Hedge Fund Manager Accused of Fraud in Subprime-Mortgage Market Collapse

    Banking Expert Witness

    This case involves a hedge fund manager who managed a hedge fund that had taken highly leveraged positions in collateralized debt obligations based on subprime mortgage-backed securities. The manager worked for a company that was one of the largest brokerages and investment banking firms on Wall Street. The firm had built its image as an industry innovator and developed an increasing focus on the bond markets. The hedge fund manager usually spoke with investors each quarter about the fund performance and market conditions. When the housing market collapsed, the hedge fund took increasing hits to the value of its portfolio and faced escalating redemptions and margin calls. As a result, the manager laid off a significant portion of his staff, including key members of the fund accounting and investor relations teams. During this transition phase, mistakes were made on the monthly performance summaries sent to investors that highlighted direct subprime exposure at about 12 to 15 percent of the fund’s portfolio. This mistake became evident after the fund collapsed when they discovered that the total subprime exposure — direct and indirect — was approximately 55 percent. The manager was indicted for fraud and conspiracy.

    Question(s) For Expert Witness

    • Can the government prove that this hedge fund manager committed fraud if he failed to tell investors about the exposure to subprime mortgage-backed securities?

    Expert Witness Response

    This hedge fund manager had no way of knowing what lay ahead in the subprime mortgage market. These subprime mortgages were outside the predictive power of the rating agencies, investment banks, and hedge fund managers. The value of mortgage-backed securities issued by the subprime market grew from $11.05 billion in 1994 to $133 billion in 2002. According to statisticians from HUD, the subprime mortgage market’s value grew from “$150 billion in 2000 to $650 billion in 2007.” Originally, many of these subprime mortgages posed risks not much worse than those of “prime” mortgages. The problem was that the growth of subprime mortgages during the housing bubble differed from traditional mortgage lending in new ways based on securitization: it was driven by an “originate to distribute” model, where unregulated mortgage brokers and lenders made loans with the intent to sell them on the secondary market and thus with less concern for risk than traditional, regulated lenders. What this case really boils down to is that the hedge fund manager was implementing aggressive management tactics in order to keep the fund afloat during the economic crisis but did not commit conspiracy or fraud.

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