Wednesday, December 1, 2010

Of Smoke and Fire

What, exactly, is insider trading? Do you know? I know what we all think it is, which is:
      a.      Trading on information of an unannounced impending takeover; or 
      b.      Trading on non-public knowledge of an earnings announcement

Ivan Boesky. Bud Fox and Gordon Gekko, right?

The problem is, the government doesn’t seem to have the same clear-cut view of this that we all do. It could be that they are making it up as they go along. The key seems to be what constitutes “non-public knowledge,” and how it is one comes to possess it.

But before we get into that, let’s look at who they are targeting. Can we draw any conclusions?

I will say up front that I have no idea whether any of the firms that were raided by the FBI have done anything wrong, either by the standards above or the evolving standards of the government. Indeed, at least two of them, Level Global and Diamondback, are now saying they are not the targets of any government investigation, something the U.S. Attorney's Office has confirmed. 

The odd thing here is that the FBI can't just raid a firm because they feel like it. A judge has to agree that there's probable cause that a crime has been committed. I have spoken to someone familiar with the ways of U.S. Attorneys, and the explanations for this can be any one of the following:

  1. Level and Diamondback did nothing wrong but there could be evidence on premises of wrongdoing by others (this seems a stretch - there's evidence, but these firms weren't involved?)
  2. The firms are not being targeted but the Feds are narrowly looking at one or two rogue employees within those firms. Diamondback has placed a portfolio manager on leave, which would seem to underscore this theory.
  3. The firms are not "targets" of an investigation but are "subjects" of an investigation. That means that the Feds believe the firms have committed crimes, but they need more evidence to prosecute. An indictment is not imminent, but could come later. If this were the case, Level and Diamondback are engaging in some language parsing. However, the U.S. Attorney coming out and confirming that they are not "targets" suggests that they are probably not subjects either. The Feds were under no obligation to say this, and probably wouldn't if an indictment were in the offing.
Based on what we know, I'd say "2" is the likely explanation.

What all three firms have in common, though, is that they are all were spawned by Steven Cohen’s SAC Capital Advisors, a tremendously successful and aggressive shop that specializes in high turnover trading strategies. It doesn't take genius to figure out that SAC is the primary target here. The smoke is everywhere.

But is there fire? 

The most curious thing, to me, about SAC is its track record: reputed to be about 30% average annual returns since 1998. I know what you’re thinking, 30% is outstanding but not impossible. Buffett’s is 21.5%. But here’s what you don’t know: unlike Buffett, SAC reputedly charges a whopping  50% incentive fee, which would mean they’ve averaged in the neighborhood of 60% gross returns. This is the part that’s a little hard to understand.

To further explore the comparison, Buffett makes his money by making significant long term bets on undervalued companies. He sees trends before most and has the stomach to make big bets when others are gun shy. It’s easy to understand that once in a while someone might come along who is just very good at this.

Or, it’s equally as easy to understand how once in a while someone is just very lucky. Buffett doesn’t make a lot of investments, after all. Maybe he’s just been on a multi-decade streak of sevens. While it’s improbable that any one person can do this, it’s actually highly probable that a random investor out of a large pool will.
If I had to say, Buffett's career has been the result of both skill and good fortune, not unlike most successful careers.

SAC reputedly trades on information flow and quantitative modeling. I know something about the latter, since it’s what I used to do. I got out of that business because I no longer saw an edge. Everyone now has access to both computational power and data, and everyone knows the basic approaches to use.  It’s possible to occasionally find an edge, but it disappears quickly. This didn’t used to be the case.

It's hard to see where they get enough of an edge with information flow, either. Advantages here tend to be fleeting as well, and while a small fund might be able to meaningfully exploit meaningfully an edge, SAC manages a beastly $12 billion. Difficult to see how they can move that elephant around quickly enough. Also, $12 billion is a non-levered number. In reality, it's probably more like $25 or $30 billion.

How about luck? If Buffett’s lucky, isn’t it equally likely that Cohen could be lucky as well?

No, it’s actually far less likely (although not impossible). Two reasons for this. First, Cohen’s 60% gross returns blow Buffett away. Instead of being a five sigma event, as some have suggested of Buffett, Cohen represents a far crazier improbability.

Second, Cohen is placing thousands upon thousands more bets every year than Buffett. This matters because it increases the odds that his lucky streak will end. To understand this, it’s easiest to think in terms of flipping coins. How easy is it to flip heads once? Pretty easy. 50/50. How easy is it ten times in a row? One in 1,024.
Buffett doesn’t toss the coin too often. He makes large, infrequent bets. Cohen, on the other hand, makes lots and lots of smaller flips, making it far harder to beat the odds. Further, it wasn’t just Cohen beating the odds; his spawn were doing it as well, albeit for a shorter period of time.

So, while I don’t know of the specifics, let’s just say it looks circumstantially…interesting. Honestly, I don't know how you make 60% even with inside information. A whole lot of things have to be working for you to get to 60%. There are lots of smart people out there, and they don’t come close.

For the record, I doubt very highly they ever trade on what you and I think of as inside information. It doesn’t make sense on a number of levels. 

The real question is the use of so-called “expert networks” and what sort of information is being obtained. The Feds are suggesting there that funds have pushed too far into this legally gray area.

On the other hand

I believe the government may be doing the same from the other direction. They want bad guys, and they want them now. That insider trading laws are poorly defined is highly convenient.

So, what is insider trading, exactly?

Case Study #1

You are sunbathing and you over hear a CEO say they have engaged Morgan Stanley to seek buyers of a subsidiary. You buy shares of the subsidiary and make a tidy profit. It just so happens, this is exactly what happened to Barry Switzer, former Super Bowl coach. Guilty? Yes, according to the government. No, according to a judge in that case.

Case Study #2

You are a rail yard worker and you see an unusual number of suits being given tours. You buy your company’s stock figuring someone’s looking to take it over. It turns out you're right. Guilty? The SEC thinks so. This case is still pending.

What if you have a friend who is a cashier at Staples and you ask them how back-to-school sales are going? Is it inside information? Unclear. The government may think so.

What if you sit in the Staples parking lot and count customers, and then make assumptions about how much people are spending? Isn’t that just good research? Hmm, maybe not. After all, not everyone has that information. You have an unfair advantage, even if you created it out of your own hard work and diligence.

The point is, when laws are poorly defined, overzealous prosecutors can use them to criminalize almost any kind of behavior.

And let’s face it, this administration needs villains. It’s Orwell 101, a state of perpetual war to justify every increasing incursions into domestic liberty. They have methodically rifled through other industries - oil, insurance, health, etc. – but Wall Street plays best, according to the polls. Mark my words, they will try to put faces on this, to make it personal. Nothing would make them happier than bagging Cohen.  He is conveniently non-photogenic.

And there’s this:
The Cohen Spread

Yes, those are private golf holes in the back and a skating rink to the left. Hard to see the ice cream parlor from this altitude (it's there).

 This Is Art

Cohen paid a reported $12 million for a shark floating in formaldehyde. (Supposedly, it’s starting to decompose, but hey, he probably got a few good years out of it.)

It’s all fine, as far as I’m concerned. A little garish (okay, a lot), but people are entitled to spend their money how they please. It doesn’t mean I have to have them over for dinner. Problem is, that’s not how Obama sees it. He doesn’t understand how it’s possible to accumulate wealth like this legitimately, and bringing folks like Cohen down to size, through whatever means, is just another way to redistribute wealth.

This is why it doesn’t bother anyone in government that when they raid a financial firm’s office –particularly a hedge fund - they no longer even have to prove their case. They know full well they may have already destroyed the business. Investors are just too freaked out these days by reputational risk to hang around. All parties may have the comfort of being completely innocent, but it may be from the ruins of what they spent years building.

Lastly,  there is Cohen's apparent political transformation. He gives a lot of money to politicians, and in 2006 it went exclusively to Democrats. In 2008, he spread things around roughly 50/50. For instance, he gave money to both the Democrat and Republican Campaign Committees (hate that!). He gave to Reid and Baucus but also Mitch McConnell and Eric Cantor. Interestingly, not a cent to Obama.

Like a lot of folks in the financial community, though, Cohen has been given pause, presumably by Democrat spending and regulatory excess. In this year's election cycle, he gave every last cent to Republicans. Is there a little retribution in the works? Make an example of Stevie so everyone else learns their place? With our current administration, there are too many examples of thugishness to rule this out as a possibility.

So, there you have my take on this from two different perspectives. If you had to pin me down, I’d guess that SAC and others on the government hit list didn’t commit acts of insider trading but that they were very aggressive about what they viewed as legitimate information gathering. But I also think that the government is being equally aggressive, maybe unfairly so, in the other direction. The question is where did the investment firms draw the line, and where is government now deciding to draw it.

In the end, perhaps some good will come out of this in the form of better understood law.  One hopes it is not at the cost of the reputations and careers of the innocent.

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