Hedge fund arrests send chill through industry

By Svea Herbst-Bayliss - Analysis

BOSTON (Reuters) - Pictures of hedge fund managers in handcuffs being led away to face fraud charges on Thursday have sent a chilling message to the $2 trillion industry.

The warning was clear: mind what you say in your e-mails if you are a manager and do a lot of due diligence if you are an investor.

While this is not the first time hedge fund managers have been arrested -- police are searching for a convicted manager who recently faked his suicide to avoid prison -- the two former Bear Stearns managers who were surrounded by a swarm of federal agents on Thursday were in a different league.

Ralph Cioffi and Matthew Tannin were called savvy managers who understood the complicated credit markets and worked for a bulge bracket investment bank that promised investors strong risk controls. Bear Stearns also had deep pockets in case something went wrong, analysts thought.

Much of the case against the two was based on e-mail traffic between Tannin and Cioffi, including one that included the prophetic line: "... the entire subprime market is toast."

The two men stand accused of having known their portfolios were in trouble, but lying to investors about it.

"You can't say one thing to investors and another thing to your colleagues and think that is OK. It is not," said Dick Del Bello, a senior partner at Conifer Securities, who used to run the U.S. prime brokerage business for UBS.

The men's arrests are the first criminal charges related to the sub-prime mortgage crisis that has impacted the loosely regulated hedge fund industry through heavy losses and a wave of redemptions.

"Unless you write it on a post-it note and put it on top of a book of matches, everything stays around and it can bite you," said a hedge fund manager who asked not to be named.

Still, endowments and pension funds need hedge funds to help boost sagging investment portfolios as the economy slows and stock markets wobble. To protect themselves, they will ask more consultants to help with due diligence.

"Investors will rely more on third parties to check statistics about how much leverage a fund is using and to demand more transparency from fund managers," said Stewart Massey, a founding partner of Massey, Quick & Co, an investment consultant with money with about 30 hedge funds.

PLAYING IT SAFE

And people may stop believing a single manager's explanation for how safe the money is, several investors said.

"We never rely exclusively on what one manager tells us," said Michael Travaglini, executive director of the $53 billion Massachusetts state pension fund, an early and big investor in hedge funds.

"We already spend all of our time monitoring our portfolios, so for us this case doesn't mean very much. But in general, it really underscores the need for investors to understand exactly what they are buying."