Evil genius: Hedge funds and the perpetual political machine


by Dean Scontras

I find myself struck—though not particularly surprised—by the short reach of the recent “Congressional Insider Trading” bill. Congress, of course, gratuitously patted themselves on the back for their “accomplishment,” and given that the complex world of finance and sophisticated trading often befuddles the average voter, they are likely to get away with their short sightedness.

But I, for one, remain skeptical, specifically because of the gaping loopholes that remain in the system, even after the passage of that legislation.

What loopholes? To start, left out of the so-called reform bill was any inclusion that would forbid a member’s spouse from trading on congressional information. Seems like a rather large omission, no?

It makes one wonder: What if said spouse, say, operates a billion-dollar hedge fund? Can this hypothetical spouse’s hedge fund short ethanol futures if they innocently discover, perhaps over a casual family dinner, that it is highly likely Congress is going to reduce ethanol subsidies in the upcoming farm bill?

Let’s face it, you can make a lot more money trading with the billions in a hedge fund than with the thousands in your personal savings.

Or, what if, just say, this couple happens to be good friends with the chair of the House Banking and Finance committee, and they just so happen to take vacations together every once in a while to the Virgin Islands? What if, while on a four-hour plane ride over international waters, the chair of the Banking and Finance committee (after one too many Mimosas) shares with the spouse of the member that they will pass some historic legislation.

Perhaps it’s the most sweeping legislation over the financial industry in a generation, and he plans to name it after himself and the co-sponsor in the Senate, Chris Dodd.

In Chapter 7 of his book entitled “Throw Them All Out,” Peter Schweitzer looks at how some hedge funds gain access to Congress to increase their funds’ returns.  He writes: “Perhaps the best investment a hedge fund can make these days is not for a financial wizard, but a politician.” The fact is that politically connected hedge fund managers and billionaire financiers can make a lot of money based on information gleaned from politicians and government officials.

Consequently, the spirit of finance and all that would normally be competitive about fully functioning capitalism and normal rates of return is perverted with congressional-crony capitalism. It seems as though now any financial firm’s success is not a function of its ability to compete, but rather its congressional relationships. Subsequently, as the hedge fund gets bigger, the returns do too. Wash. Rinse. Repeat.

A hedge fund is only as good as the capabilities of their internal quantitative analysts, or “quants,” as they have become popularly known. Quants are mathematical geniuses who develop sophisticated, proprietary software models that can make thousands of transactions in seconds.

One of my favorite quotes about quants and their “models” came from someone at Goldman Sachs, when they discovered someone was trying to download their proprietary “model” to a server in Germany. The Goldman guy said: “That model in the wrong hands could be used to manipulate the markets.”

Hedge funds are not limited to the normal buying and selling of stocks that you and I are accustomed to doing on E*TRADE. Hedge funds participate in many complicated “derivative” transactions that those of us without a Ph.D. in quantitative math will never understand. Regardless, perhaps more critical than the model itself, is the accuracy of the data inputs. The better the information funneled into the model, the better the outcomes.

Theoretically, this equation (tradable political info + quant = $$$) could be used to perpetually fund a political operation as long as there was access to important policy makers. Early, actionable information results in greater profits; greater profits are funneled to political causes, candidates; etc.

The evil genius is that it is legal and that the lack of transparency into hedge funds prohibits the general public from ever knowing if the spouse of a member is participating in such a matter.

So, forgive me if I don’t get excited about Congress’s latest attempt to legislate itself. As always, they tried to make it look like they accomplished something meaningful, while perpetuating the problem they supposedly solved.

The system remains rigged, and the well connected continue to profit.