How Hedge Fund Vampires Use Insider Info to Extract Their Dishonest Fortunes
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Ever wonder how hedge funds can make 20 percent returns during the worst economic crisis since the Great Depression, while your savings account grows smaller? Ever wonder how it’s possible for the top hedge fund manager in 2011 to make $1,442,308 an hour, while it takes the average American family over 29 years to earn that much?
Well, a slew of financial writers are quick to tell you that the answer is simple: hedge fund managers are simply much smarter than you are, so get used to it. But that's nonsense.
Hedge funds make enormous sums of money because they have an edge – one that pushes them out to the ethical limit...and beyond. Their edge often depends on obtaining privileged information that is inaccessible to the rest of us. Sometimes they get information illegally through well-paid sources inside corporate boardrooms, as Raj Rajaratnam did before he was sentenced to 11 years in the hoosegow. In other cases, hedge funds can buy it from congressional “sources.” And they even can get it for free when one of their own is appointed to the highest councils of government.
This sets up a vicious cycle – hedge fund money buys more information which leads to more hedge fund money which buys more information. It doesn’t take long for hedge funds to turn Washington into a wholly owned subsidiary.
But, surely this is a gross exaggeration, isn’t it? If only.
Why is privileged information so important?
If you know something that will move markets and the rest of the investment community doesn’t know it, you will make money. If it’s good news for an industry – like news that a regulation will be removed or new money will be coming from Washington– you can jump in and then ride the market up and out. If it’s bad news, you can short the stock and do the reverse. You will always make money as long as you’re ahead of the information curve.
Hedge funds get the scoop on healthcare reform
For example, as the national healthcare bill was nearing completion late in 2009, “Hedge-fund managers at Viking Global Investors and Karsch Capital Management were among investors who met privately…in a nondescript Capitol basement with senators whose support was crucial to passage,” reported the Wall Street Journal. At the meeting, these senators revealed to the hedge funds -- but not as yet to the public -- that there would be no public option in the bill, which, in turn, would be great news to health insurance companies. Lo and behold these hedge funds quickly bought into several large health insurers and made a handsome return in a matter of days...and all of it perfectly legal.
Hedge funds get the scoop on the takeover of Fannie and Freddie
Perhaps the most obscene way to get an edge is when a top official lies to the public and then in private tells hedge funds the truth. In the summer of 2008, when Fannie Mae and Freddie Mac were near collapse, Hank Paulson, Bush’s Treasury secretary, told lawmakers and the press that the government would not take over the two troubled mortgage giants. Instead the Treasury Department, in a confidence-building move, would review their books, while also asking for takeover authority, just in case. Why the takeover authority? As Paulson put it to Congress, “If you have a bazooka, and people know you have it, you’re not likely to take it out.”
This was good news for investors as the stock prices of Fannie and Freddie improved. But if the bazooka was fired and the government took over the two giants, its shares would plummet in value with some preferred classes being liquidated entirely. So if you knew that a government takeover would happen soon, you could short their stocks and make a killing.
While Paulson, who was the CEO of Goldman Sachs from 1999 to 2006, was telling the public and Congress one thing, he met privately with his old hedge fund cronies from Goldman to give them a different message. During that secret luncheon he disclosed that he was about to fire that bazooka – that the government would soon take over Fannie and Freddie. “Around the conference room table were a dozen or so hedge fund managers and other Wall Street executives -- at least five of them alumni of Goldman Sachs,” reported Bloomberg News.
No one knows for sure how many of those hedge funds placed their bets right after that meeting. But overall the short bets on Freddie and Fannie spiked right after that meeting. Those short betters did very well indeed when the takeover was announced and the stocks plummeted.
Did Paulson violate any laws by having this secret lunch with his cronies? No. But Paulson may have misled Congress. Couldn’t he have been indicted for perjury? Dream on. That would have “unsettled” markets. So nothing happened…nothing at all except that well connected hedge funds got access to very valuable privileged information.
Isn’t there a law against selling the government to hedge funds?
When congressional members and staff see how hedge funds make a killing based on information they provide to hedge funds, it’s only natural for our public servants to use their own information to make shrewd investments for themselves. Why let the hedge funds have all the fun? It got so bad that reports circulated on the Hill that congressional members and staff were trading hundreds and thousands of stocks per day. They were day traders while on the public payroll!
So Congress felt compelled to pass a bill that would at least help polish its public image.
Earlier this month, both the House and Senate passed versions of Stop Trading on Congressional Knowledge (STOCK) Act which:
Prohibits members and employees of Congress from buying or selling securities, swaps, security based swaps, or commodity futures based on nonpublic information they obtain because of their status;
Prohibits Executive Branch employees from buying or selling securities, swaps, security based swaps, or commodity futures based on nonpublic information they obtain because of their status;
Prohibits those outside Congress from buying or selling securities, swaps, security based swaps, or commodity futures based on nonpublic information obtained from within Congress or the Executive Branch;
Prohibits members and employees of Congress from disclosing any non-public information about any pending or prospective legislative action for investment purposes;
Requires members and employees of Congress to report the purchase, sale or exchange of any stock, bond, or commodity future transaction in excess of $1,000 within 90 days. Members and employees who choose to place their stock in holdings in blind trusts or mutual funds would be exempt from the reporting requirement; and
Requires firms that specialize in "political intelligence" and that obtain their information directly from Congress to register with the House and Senate, much like lobbying firms are now required to do.
Looks good, doesn’t it?
Well, as you might expect, there’s one important loophole designed by and for hedge funds. It centers on requiring “political intelligence” firms to register like regular lobbyists. Hedge funds don’t give a damn if congressional members and staff do a little day trading. (In fact, hedge funds that engage in high-frequency trading will fleece them anyway.) What hedge funds do care about is hiding in the shadows. They don’t want to register their “political intelligence” operatives with anyone. That would make it all too easy to trace leaks back to them, which in turn would undermine their edge. So hedge funds had to kill that last provision.
To do so they successfully lobbied the Wall Street-friendly House to kill that part of the bill by instead having “the Government Accountability Office assess the use of ‘political intelligence’ first and then make recommendations on narrowing the definitions.” Don’t hold your breath.
Will the STOCK Act stop the corruption?
You’re kidding, right? Let me make a sure-fire prediction: The transformation of Washington into an information feeder arm of hedge funds and Wall Street banks will continue until an outraged public builds a mass movement to counter Wall Street. Billion-dollar hedge funds have ample resources to grease the wheels in order to protect their interests. And congressional members always need campaign funds. As a result, even if the new legislation is fully enforced (fat chance) congressional members will trade legislation to get campaign funds. That’s why hedge funds still have their outrageous “carried interest” loophole that allows them to morph their income (which should be taxed at the 35 percent rate) into capital gains (which is taxed at 15 percent.) Also that’s why any and all efforts to enact a sensible financial transaction sales tax on Wall Street are going nowhere.
But Wall Street really wins big in another important way. As the public becomes more and more aware of the money-making ties between Washington and Wall Street, it will further despise Washington – which is precisely what Wall Street wants. The more the public turns against the federal government, the easier it becomes to attack government regulations of all kinds. And the sooner regulation and enforcement fades from the scene, the easier it becomes for Wall Street to operate its casinos at will and continue to fleece the American public.
Which is why we need a beefed up version of Occupy Wall Street…and soon.
Les Leopold is the executive director of the Labor Institute and Public Health Institute in New York, and author of The Looting of America: How Wall Street's Game of Fantasy Finance Destroyed Our Jobs, Pensions, and Prosperity—and What We Can Do About It (Chelsea Green, 2009).