By Pam Martens: July 22, 2014
Only one word comes to mind to describe the testimony taking place before the U.S. Senate’s Permanent Subcommittee on Investigations this morning: Machiavellian.
The criminal minds on Wall Street have twisted banking and securities laws into such a pretzel of hubris that neither Congress, Federal Regulators or even the General Accountability Office can say with any confidence if the U.S. financial system is an over-leveraged house of cards. They just don’t know.
According to a copious report released last evening, here’s what hedge funds have been doing for more than a decade with the intimate involvement of global banks: the hedge fund makes a deposit of cash into an account at the bank which has been established so that the hedge fund can engage in high frequency trading of stocks. The account is not in the hedge fund’s name but in the bank’s name. The bank then deposits $9 for every one dollar the hedge fund deposits into the same account. Some times, the leverage reaches as high as 20 to 1.
The hedge fund proceeds to trade the hell out of the account, generating tens of thousands of trades a day using their own high frequency trading program and algorithms. Many of the trades last no more than minutes. The bank charges the hedge fund fees for the trade executions and interest on the money loaned.
Based on a written side agreement, preposterously called a “basket option,” the hedge fund will collect all the profits made in the account in the bank’s name after a year or longer and then characterize millions of trades which were held for less than a year, many for just minutes, as long-term capital gains (which by law require a holding period of a year or longer). Long term capital gains are taxed at almost half the tax rate of the top rate on short term gains.
There are so many banking crimes embedded in this story that it’s hard to know where to begin. Let’s start with the one most dangerous to the safety and soundness of banks: extension of margin credit.
Under Federal law known as Regulation T, it is perceived wisdom on Wall Street that a bank or broker-dealer cannot extend more than 50 percent margin on a stock account. But since the banks involved in these basket options called these accounts their own proprietary trading accounts, even though the hedge fund had full control over the trading and ultimate ownership of profits, the banks were justified (in their minds) with thumbing their nose at a bedrock of doing business on Wall Street.
We learn from a footnote in the Senate’s report that hedge funds have gamed Regulation T further. The report advises: “ ‘Joint Back Office’ (JBO) and international prime brokerage accounts offer two alternatives for hedge funds seeking higher leverage. JBO arrangements have been given an exemption from Regulation T and are permitted leverage of 6.7 times. JBO arrangements require the margin lender and margin borrower to form a joint venture, creating a closer association than is typical for a prime brokerage relationship.”
Another key issue is the falsification of books and records – a serious no-no for a bank. How can Federal regulators understand what is going on in a financial institution if the true ownership of accounts is not honestly indicated by name, address and tax ID number. This system sounds like a perfect cover for money launderers and insider trading.
According to the Senate’s report, at least 13 hedge funds engaged in these basket options to conduct over $100 billion in securities trades. Two banks mentioned by name for their involvement are Barclays and Deutsche Bank.
One hedge fund stands out in the report for using this strategy for more than a decade to obtain excess leverage with which to trade and to cut its tax burden. According to the Senate report, Renaissance Technologies may have engaged in “tax avoidance of more than $6 billion.”
It didn’t take more than a quick reading of the resumes of the multiple executives from Renaissance, who will be giving testimony before the Senate today, to see why it has landed in such hot water. One Executive Vice President, Mark Silber, wears all of the following hats: CFO, Chief Compliance Officer and Chief Legal Officer. And, by the way, he was previously a CPA with the accounting firm that now audits the books of Renaissance – BDO Seidman.
A CPA attempting to plead ignorance on what constitutes a long term capital gain should make for interesting theatre in the Senate today.
The potentially catastrophic danger these types of cavalier arrangements have on the overall U.S. financial system is impossible to quantify according to the Senate report. It tells us the following:
“Large partnerships – which include hedge funds, private equity funds, and publicly traded partnerships – are some of the most profitable entities in the United States. According to a 2013 preliminary report issued by the U.S. Government Accountability Office (GAO), ‘[i]n tax year 2011, nearly 3.3 million partnerships accounted for $20.6 trillion in assets and $580.9 billion in total net income.’ That GAO report also found that the IRS was failing to audit 99% of the tax returns filed by large partnerships with assets exceeding $100 million.”
We don’t know what’s going on with those 3.3 million partnerships and their $20.6 trillion in assets. We don’t know if the biggest banks on Wall Street have similar arrangements where they are offering 20 to 1 leverage. Until we know, to borrow a phrase from bestselling author, Michael Lewis, we’re all “dumb tourists” when it comes to Wall Street.