. Hedge-fund investors as a rule want to be the first out of a sinking fund. So-called funds-of-funds, which place money for investors in various hedge funds, have no patience with losing funds.

The irony is that some of these funds won't survive at a time of maximum opportunity for them. Investors may find that any "alpha," or excess returns, that the funds generated in recent years, was lost in the past month. The quant-fund rout is just another example of the perils faced by investors in leveraged hedge funds with opaque strategies. Investors ought to be wary of any fund that needs to use leverage to enhance returns.

Keith Trauner, the co-manager of the Fairholme mutual fund (FAIRX), says that if investors can't understand a manager's strategy, "Walk away."

The recent market dislocations could provide opportunities to cash-rich companies like Berkshire Hathaway (BRK.A) and Loews (LTR) that have well-deserved reputations for both investment smarts and the ability to take advantage of depressed markets. Berkshire and Loews have shown a willingness to invest in any appealing asset class, including stocks, bonds, commodities and entire companies.

BERKSHIRE SHARES HAVE HELD UP well recently, rising 1.55% to $111,600 last week, reflecting investor expectations that Chief Executive Warren Buffett will find attractive investments using Berkshire's huge cash hoard, which totaled $40 billion at the end of the second quarter. It's tough, however, for Buffett to move the needle with any single investment, given Berkshire's $170 billion market value.

Loews, the conglomerate controlled by the Tisch family, has seen its stock drop to 44 from a June high of 53. Loews' allure is that investors can buy the stock for a 23% discount to its estimated net asset value of $57 a share and get the services of CEO Jim Tisch and the rest of his management team, which has done a great job of creating value for shareholders in recent years. After a $4 billion oil-and-gas investment last month, Loews has about $2.6 billion of net cash, or $5 a share.

Berkshire and Loews are good alternative to hedge-fund investments. Berkshire trades for a modest 1.5 times book value and less than 20 times earnings. Investors pay no incentive fee to get Buffett and the Tisch family to work on their behalf.

There aren't many companies like Berkshire and Loews that are rich in cash and willing to make opportunistic investments. Others include Leucadia National (LUK), Alleghany (Y) and American Real Estate Partners (ACP), which is controlled and run by Carl Icahn. Companies that build cash often find themselves targets of activist investors seeking to prod managements to buy back stock, pay large dividends or go private.

"Unless you're a company controlled by an individual or a family, it's difficult to behave in a conservative financial fashion now," says Trauner. His fund is attracted to companies with ample liquidity, including Berkshire, Leucadia National and Echostar Communications (DISH). Echostar's chief executive and controlling shareholder, Charlie Ergen, has resisted pressure from investors for a big debt-financed stock buyback, arguing that a strong balance sheet is a major attribute. The Roberts family, which controls Comcast (CMCSA), also has turned aside similar shareholder entreaties for big buybacks.

Fairholme is better poised to capitalize on market dislocations than most other mutual funds because it carries a 20%-plus cash position. For mutual funds, it's tough to hold cash because it acts as a drag on returns in a rising market. Over time, having cash at the right moment generally leads to profitable investments.

The 21st century version of a bank run encircled the globe, but by week's end it seemed to be contained by central bankers using tried-and-true 20th century methods.

But the real question is how, and whether, the damage from the subprime mortgage meltdown can be contained. The good news is that the positives of a strong global economy should mute the repercussions from this financial debacle. The bad news is that mortgage crisis still is in its early innings.

Central banks around the globe injected $290 billion of liquidity Thursday and Friday after money markets in Europe and the U.S. suddenly tightened. It followed BNP Paribas' halt in withdrawals from two of its funds with big chunks of U.S. subprime paper, the firm citing the inability to value its assets during the market's collapse.

Thursday's efforts, totaling $154 billion with $130 billion coming from the European Central Bank, did little to relieve the distress. But Friday, the Federal Reserve was able to restore a semblance of normalcy, if only by taking extraordinary actions. First, like the mythical Chicago voter, it entered the market early and often. It arranged three rounds of repurchase agreements, which is unusual, for a total of $38 billion, up from $24 billion on Thursday, and the most since the days following Sept. 11, 2001. The Fed also accepted mortgage-backed securities as collateral in the first round to bolster that beleaguered sector instead of the more usual Treasuries.

And just to make sure nobody missed the message of these open-market operations, the Fed issued a press release saying it would provide liquidity to keep the financial markets functioning and to keep the federal-funds rate close to its target of 5 1/4% after the cost of overnight money had climbed as high as 6%. The Fed added that the discount window was open to banks and other depository institutions experiencing "unusual funding needs."

Bernanke & Co.'s words and actions had the desired effect Friday, and nowhere was their impact more evident than in the action of Countrywide Financial (ticker:CFC). Shares of the big mortgage lender were slammed with a 13% loss at the open after it said in an SEC filing that it and other lenders faced "unprecedented disruptions" in the credit markets that resulted in Countrywide having to hold $1 billion in mortgages on its books that it had planned to sell into the secondary markets. By Friday's close, Countrywide was off less than 3%, a huge recovery that extended to the overall stock market.

Not since 1966 -- when the term "credit crunch" was coined after the Fed pushed market interest rates above the legal limits banks and thrifts then could pay on deposits and thus stopped lending in its tracks -- has the nation's mortgage apparatus been so close to breaking down.

The current crisis arguably has the potential for more economic disruption than the celebrated 1998 Long Term Capital Management meltdown. Then, as Northern Trust economist Asha Bangalore points out, the economy cruising along -- in contrast to the past four quarters, which have seen below-potential growth on average.

Moreover, mortgage borrowers perversely benefited from the LTCM fiasco. Not only did the Greenspan Fed lower rates, sparking a huge bond rally, but, also, the government-sponsored enterprises Fannie Mae (FNM) and Freddie Mac (FRE) went on virtual buying sprees. As a result, the biggest part of the credit mar- ket -- mortgages -- remained flush. Now, Fannie is looking to expand its portfolio beyond the $727 billion limit imposed on it after its accounting and governance scandals -- a move viewed skeptically by the White House but supported by some congressional Democrats.

Indeed, the full impact of the mortgage crisis still lies ahead. From the beginning of 2007 through mid 2008, interest rates on over $1 trillion of adjustable-rate mortgages are slated to be reset, many from low "teaser" rates.

The subprime mess also recalls another crisis -- the virtual collapse of the commercial-paper market in the wake of the Penn Central bankruptcy of 1970. Back then, the paper market consisted of relatively simple short-term corporate IOUs. Now, so-called asset-backed commercial paper is backed by all manner of things, from credit cards and auto loans to collateralized debt obligations, and comprises over half the CP outstanding. Moreover, notes MacroMavens' Stephanie Pomboy, money-market funds own 27% of CP outstanding.

While the Fed managed to soothe the financial markets' nerves by week's end, the potential for future upheavals remains. As a result, the futures market is looking for the central bank to ride to the rescue with rate cuts. Fed-funds contracts are fully discounting a quarter-point cut, to 5%, at the Sept. 18 Federal Open Market Committee meeting, and a further reduction to 4 3/4% in December.

As the chart here shows, financial crises have tended to coincide with peaks in the fed-funds rate and subsequent Fed easing. The subsequent rate relief would be hailed by the markets as the start of a new bull run.(see accompanying illustratione -- Barron's August 13, 2007)

There is a new wrinkle -- the precarious state of the dollar. No longer is the greenback viewed as a safe haven in the world, contends Barclay Capital's currency team.

Indeed, as MacroMavens' Pomboy has posited, a Fed rate cut that sends the dollar tumbling could have a perverse effect. The influx of foreign capital has kept U.S. interest rates low and provided a flood of credit for everything from leveraged buyouts to, of course, subprime mortgages. If there's an exodus of foreign capital fleeing a declining dollar, credit could tighten even as the Fed eases. Be careful of what you wish for.

WHOM SHALL WE BLAME FOR the so-called credit crunch? Casting about for scapegoats has never been easier, because the herd includes dozens of famous people, thousands of obscure but important financiers and millions of impecunious borrowers. Not in any special order, we blame:

Alan Greenspan and George Bush. The "maestro" of the Federal Reserve pounded the monetary gas to get the country out of recession in 2001, the "compassionate conservative" president pounded tax cuts and allowed the Republican Congress to boost spending as if they were Democrats. Either stimulus might have been enough; together they were too much.

Bill Clinton and his housing promoters at the Department of Housing and Urban Affairs, Henry Cisneros and Andrew Cuomo. It takes a long time to get a housing boom started, just as it will take a long time to cut back the inventory of new condos and houses that is pushing the market down.

William R. Fair and Earl J. Isaac, who started the eponymous credit analysis company. Fair Isaac analytics are used in three out of four U.S. mortgage originations, and the company sells 10 billion credit scores a year. Though the company has reduced the effect of prejudice and allowed lending to move more quickly, it has turned credit from a character judgment into a commodity. Commoditized loans, in turn, are turned into commodity packages of loans.

The rating agencies, Standard & Poor's and Moody's, swallowed tonics compounded with financial alchemy that lead them to believe that over-collateralization could trump high leverage and poor quality in a package of loans. Or, if it was not an alchemical elixir, perhaps it was money. Issuers pay the rating agencies to bless their bits of paper.

Supposedly professional investors who rushed to put their funds' funds into Triple-A rated things they did not understand, ignoring the market's warning signal that risk premiums were nearly non-existent. Sometimes you get paid for buying junk, and sometimes you don't.

There's also room to blame predatory lenders and their phony appraisers and brokers. Their chief concern was that fees were paid up front. The worst of these made their living inducing old folks with free-and-clear homes to become speculators in real estate and credit. But the greatest blame attaches to people who borrowed imprudently, and who should have known better.

They are still around waiting to be fleeced again, to judge from the lower dregs of commerce.

An advertisement from "Lowermybills.com, an Experian Company" slipped through our office spam filter the other day. Headlined "Mortgage Rates Fall Again," it purported to offer a "$430,000 mortgage for under $1,299 a month," which seems to be a rate of 3.5% or less, depending on the amortization of principal, if any. It urged the would-be borrower, "Select your credit: Excellent, Good, Fair, Needs Improvement, Poor." We stopped following the lead when it asked for personal information. Experian, which likes to describe itself as "a global information solutions company," is not to be trifled with, since it runs one of the major credit-reporting bureaus.

People get this kind of junk mail all the time, but the odd thing was the corporate spokescreature: Instead of a gecko or a frog, the ad featured an animation of a little green alien, dancing what appeared to be the Macarena.

What were they trying to say, that Experian has investors on Mars who haven't heard about the problems with subprime mortgages?

In the snail-mail at our house the other day there appeared a come-on from an outfit called Crown Mortgage Corp., which may beat the little green alien. "Start saving now with our 1.750% loan program," it said. "It's almost impossible not to qualify! And it's fast and easy." No worries: "Borrow up to 100% of the value of your home and take cash out for any purpose. Use the cash for anything you want. Pay off high-interest debt or tax liens, take a vacation or finance your child's education. It's up to you."

Compared to companies like these, Countrywide Financial is as sound as the U.S. Treasury. Which may be true anyway.

Henry Kaufman, who used to be known as "Dr. Doom" back a few financial crises ago, weighed in last week with the all-too-accurate assessment that financiers redefined liquidity over the past couple of decades. Liquidity used to mean cash, or assets that certainly could be converted to cash with the stroke of a pen.

"Firms and households today often blur the distinction between liquidity and credit availability," Kaufman said. "When thinking about liquid assets, present and future, it is now commonplace to think in terms of access to liabilities."

Personal liquidity recently has been defined as what you can borrow with the stroke of a pen. An individual adds up all the limits on the credit cards in his wallet, permissible overdrafts on his checking account, margin-loan limits on his brokerage account and home-equity loan checks in his desk. Maxing them out, he may command two years' salary, or more if he had worked at it when lenders were bullish.

Corporate liquidity is not much different. Companies maintain credit lines that would have constituted the mark of Cain many years ago, confident that they can borrow their way through any crisis.

When a person or a corporate treasurer writes a check on air to achieve liquidity, he should think of Owen Glendower, the Welsh magician who tries to impress Henry Hotspur in an early scene of Shakespeare's Henry IV, Part I. Glendower brags that he can "call spirits from the vast deep!" Hotspur gives him no credit: "Why, so can I; or so can any man. But will they come?"

What is shaking the markets is a refusal of the spirit of easy money to come from the vast deep. We are undergoing an agonizing reappraisal of the power and security of credit.