Market Overview

2 Amazing Stories in the Past Week on the Legality of Trading on Insider Information in D.C. - and Not Just in Congress

Lost in the 60 Minutes piece a few weeks ago [Nov 13, 2011: (Video) Trading on Inside Information? It's Cool if You are in Congress] about the 'benefits' Congress and its staffers receive in terms of trading on inside information, is the rise of a subsector of 'information' to be sold to hedge funds, using these same channels in D.C.  It's so outrageous on the face of it - but apparently perfectly legal.  There was a piece on this about a month ago in the WSJ - Hedge Funds Pay Top Dollar for Washington Intelligence.

Now if this was just information that was available to anyone it would be one thing, but it appears its the same information that Congress and staffers are privy to, but can be sold to the highest bidder.  Hence the name 'smart money' given to the hedge fund class I suppose.

But in the past week we have 2 stories that are even more egregious.... if possible.  I didn't have time to post this story last week regarding the Federal Reserve giving 'tips' to the superior class of investors.... but combined with another barn burner from Bloomberg Markets magazine on Hank Paulson tipping off the illumanti from the squid Goldman Sachs & Eton Park hedge fund on what would could happen to Fannie and Freddie, WHILE telling the public (and Congress) a totally different story.... well folks, you just can't make this stuff up.  And yes that was a run on sentence of epic proportion but trust me, you will be incensed too at what apparently is 'cool' by legal standards, as long as your part of the D.C. set and/or have enough money to access such 'market movers'.

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First to the piece on the Fed.... long article; worth the full read, make sure to take blood pressure medicine ahead of time.

  • Hours after an Aug. 15 meeting with Federal Reserve Chairman Ben Bernanke in her office, Nancy Lazar made a hasty call to investor clients: The Fed was dusting off an obscure 1960s-era strategy known as Operation Twist.  The news pointed to a boom in long-term bonds.  
  • It was a good call. Over the next five weeks, prices on 10-year Treasury bonds soared, offering double-digit returns in an otherwise dismal year.  By the time the Fed announced its $400 billion Operation Twist on Sept. 21, the window for quick profits had all but slammed shut.
  • Ms. Lazar is among a group of well-connected investors and analysts with access to top Federal Reserve officials who give them a chance at early clues to the central bank's next policy moves, according to interviews and hundreds of pages of documents obtained by The Wall Street Journal through open records searches. 
  • The access is part of a push by hedge funds and other traders to get more information about the inner workings of government. Developments in Washington have become more important after the financial crisis in 2008 spawned new regulations and a stronger hand by lawmakers in businesses.
  • The words and actions of the Federal Reserve, in particular, have an enormous impact on markets, prompting the creation of new guidelines at the central bank to combat the perception of favoritism.  Conversations are important to both sides, making it difficult for the Fed to completely close its doors to traders and analysts. Fed officials want to know how investors might respond to changes in monetary policy and to avoid surprising markets. Investors, meanwhile, reveal developments that might pose unseen dangers to the U.S. economy, say people familiar with the matter.
  • Such talks are perfectly legal but create a delicate dance for the Fed, which tries to sate its need for information to help guide monetary policy without giving Wall Street an unfair advantage over Main Street.  
We interrupt this story for tape of an actual conversation (ok not really) but in theory highlighting how this awesome give and take works:

Prominent Fed official with beard:  "So.... if we were going to launch a purchase program with an unspecific name.... in an amount somewhere between say $599.8B and $601.2B... I don't want to get too specific to give you an advantage....how would the fellas down on the Street react?"

Very important, well connected, and wealthy investor type:  "Wait are you hinting to me you are going to do a new QE program of $600B?"
Prominent Fed official with beard: (while stroking beard) "Now I could not say that could I?  It would unethical and stink of favoritism.  I am simply asking if I were to use my omnipresent powers to make it rain dollars.... in say the next meeting or two, would you like it?  Wink twice for yes, and three times for hell yes."
Very important, well connected, and wealthy investor type: (blinking rapidly)  "Ok so you are not telling me you are doing QE, but by not telling me, you are preparing the market, so the market is not surprised when it happens.  Because all policy in America must please the market."
Prominent Fed official with beard:  "Now I didn't say that.  But if you said it, it would not be a disagreeable thing."
Very important, well connected, and wealthy investor type: "When are you leaving?  I need to make some calls... pronto."
Back to your normally scheduled WSJ article:
  • Mr. Bernanke discusses only matters already public, a spokeswoman said. But hedge fund managers and Wall Street executives who meet regularly with him and other Fed officials—both in his office and through advisory committees—say they get valuable insights during the face-to-face talks.
  • "It's like an inquisition, they have a topic," said Laurence Fink, chief executive of investment-management giant BlackRock Inc. "By the questions they ask, by definition, you know what's on their mind."
  • New York Federal Reserve Bank President William Dudley also meets regularly with investors, both in his office with individuals and in committee groups. The New York Fed, one of 12 regional banks that constitute the Federal Reserve System, has the strongest ties to investors because it conducts the Fed's bond-market transactions.
  • Mr. Dudley, who also is vice chairman of the Federal Open Market Committee, which sets the nation's monetary policy, acknowledged the discussions could give the misperception that investors with access to Fed officials have an advantage.  "We take great care to frame subjects and questions in a neutral manner that does not provide any insight into our own thinking and we are careful to keep in mind that their comments may sometimes reflect their firms' own interests," Mr. Dudley said in a statement.  (insert laughter here)
  • Over the past two-and-a-half years, Mr. Dudley has had dozens of private meetings, according to his calendar, which lists SAC Capital Advisors, Citadel Investment Group, Duquesne Capital Management, and Tudor Investments, among others. Lloyd Blankfein, chief of Goldman Sachs Group Inc., (God's work) and Mr. Fink, of BlackRock, also had private meetings, according to Mr. Dudley's calendar.
  • These investors employ strategies tied to interest-rate policy and economic trends—making snippets of information as subtle as head nods and body language extremely valuable.  (as I outlined above...winking is also very important
  • Worries about Fed access surfaced a year ago.  (and what was done about it? Nothing?  Oh.  Carry on)  On Aug. 18, 2010, former Fed governor Laurence Meyer, who runs a research service predicting and analyzing Fed actions, told clients in a note the central bank's "bazooka is loaded" to buy bonds to stimulate the economy. (obtained through winking or strokes of the beard in a private meeting I am sure... )  The note described how the Fed's "doves," members inclined to ease monetary policy, had said the Fed couldn't "sit on its hands," according to Mr. Meyer's account. An Aug. 20 note included some specific information about the Fed's balance sheet.
  • A week later, Mr. Bernanke said during a speech in Jackson Hole, Wyo., that "policy options are available to provide additional stimulus" to the economy. Stocks rose on the news, which by then had given Mr. Meyer's clients plenty of time to profit.  The Fed announced its move in November—a second, so-called quantitative easing plan, known as QE2, that entailed buying $600 billion worth of long-term Treasurys.

As for our current Treasury Secretary?  Well in his last role as head of the most powerful regional bank - he helped grease the skids for the current system.

  • When Treasury Secretary Timothy Geithner was president of the New York Fed beginning in 2003, he worried the Fed wasn't close enough to big investors, (that line is so open to interpretation it's beyond the pale) especially financial firms like hedge funds that operated outside of the regulated banking industry. He set up a new staff position to coordinate private meetings with hedge fund managers and other Wall Street power brokers. (what a gentleman - with kind moves like that I bet the power players would like to see him in say a role as.... Secretary of the Treasury someday)

The rest of the piece goes on to give example after example of these 'hints' and how "the cool kids" benefited from them - nothing overt that could lead to criminal charges mind you.  But even though we know the playing field is unfair, when you peel back the onion to see the stink below... and how those in power positions today made it even easier on their way to the top reaches of D.C. - it is all a joke.  Thankfully, no one reads stories like this ...

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So that takes care of your bond portfolio as long as you are 'important' (read: rich, or connected) enough.  But you still need to work on that equity side of the portfolio.  Who do you call? The U.S. Secretary Treasury... in fact, he even comes to you to tell you cool things per this awesome piece in Bloomberg Markets.  And since shorts need not be publicized to the SEC - everyone wins!  God's work... indeed. 
  • Treasury Secretary Henry Paulson stepped off the elevator into the Third Avenue offices of hedge fund Eton Park Capital Management LP in Manhattan. It was July 21, 2008, and market fears were mounting. Four months earlier, Bear Stearns Cos. had sold itself for just $10 a share to JPMorgan Chase & Co. (JPM).  Now, amid tumbling home prices and near-record foreclosures, attention was focused on a new source of contagion: Fannie Mae (FNMA) and Freddie Mac, which together had more than $5 trillion in mortgage-backed securities and other debt outstanding.
  • Paulson had been pushing a plan in Congress to open lines of credit to the two struggling firms and to grant authority for the Treasury Department to buy equity in them. Yet he had told reporters on July 13 that the firms must remain shareholder owned and had testified at a Senate hearing two days later that giving the government new power to intervene made actual intervention improbable.  “If you have a bazooka, and people know you have it, you're not likely to take it out,” he said.
  • On the morning of July 21, before the Eton Park meeting, Paulson had spoken to New York Times reporters and editors, according to his Treasury Department schedule. A Times article the next day said the Federal Reserve and the Office of the Comptroller of the Currency were inspecting Fannie and Freddie's books and cited Paulson as saying he expected their examination would give a signal of confidence to the markets.  (so Paulson said this to the press.... hours before he went to the Eton Park - you can guess what happened next)
  • At the Eton Park meeting, he sent a different message, according to a fund manager who attended. Over sandwiches and pasta salad, he delivered that information to a group of men capable of profiting from any disclosure.
  • 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 Group Inc. (GS), of which Paulson was chief executive officer and chairman from 1999 to 2006. In addition to Eton Park founder Eric Mindich, they included such boldface names as Lone Pine Capital LLC founder Stephen Mandel, Dinakar Singh of TPG-Axon Capital Management LP and Daniel Och of Och-Ziff Capital Management Group LLC.
  • Non-Goldman Sachs alumni who attended included short seller James Chanos of Kynikos Associates Ltd., who helped uncover the Enron Corp. accounting fraud; GSO Capital Partners LP co-founder Bennett Goodman, who sold his firm to Blackstone Group LP (BX) in early 2008; Roger Altman, chairman and founder of New York investment bank Evercore Partners Inc. (EVR); and Steven Rattner, a co-founder of private-equity firm Quadrangle Group LLC, who went on to serve as head of the U.S. government's Automotive Task Force.  (the only value of this story to me other than exposing more crony capitalism, is a whose who of who I should be watching much more closely on TV knowing they have access to inside information - legally
  • After a perfunctory discussion of the market turmoil, the fund manager says, the discussion turned to Fannie Mae and Freddie Mac. Paulson said he had erred by not punishing Bear Stearns shareholders more severely. The secretary, then 62, went on to describe a possible scenario for placing Fannie and Freddie into “conservatorship” -- a government seizure designed to allow the firms to continue operations despite heavy losses in the mortgage markets.  Paulson explained that under this scenario, the common stock of the two government-sponsored enterprises, or GSEs, would be effectively wiped out. So too would the various classes of preferred stock, he said.
  • The fund manager says he was shocked that Paulson would furnish such specific information -- to his mind, leaving little doubt that the Treasury Department would carry out the plan. The managers attending the meeting were thus given a choice opportunity to trade on that information.
  • At the time Paulson privately addressed the fund managers at Eton Park, he had given the market some positive signals -- and the GSEs' shares were rallying, with Fannie Mae's nearly doubling in four days.

So what did said 'smart money' fund managers so next with this information you may ask?  Well you will never know - because there is no need to disclose short positions ;) 

  • There's no evidence that they did so after the meeting; tracking firm-specific short stock sales isn't possible using public documents.
  • (blah blah blah)  Brosens and Rattner both confirmed in e-mails that they had attended and said they couldn't recall details. They didn't respond when asked whether they traded in Fannie Mae- or Freddie Mac-related instruments after the meeting. Chanos declined to comment.
  • Eton Park's Mindich, Lone Pine's Mandel, TPG-Axon's Singh and Och-Ziff (OZM)'s Och all declined to comment through spokesmen. Reservoir's Stern didn't return phone calls. Altman, through a spokesman, confirmed his attendance and declined to comment further.  (I am noticing a pattern
But we all know how this ended up:
  • Seven weeks later, the boards of the two firms voted to go into conservatorship under the newly created Federal Housing Finance Agency. 
And it's perfectly legal in our $*(*(#*#(@(#* system:
  • And law professors say that Paulson himself broke no law by disclosing what amounted to inside information.
  • William Black, associate professor of economics and law at the University of Missouri-Kansas City, can't understand why Paulson felt impelled to share the Treasury Department's plan with the fund managers.  “You just never ever do that as a government regulator -- transmit nonpublic market information to market participants,” says Black, who's a former general counsel at the Federal Home Loan Bank of San Francisco. “There were no legitimate reasons for those disclosures.”

And the rest of the very detailed article goes on from there.  I myself cannot continue posting it due to the puke inside my mouth.  All in another day of 'free market capitalism' and 'free and transparent markets'.

The following article is from one of our external contributors. It does not represent the opinion of Benzinga and has not been edited.

Posted-In: Markets

 

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