As if the global capital markets hadn’t suffered enough shocks lately -- artillery fire in Korea, meltdown in Ireland, Eva Longoria Parker’s divorce filing -- life just threw America’s hedge-fund masters a beanball. It appears the government wants to toss many of them in jail.
This week the Federal Bureau of Investigation executed search warrants at three large hedge funds’ offices as part of a widening insider-trading investigation. Several other funds, including SAC Capital Advisors, got subpoenas for documents.
What does this crisis mean for the industry? We already can guess the first question that must have leaped to the mind of every self-respecting wealth maximizer: “How can I use this information to make enough money to buy myself a jet?” The answer, of course, is that it pays to be on the inside.
This raises an even more intriguing existential question. Is it possible for a hedge fund to profit off its own imminent collapse? A little role-playing exercise shows it’s not only possible -- it’s preordained.
Imagine you are a skilled trader at a hedge fund with a few billion dollars under management. You learn that FBI agents have just arrived to raid your firm. Lesser beings might cower under the pressure. You, though, realize that you now possess the ultimate edge: The knowledge of what is happening to you at this very moment. You scan the latest news for headlines about your firm and, seeing none, set about on an action plan.
Soon the unsuspecting public will be told that financial stocks are plunging on the news that your firm is being raided. You have the benefit of knowing this in advance. The only remaining questions: Do you short Goldman Sachs? Do you short other large banks, too? More importantly, do you short them for your personal account, or for your fund’s? Sensing nothing but upside in the downside, you settle on all of the above.
“The masterminds leave the fewest footprints, and they are often planning their defense at the same time they are committing the fraud,” he said. “To take a simple example, those who trade on insider information may well accumulate at the same time a stack of research reports on a company whose stock they just illegally purchased, and point to that file when law enforcement comes knocking.”
As you consider whether to send Khuzami a thank-you note, you hit the print button. Piles of bearish research reports churn out, ready to be placed on your desk as if they had been there for weeks. You’re probably just being paranoid, though. For all you know, the trades you executed were legal.
Make a Call
Right about now, your attention starts to shift. There’s the question of whom to call first about the FBI raid. Personal lawyer? Spouse? Lover? No, you resolve instead to call your fund’s top so-called expert-network service. They helped get you in this mess. Surely they can get you out, right?
Past experience tells you the experts’ information always falls into one of two categories: Worthless or way, way too good. You hope for the latter. Even if the network can’t lure away Khuzami from the SEC to represent you, maybe the experts could dig up some dirt on the pimply FBI agents downloading your firm’s e-mails? Suddenly it occurs to you that all your phones probably are tapped. Better hold off on making that call.
Now the waiting game begins. There will be immediate family members to become reacquainted with, and monstrous legal bills to pay. At least you know better than to let your employer pick your law firm for you. Turning state’s evidence isn’t an option, not yet at least. Eventually, you figure you can stage a comeback. Your firm, though, is toast.
Where You Stand
It’s about this time that it dawns on you: Your social standing wasn’t what you thought it was. The FBI wouldn’t dare raid the headquarters of a too-big-to-fail bank like Citigroup, much less allow the press to photograph the scene. You, though, chose what you thought was the more lucrative path of working for a hedge fund -- which can, and soon will, fail. The government doesn’t care if it starts a run on you.
Passing the time, you run across a stock quote for Allied Irish Banks. It still trades for about a dollar in New York, even though its bailout just took down a whole country. “I never took down a whole country!” you scream inside your head. Reality sets in: You’re now lower than an Irish banker.
You also start to recognize you’re not as rich as you once thought. You recorded your $10 million bonus last year (after taxes) as an asset on your personal balance sheet. What you should have done was put down a contingent liability of equal size for all the money you’ll have to pay to get out of this mess. Oh well, live and learn.
All in all it was worth it, you reckon. We’ll be lucky if the whole financial system doesn’t crumble anyway at this rate. At least you got what you could while the going was good. Still you worry: Where’s a safe place to put it all?
The answer will have to wait. You hear a voice. It’s an FBI guy. He’s asking you to back away from the computer keyboard.
(Jonathan Weil is a Bloomberg News columnist. The opinions expressed are his own.)
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