Ari Officer, writing at Time.com, explains just how fragile our financial cathedrals have become.
Bernard Madoff’s $50 billion Ponzi scheme continues to rock the financial world. But most hedge funds actually engage in similar — albeit legal — practices in the short run. These practices helped inflate their gains, as well as hedge fund managers’ salaries and bonuses, in the past, but subsequently helped bring about the recent failure of many major hedge funds.
At the heart of this is the distinction between realized gains and unrealized gains. Gains are realized when assets are liquidated into cash. For instance, if you buy a stock for $100 and it is currently trading at $200, you have made $100 in unrealized gains. If you sell it at $200, you have made $100 in realized gains. Most hedge funds do not regularly liquidate their entire portfolio, so they always report unrealized gains to their investors and to the public.
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. Here’s 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?
Read the whole thing here.