Modern Investing

by David Schneider

  Two minutes after the opening bell on the New York Stock Exchange, Nortel Networks reported terrible earnings and earning forecasts. During after-hours trading, their price had plummeted more than 10%, and Rajaratnam had made a killing. It was apparent that some cronies had tipped him off a couple of hours before the company released its earning news. The letter to the investors was just an alibi to justify his abrupt investment decisions.

  Rajaratnam was known for pushing his employees to get “an edge” on Wall Street, to justify their high salaries and bonus payments, and he lived by his own philosophy. But, as is usually the case, his own success caused him to be complacent and sloppy in his research and trading activities. He simply didn’t know when to stop, because he thought that he had a foolproof, working system. After all, it had worked for several years, by simply creating bogus research reports and alibis. But in the end, the evidence was too great for him to escape; his sloppy behavior led the FBI to bug his entire office.

  Rajaratnam is a rare case because he didn’t get away with it, even with the support of an army of accomplished and expensive lawyers. Steve Cohen, on the other hand, founder and manager of SAC Capital, settled all charges against him in a civil lawsuit brought forward by the SEC for failing to supervise his staff. That was, of course, after he was cleared for insider trading himself, which was entirely the doing of his minions – or, at least, that’s what the final judgment was. Mathew Martoma, a former employee, was sentenced to a 9-year spell behind bars. According to prosecutors, Martoma accumulated profits of $276 million based on insider information during his time at SAC Capital. The company and Steve Cohen agreed to stop managing funds for outsiders, but paid a $1.8 billion fine, a small amount considering Cohen’s overall $15 billion fortune. He is now managing his money in a family office closed to the public. Recently he has been hailed as a tremendous philanthropist for being very generous with the funds of his own family foundation, the Steven & Alexandra Cohen Foundation.

  Insider trading is the true edge for a few professional investors, as it increases their odds of winning dramatically; and hence, allows them to increase the stakes and the amount of money they can place on these bets. Going to great lengths in attaining insider information is still worthwhile. The range of possible sources is endless, whether we are talking about hot IPOs, new product launches, the release of bad earnings news or any other market moving news, including spreading rumors and false reports. Insider trading will always be a gray zone, difficult to prove, and hard to track down. The official definition is already a mouthful: Illegal insider trading refers generally to buying or selling a security, in breach of a fiduciary duty or other relationship of trust and confidence, while in possession of material, nonpublic information about the security.42 How on earth are you supposed to know it when you see it?

  Front Running

  Another technique is “front running.” The textbook definition of “front running” is “the practice by market-makers of dealing on advance information provided by their brokers and investment analysts, before their clients have been given the information.”43 It simply means that a party with fiduciaries duties is in possession of order information about their client’s immediate investment decisions. Hence, they can overcharge their own clients or sell this information to a third party for a cut of the trading profits. Imagine you call your broker with an order to buy 100,000 shares of Google. You want it done as soon as possible for the best price. He takes your order and calls his prop trader on another floor to buy a similar amount of Google shares. When the prop trader has completed the position, your broker buys the same amount of shares from the prop trader, with a slight price premium. Voila! Risk-free gains for the investment bank, and a perfect team play. The customer is also happy. He got his 100,000 Google's shares for slightly more than necessary, but how would he know? This is old-fashioned front running. Front running has been part of the system since Amsterdam opened its doors over 400 years ago.

  However, in modern times, Wall Street took front running to a new level. In 2003, for example, New York Attorney General Eliot Spitzer began to investigate a spate of illegal late trades and suspicious market activities. After an investigation, it became apparent that some hedge and mutual funds were cooperating with each other to maximize their profits through insider trading and front running.

  How was that possible?

  You must understand that much market-moving news is published after the closing prices of many mutual funds are determined and announced. Those who are able to purchase these funds, at the current day closing price, after these market moving news are revealed, have a clear information advantage. The logic behind this trade is simple: be the first in before the general market can react to news, and be the first out in the morning, when markets have time to react. On the surface, this is nothing new. In 1968, there were cases of front running and market timing investment fund prices that allowed some few chosen clients to profit from a simple information advantage. The depth and reach of this scandal in 2003 shocked even the most hardened investors. Names such as Putnam Investments, Janus, and Invesco were involved. Worse was that their behavior clearly harmed the interests of the majority of their own clients.

  Alerted by Spitzer’s investigations, and a bit late to the party, the Securities & Exchange Commission (SEC) launched its own investigation, which uncovered even more dubious practices among the leading mutual fund companies, which included the practice of front running in individual stock holdings rather than mutual fund prices. The SEC claimed that “certain mutual fund companies alerted favored customers or partners when one or more of a company's funds planned to buy or sell a large stock position. The partner was then in a position to trade shares of the stock in advance of the fund's trading. Since mutual funds tend to hold large positions in specific stocks, any large sales or purchases by the fund often impact the value of the stock, from which the partner could stand to benefit.”44

  To clarify this situation, imagine a huge Boston fund management company that sells or buys a medium-sized company with market capitalization between $2 and $10 billion, and distributes the purchases across all these funds at the same time. This will, inevitably, move up the stock price of the company being bought or sold, because people will see that the trade turnover has skyrocketed. Crucially, people with advanced knowledge about the fund’s investment decisions could take a position in advance, usually with borrowed money to maximize gains before the fund executes its trades. Once the order flow of this big fund hits the markets and the prices increase, the same people will sell their accumulated shares to the fund with a profit.

  As in the cases above, many easy and relatively risk-free gains on Wall Street rely on a simple principle that I like to call “First in, first out.” If you look closely, most financial cons and Ponzi schemes work on the very same principle. The “first in” enjoy the most favorable prices, which guarantees them the easiest and biggest return potentials. What usually follows is the release of market moving new or an elaborate promotional and marketing campaign, to shift the supply and demand balance that causes prices to increase. With superior and advanced knowledge, the same operators are also the first to leave (first out), cashing out to secure their gains. Today, they might be considered “smart money.”

  Flash Traders

  With the increase in trading speed and the rise of technology on Wall Street, we can see the new form of front running described in Michael Lewis’s Flash Boys: A Wall Street Revolt. Imagine you want to purchase an ETF or single stock through your online broker. You set up your purchase order on your electronic order form close to the current market price. But somehow, whenever you hit the buy button, the price suddenly increases, making your purchase order more expensive. It’s as if (cue the X-files theme) someone knew exactly what you were going to do and what your order details are. In the process, they are buying it cheaper from the market and selling it to you for a slightly higher price. That’s classic front running: very s
mall profits, but risk-free. If you multiply it by the daily billion dollar trade volumes that are traded on NYSE alone, some fantastic profits can be racked up quickly.

  How is that possible? High-speed trading. Those who have access to the fastest trade execution and friendly Wall Street brokers with stuffed trading books can win over your orders and make those tiny little profits. It’s simple—the trader with the fastest trading system wins and gains a tiny, risk-free profit every time.

  What has been revealed by Michael Lewis's detailed accounts has caused havoc on Wall Street, with brokers, exchanges, and high-frequency traders targeted in FBI operations, and some federal investigations still ongoing. It has also revealed– again– the enormous complexity of trading systems, technology, and software involved and those few who are able to capitalize from this complexity and gray zones of regulations.

  Market Manipulation

  If you are a trader and your annual bonus is coming up, but the performance numbers don’t look good this month, you need divine intervention. Or you could take the future into your own hands with a familiar technique called window dressing.

  Window dressing is a simple form of price manipulation where you put in a large buying order at the very end of the trading day of a calendar month, and the price of that stock in question moves up a few percentage points. Who cares what happens the next day? All that counts on paper is the last price of the previous trading day, because that price determines performance numbers and bonus payments. Hence, according to one definition, “Market manipulation is a deliberate attempt to interfere with the free and fair operation of the market and create artificial, false, or misleading appearances with respect to the price of, or market for, a security, commodity or currency.”45

  In an interview with Jim Cramer with TheStreet.com, the former hedge fund manager and current host of CNBC's Mad Money, explained how he single-handedly manipulated the price of Blackberry (formerly known as Research In Motion) to his liking. These were the days when he was under pressure to make day trading profits at his hedge fund.46 Apparently, all of his buddies were doing the same, and he admitted that he learned the trade from his wife who was by far the better trader. Ironically, Eliot Spitzer, who uncovered so many Wall Street scandals, was an early investor in Cramer’s fund. Spitze decided to withdraw his funds for some election campaigns at a very inopportune moment for Cramer, nearly crashing his whole enterprise.

  There are many forms of market manipulation with names like “churning,” “layering,” “stock bashing,” or “pump and dump.” I recommend remembering only one scheme, “pump and dump.” Imagine that I published on my Twitter feed a new trading idea in a micro-cap (so-called “penny stocks,” very illiquid and small and often dodgy companies with questionable business operations). You check the price on the trading screen of your online broker and notice that the price has gone up for the last week by more than 10%. Eager not to miss out on this lucrative opportunity, you decide to place an order for $10,000. After all, you have been following my trades on my blog and Twitter feed. The few trades I published have all been profitable. While you complete the electronic order form, the price moves up and is running away from your limit order. But damn it, now you want it even more; and finally, your order gets filled at a much higher price. It is almost as if someone knew you were buying these stocks.

  You check the price of the stock every day, and you are very pleased with the development. Your position now displays a 20% profit. And then, abruptly, I call it a day, sell all my stocks, and make a quick and easy profit of more than 30% for three weeks work. While I take victory laps in my office, open a bottle of champagne, and probably meet my buddies for cigars (and more, because I am terribly debauched), the penny stock drops like a stone. It finally trades below where it started a couple of weeks ago. Your portfolio now shows a fat, red minus of more than 20%.

  You have been the sucker all along and became a victim of a semi-legal, but very unfair “pump and dump” game. It was a simple scam. I purchased stocks of a very illiquid listed company way in advance. Through my tweet and email campaign, I caused several buy orders from my loyal followers, causing the demand and supply of this particular stock to shift and the stock to rise. You just saw the end result of a covert operation that simply appealed to your own senses and the inner urge to follow up on easy gains. But as soon as I see the share price hitting my profit targets, I sell my shares to all those naive latecomers eager to grab them out of my hand at inflated prices. You might have been the last in the loop.

  In the end, you decide to close the position, because you can’t stand seeing the big deficit as a reminder of your gullibility. But, you swear never to trust me ever again. The following week you get an email in your mailbox that catches your attention: “How to Trade Penny Stocks for Big Profits,“ and the dreadful cycle repeats itself. Judging from my spam folder, this is what takes place day in and day out. As they say, "There's a sucker born every minute."

  The Libor Scandal 2012

  The previous example of market manipulation is nothing compared to the Libor Scandal. Libor stands for the London Interbank Offered Rate. It is connected to the well-coordinated work of a few prop desks at leading investment banks. The Libor Scandal was essentially one of price fixing. Think of the interest rate on a loan as the “price” of money. If you give me $100, and I agree to return $105 to you in three weeks, then technically, I am paying you a $5 premium for your $100. In international currency trading, this $5 premium is determined by the Libor rate. The Libor is an average interest rate calculated through submissions of fictitious rates by major banks across the world, connected to approximately $350 trillion in bonds and their respective derivatives.

  On July 27, 2012, the Financial Times published an article by a former trader which stated that Libor manipulation has been common, since at least 1991. There was an immediate uproar, as the manipulation had a direct impact on many other securities traded worldwide. U.S. markets were particularly affected, as U.S. fixed income securities such as mortgages, student loans, financial derivatives and other financial products have been using the Libor rate as a reference rate for many years.

  Since the scandal, academics and law firms have been trying to answer an urgent question: how much did the banks make off this? Well, so far, Barclays, UBS, and the Royal Bank of Scotland Group, all of whom were involved, agreed in 2014-15 to pay a combined $2.6 billion to resolve U.S. and European regulators’ claims. Twelve global banks that have been publicly linked to the Libor rate-rigging scandal face as much as $22 billion in combined regulatory penalties and damages to investors and counterparties, according to Morgan Stanley estimates.47

  Whatever the real economic damage was, the total penalties paid by banks are peanuts relative to the size of the entire market they have been manipulating for all those years. It is also a fact that the few bankers and traders responsible for the damage have never been prosecuted individually, while all those mutual funds, index funds, pension funds, and many more financial institutions fed the bill. I am sure that you have a real financial interest in any of those paying patsies, and all done with the money of savers and investors.

  CHAPTER 9

  PUTTING IT ALL TOGETHER

  “That some minority on Wall Street is getting rich by exploiting a screwed-up financial system is no longer news.”

  – Michael Lewis

  Let me tell you a story about the early prop desks on Wall Street. Robert Rubin, Treasury Secretary under Bill Clinton and former COO of Citigroup, was part of a prop trading team at Goldman Sachs in the 70s. At that time, he worked, by today’s standards, a fairly elementary trading strategy called M&A Arbitrage or Risk Arbitrage.

  Imagine Company A announces that it’s going to buy Company B in three months. In order to entice shareholders of B to sell their shares, company A usually offers a substantial premium to current share prices. The share price shoots up (sometimes dramatically). But there usually remains a price different
ial between market price and offering price, the price that the bidding company offers to shareholders of company B. This is called a spread and reflects the market’s view of how likely the deal will be completed successfully. The spread can be positive or negative, depending on how likely the market considers a positive outcome. The higher the risk of a failing deal, due to regulatory or antitrust issues, the higher the spread. The spread shrinks with each passing day until the predetermined date is reached and cash flows from company A to shareholders of company B. The deal is completed and the player who traded that spread made a nice profit. It’s a fantastic trading strategy if you pick the best deals and the best spreads. But it is not risk-free, as deals do get canceled, and in that case, the prices drop dramatically back to the level before the takeover bid.

  This was the strategy Robert Rubin practiced and it taught him to think in probabilistic terms– a bit like a gambler calculating and assessing his odds. The interesting thing was that, at that time, Goldman Sachs wasn’t that active in sourcing their own M&A deals as a traditional merchant bank. It seems that they truly aimed at avoiding any potential conflicts of interest between their own trading activities and their fee business. Goldman Sachs was still a partnership back then and required all partners to hold their private fortune against all possible losses and lawsuits. Only later did they become a global M&A powerhouse, with a giant internal hedge fund attached and a public corporate structure designed for profit maximization. They went public in 1999 in the middle of an epic tech bubble, making their partners wealthy beyond the wildest dreams of any of Goldman’s founders.