This week I read Black Edge by Sheelah Kolhatkar, a reporter, about the battle between the SEC and the New York US Attorney's Office on the one hand, and SAC Capital, the hedge fund run by Steven Cohen, on the other. Although no one seems to want to talk about it very much (including Terry Gross and Kolhatkar when the author appeared on Fresh Air), the story is obviously the inspiration for the superb HBO series Billions, which just finished its second season. The book offers extraordinary insight into the world of hedge funds, which have become so important within our whole economy. Rather than review it in detail, I am going to talk about the biggest lessons that I learned from it.
Although I also read a history of hedge funds by Sebastian Mallaby and blogged about it here, I am still quite unclear as to how this key new financial institution got off the ground and became so powerful. Kolhatkar indicates that regulators allowed them to operate far more freely than banks, on the assumption that their investors would be wealthy enough to take risks. Many of their investors, of course, hvae turned out to be institutions like pension funds. In any case, many of the funds--led by SAC Capital--generated extraordinarily, Madoff-like returns for decades. The returns vastly exceeded the growth rate of the economy, and thus contributed to the growth of inequality in our society. The question that hangs over the book, and became key to the prosecutions of various hedge fund traders, was exactly how they did it.
It is impossible, sadly, to disaggregate the answer to that question, but it is clear that many of the profits came from inside information. The old model of investing, represented by Lou, the GI character played by Hal Holbrook in Wall Street, involved identifying a promising company and investing to secure a share of its profits. That model seems to be moribund, if not dead. A more common model involves bets on a sudden rise or fall of a stock, based on an event such as the release of an earnings report or the results of a clinical trial of a drug. It doesn't matter whether the news is bad, what matters is to know what the news will be before it is public, in order to short the company's stock or buy more of it before the news has moved the market. Traders are gamblers, and all gamblers prefer to bet on sure things. The problem, of course, is that such trading on inside information has been illegal, for good reason, for more than 80 years.
In a rational world moved by civic virtue, I think, a Congressional committee would long ago have done a multi-year investigation of hedge funds in an effort to find out roughly how much of their profits come from illegal inside information. I have no idea exactly what it would find, but it could be high enough to suggest that a law making their operation illegal would be in the public interest. What Kolhatkar does show is that information has become a huge business. Entire stand-alone firms have formed to become intimate with firms in various industries. Hedge funds pay them retainers for their information. They evidently feel that they are getting their money's worth. I got the impression that these firms, as well as some traders, work more like intelligence agents than anything else, trying to win the confidence, or intimidate, or corrupt sources of valuable information by any available means. We shall return to this issue in a few minutes, after looking at the ennvironment within the funds
I am increasingly depressed by the lack of institutional loyalty in today's world. From academia through the financial world and into medical care, politics, and government, fewer and fewer people, it seems to me, seem to care about the long-term future of the institutions they work for, or for their fellow employees. Most care only about what they can get out of their institution. I have to admit that I have been a devoted fan of Survivor since it began, even though I am always depressed by the inability of most of the contestants to focus on the interests of their particular tribe, even in the first stage of the game when individuals' fortunes depend largely on the fortunes of their tribe. And this tendency has if anything gotten worse as Millennials, who were supposed to be team players, replaced Gen Xers in the contestant pool. This is the way many hedge funds are organized as well. Cohen at SAC gave individual traders huge leeway and did not oversee their operations closely--but he expected them to provide him with their best information and allow him to profit from it. That kept him at one remove from the information itself, and that is what in the end saved most of his fortune and his freedom from the US Attorney's office.
What is so maddening about the story of the insider trading prosecutions, to those of us who care about the law and have a reasonably good head for figures, is that insider trading is anything but difficult to detect. Like large-scale bets on a fixed sporting event, the evidence is unequivocal and obvious. To cite a related example, in the early 1980s, the Pennsylvania daily lottery was fixed to as to produce the number 666 by infiltrators into the TV studio that drew the number with the help of numbered ping pong balls. On the afternoon before the drawing law enforcement received numerous calls from illegal numbers brokers predicting the fixed outcome--which was the only possible way to explain the deluge of bets they were receiving on 666. A sudden, large purchase or short of a stock just days before important information about the stock reaches the public is virtually a confession of guilt. But the courts do not accept that kind of evidence--it is necessary to show exactly whom the information came from and how it was acquired.
Cohen was implicated in two trades. The first involved a leak of an earnings report from the computer manufacturer Dell. An SAC trader named Michael Steinberg was indeed convicted of insider trading in that case. But in a catastrophic decision in a similar case in December 2014, an appeals court overturned another insider trading case, rebuked Southern District prosecutor Preet Bharara for an overly aggressive strategy, and declared that traders who used inside information that they obtained from a third party, rather than from some one in the firm involved, were not guilty. That led to the dismissal of Steinberg's case as well. The Supreme Court has repudiated that decision, but the state of the law remains very unclear. The second case, which was widely publicized, involved an Alzheimer's drug trial. An SAC trader named Matthew Martoma had spent years cultivating an elderly University of Michigan Med School professor, Sid Gilman, who was involved in the trial. (Martoma, it turned out, had previously forged his Harvard Law School transcript to try to get a prestigious clerkship.) Gilman had collected hundreds of thousands of consulting fees from the financial industry, and eventually provided Martoma with his power point presentation on the disappointing results of a clinical trial. Martoma had emailed these results to Cohen, who had promptly shorted the drug company's stock on a large scale.
Martoma, who refused to cooperate with the government and testify against Cohen, was convicted and received a long sentence. But after a long conference with Cohen's well-heeled attorneys--essentially, a dry run for a trial, without judge or jury--Bharara's office decided not to risk a trial that they might lose. Cohen escaped with a fine that, while huge by ordinary standards, represented a fraction of his assets. He also had to shut down SAC capital but continues to trade on his own behalf. (This was exactly the deal that "Axe," played by Damian Lewis, turned down during the first season of Billions.) Martoma had actually sent Cohen an email just before Cohen began shorting the drug company's stock, but the prosecutors were worried that they could not prove that he had read it. It has become notoriously easy for prosecutors to put any poor person in jail that they choose, by threatening them with draconian sentences if they will not plea. Black Edge and the history of the Obama Administration and the big banks show that it is nearly impossible to put the superrich behind bars.
I was most struck, in all this, by the ethos--or pathology--that seems to rule the hedge fund world. Everyone wants a spectacular result, and inside information is the easiest way to get one. But when you have done it once, it seems, you feel greater pressure to do it again, forcing you to look harder for the next coup. These traders, who siphon many billions out of our economy every year to inflate the high end housing and art markets, are addicted to large sums of money, which function, for them, like opiates for millions of their fellow citizens. They are addicted to huge sums of money. The cure is simple, and it is one that the country tried from about 1940 until 1964: 91% marginal tax rates above a certain amount. But under current tax law hedge fund traders pay lower taxes than the rest of us, through the carried interest loophole. We are all feeding their addiction.
And what it means for addicts to have such power was succinctly stated by Gus Fring, played by Giancarlo Esposito, in my favorite moment of Breaking Bad, when Walter White and his partner Jesse came to meet Gus at Pollos Hermanos, but waited all day without making contact. Jesse eventually left, and Walter took the bull by the horns, went up to the counter, and confronted Gus.
Gus explained why he didn't want to work with Walter. "I don't think you are a cautious man, Mr. White," he said. "Your partner was late. And he was high. He's often high, isn't he?"
Walter replied that while that was true, his partner was someone that he could trust.
"You can never trust a drug addict, Mr. White," Gus replied.