Gupta’s answer: “Yeah. This was a big discussion at the board meeting.” However, he added that he would be surprised that the firm’s desire to splurge to buy a bank was “imminent.” For one thing, Goldman had no funding problems just yet.
Was that enough to nail either party? Not by a long shot. The information wasn’t acted upon, and in and of itself, knowing that Goldman was considering something that was rumored in the market took away from the standard of nonpublicness that a dirty tip would have to meet.
But it was a start, and given Gupta’s apparent comfort level and ease in sharing with Rajaratnam board discussions that were supposed to remain confidential, the investigators were sure better stuff awaited.
That better stuff came a few months later, in September 2008. Lehman Brothers had just filed for bankruptcy and the entire financial system was in turmoil. A massive government bailout was unfolding, one that would inject tens of billions of dollars into the remaining investment banks.
And still it wasn’t enough to calm the jittery markets as investors continued to sell the shares of financial firms and refused to lend them money to finance their operations. For Goldman, buying a commercial bank like Wachovia never looked so good except for the fact that Wachovia was now in trouble as well. It was about to fail, as its investments in housing-related securities tore into its balance sheet (as similar housing bubble deals did to the rest of the banking system).
But Goldman being Goldman, historically one of the savviest and most creative firms on the Street, came up with a solution—a $5 billion infusion of cash from legendary investor Warren Buffett.
The Buffett investment was controversial for several reasons. Some critics would say he traded on something similar to inside information, knowing that Goldman was being bailed by the federal government through various post-crisis programs, including the Troubled Asset Relief Program, or TARP. The same charge would be made against several lawmakers who traded in and around the crisis. Yet such moves were perfectly legal under the law. Buffett and these lawmakers may have had an informational edge against the average investor but it was in the type of information that was legal—it wasn’t misappropriated from any company, just possibly the massive rumor mill known as the U.S. government.
Goldman, meanwhile, was less focused on any insider trading around its stock than it was in surviving the tumult as investors began dumping shares and closing lines of credit to a bank that had until now avoided the worst of the financial crisis. In exchange for the money, Goldman agreed to Buffett’s extortion-like albeit perfectly legal terms: Lloyd Blankfein, the firm’s CEO, said Buffett would provide Goldman with an immediate $5 billion in cash in exchange for preferred stock with a 10 percent dividend, as well as warrants to buy shares at $115, which were good until 2013. The investment, Blankfein knew, would ensure Buffett a huge payday, $500 million annually, or as Buffett later boasted, “we’re getting fifteen dollars a second from this investment.”
Rajaratnam, thanks to Gupta, didn’t do too shabbily, either, though unlike Buffett’s, his methods were far from legal. The Buffett deal was sealed during a board meeting on September 23, which Gupta attended via conference call; he dialed in from an office that he still had at McKinsey’s New York headquarters.
Then he called Rajaratnam with the news before it was made public. Goldman now had the blessing of the world’s most prominent investor; shares would almost certainly spike when that was announced the following day.
The conversation wasn’t recorded because rather than calling Rajaratnam’s cell, Gupta called his office phone, which wasn’t wiretapped. But investigators had a trace on Rajaratnam’s phone records and trading account. The Goldman board meeting ended around 3:50 p.m. and a few moments later, records indicated, Gupta called Rajaratnam. Just before the markets closed, Rajaratnam began snapping up Goldman shares.
He would earn a quick $1 million on the trade, and as he would explain in a telephone call that was recorded with a Galleon trader, “I got a call, right, saying something good might happen to Goldman.”
The “good” that was happening wasn’t confined to Goldman’s bailout. It also included the increasingly airtight case against Rajaratnam and his cohorts. By the end of 2008 and into early 2009 dozens of people were facing charges in one form or the other from the Kang investigation, and dozens more were being developed separately by the Chaves/Makol squad, with Wadhwa in the middle.
One irony still lost on the government apparatus assembled to take down Rajaratnam and Gupta and possibly larger players in the future was that the biggest insider trading investigation in the nation’s history was coming together at a time when the public couldn’t care less about insider trading.
Investors were now shell-shocked by far bigger issues; between the end of 2008 and March 2009, the country would go through wrenching change, including a new president, after Barack Obama, a junior senator from Illinois, beat his Republican challenger, Senator John McCain of Arizona.
Even during the height of the financial crisis, Obama was receiving huge contributions from the big Wall Street firms and many hedge fund players—in part because he was the likely winner, after a Republican had held the office for two terms, and in part because in private meetings he seemed very smart on economic matters.
But within a few weeks of his election investors saw something else in the new president: He was a novice when it came to the economy. That realization began to set in when he selected an unsteady bureaucrat, Timothy Geithner, then the president of the New York branch of the Federal Reserve, to be his Treasury secretary.
The markets initially cheered when Geithner was appointed because he was seen as one of the architects of the bank bailouts and had knowledge of the financial system. But it wasn’t long before he started making public statements about the economy and the banking system that gave investors just the opposite reaction, sending the Dow Jones Industrial Average to around 6,000—its lowest point since 1996—in March 2009.
It didn’t help, of course, that Obama and Geithner and the SEC had the financial crisis to contend with, or the Bernie Madoff scheme to unravel. But one thing is certain: Investors made it clear that their lack of trust in the economy or the markets was grounded in simple concepts: They didn’t believe in the health of the financial system or the acumen of the new administration enough to jump back into the markets.
Insider trading, much less Rajaratnam, Steve Cohen, or any of the other traders on the government’s unofficial white-collar crime most wanted list, wasn’t on public investors’ radar.
Yet even with a new SEC chief, Mary Schapiro, and her new enforcement chief, a former prosecutor named Robert Khuzami, the insider trading investigation rolled on. For a few months after joining the commission, Khuzami decided to “recuse himself” from the Galleon portion of the investigation. Before taking the SEC post he had been general counsel of Deutsche Bank, which did business with the hedge fund. But not Schapiro, who was appointed SEC chief by President Obama, approved by the Senate, and shortly after held a private meeting with Wadhwa on what he had been doing for the past two years.
Wadhwa was said to be impressed with the show of additional support. He had never met Chris Cox, and he wasn’t even sure Cox knew about the Galleon probe. But Shapiro did, it appears, almost immediately when she started to run the agency.
The reason was simple: Word of Wadhwa’s success filtered through Washington, and for the political types who run the SEC, insider trading was viewed as the easiest way to restore the agency’s reputation following the Madoff catastrophe and the image hit taken in the aftermath of the financial crisis.
The enforcement division of the SEC was known as an independent unit (within an independent agency), theoretically immune from political pressure by the presidentially appointed chairman. The reality is somewhat different.
The enforcement agenda is set by the chairman, a presidential appointee who bears the brunt of the political pressure exerted by the White House.
Arthur Levitt, the longtime SEC chairman, appointed by President Bill Clinton, created the image of being a crusader for the small investor, installing rules that were supposed to democratize the release of company information among small and large investors. But he also ushered in an era of deregulation of the securities business—a move advocated by Clinton when he signed into law a bill that allowed commercial banks to merge with investment banks.
There would be much wealth creation in the Clinton years, of course, bolstered by the big banks that were created after the passage of the Gramm-Leach-Bliley “financial modernization” act. New mega-banks like Citigroup used all their financial might to take greater levels of risk and developed new and more profitable investments. The collateralized debt obligation was a way to package all kinds of consumer loans, from mortgages to credit card bills, into a bond that had the practical effect of allowing banks to extend greater and greater amounts of credit to more and more people regardless of their long-term ability to repay loans. Through financial alchemy, risk was being reduced by having bonds that were sold to other parties and not held on the banks’ balance sheets, or so the story went.
The banks created other ways to hedge it: The credit default swap (CDS) was an insurance contract that could theoretically cover any bond in the market. The holder of a CDS on the bonds of a big bank, for instance, would have a guarantee that the issuer of the contract (often an insurance company like AIG) would repay the bonds if the bank defaulted.
The conventional wisdom was that the banks wouldn’t, that is, until 2008, when they almost did.
Between the mega-banks that created bonds based on loans that couldn’t be repaid, and the insurance companies that created a hedge against the possibility that the financial system would implode, Wall Street became a tinderbox of risk. It was a bipartisan failure on the part of policy makers to understand the notion of risk and why and how it can spread.
However, many in the hedge fund business saw the house of cards for what it was, and they had the tools to make an easy killing. In 2007 and 2008, the best way to make a quick buck in the markets wasn’t just by being part of Rajaratnam’s circle of friends; there was a separate circle that involved calling a couple of your buddies and simultaneously shorting shares of bank stocks, and then buying the banks’ CDSs.
With the financial system on edge, simply buying the CDS would drive shares of bank stocks dramatically lower as investors saw it as a sign of imminent doom. The run on Bear Stearns, the first bank to fail during the financial crisis, began with a sharp increase in the price of its CDS contracts.
Top executives at Bear complained publicly that the company stock was being manipulated to death—literally—through rapid-fire purchases of CDSs and the simultaneous shorting of its stock that crushed shares. A vicious cycle ensued. Lenders pulled lines of credit, and shares fell further, and CDSs would rise. In just one week in March 2008, that process would lead to the demise of the firm (what was left was sold to J. P. Morgan). A similar cycle would play out in Lehman Brothers’ demise, and the rest of the big banks were threatened, too, before the bailouts saved the system.
The manipulation of the credit default swap became a brief and fleeting controversy during the financial crisis. It also exposed a form of insider trading that had a profound impact on the markets but went unaddressed by regulators. Bank executives like John Mack of Morgan Stanley complained to securities regulators during those dark days. To deal with it, SEC chairman Chris Cox banned short-selling of bank shares until the crisis had subsided. But the manipulation never emerged as an enforcement issue.
Of course, many factors led to the near demise of the big banks, but the fact remains that traders could make a quick and easy buck simply buying a credit default swap not for its intended purpose of hedging against a company’s debt but in fact to drive shares lower and profit off a short sale.
Bob Khuzami, the general counsel for Deutsche Bank’s U.S. subsidiary, knew as much about the practice as anyone in law enforcement even before he received the call from Schapiro to run the SEC’s enforcement division. While an assistant U.S. attorney in the Southern District of New York, he was chief of the securities fraud unit and focused on high-profile white-collar crimes, including an investigation of improper trading on the floor of the New York Stock Exchange.
His reputation for diligence got him a key assignment as part of the team that prosecuted the so-called Blind Sheikh, Omar Abdel-Rahman, for the 1993 bombing of the World Trade Center. Beginning in 2002, Khuzami decided to cash in on his government experience, taking a job as general counsel for the U.S. unit of the German mega-bank. He did so at a time of great excess on Wall Street in terms of risk-taking that spread even among foreign firms and their U.S. units. Deutsche Bank was one of the top packagers and sellers of toxic mortgage-backed securities to other firms—instruments that were a primary cause of the 2008 banking collapse.
Khuzami was hardly on the ground floor of the bank’s mortgage business, and as general counsel, he wasn’t in charge of the bank’s risk taking. But those untidy little facts were barely mentioned when Schapiro announced that Khuzami would now head the SEC’s enforcement division, the agency’s primary investigatory weapon against white-collar crime.
How well Khuzami fared is a matter of debate. Khuzami “moved heaven and earth” to bring cases involving mortgage fraud and the broader financial collapse, according to one senior SEC official. His record, according to the raw data, was impressive: During the Khuzami era, the SEC brought cases against 150 individuals for financial-crisis related activities and set new records for overall enforcement activity.
But the cases of CDS manipulation largely evaporated, as did major cases against executives from Lehman Brothers, Bear Stearns, and other big U.S. banks for broader abuses that led to the banking crisis. Brad Hintz, an analyst for Sanford C. Bernstein who covers brokerage stocks, had been called by government investigators just weeks after the September 2008 bankruptcy of Lehman Brothers about crisis-related fraud, but he never heard from them again.
In private moments with his staff and with reporters, Khuzami would explain the difficulties of bringing cases involving the financial crisis. The accounting gimmicks employed by Lehman during its final months were used elsewhere and received approval by major accounting firms. So, Lehman was simply listening to its auditors, who were interpreting accounting rules. No intent to break the law here.
A 2010 report by an auditor looking at Lehman’s bankruptcy said there were “colorable claims” against the firm’s senior executives for their crisis-related risk disclosures, but by early 2011, the SEC had all but concluded that it couldn’t charge any of them for fraud; not even a parking violation.
Maybe the bank chiefs really believed their firms would survive when they made all those statements projecting confidence in the face of mounting evidence that they wouldn’t survive, Khuzami explained at one point when questioned about the lack of cases. It’s hard to press a fraud case of misleading the investing public unless there is clear evidence of intent to mislead.
Or maybe Khuzami knew that the political clock was ticking, with President Obama gearing up for a second term and declaring war on fat cats, even if those fat-cat cases were taking longer than desired. Thanks to the work of Wadhwa and the people at the FBI, they had instant gratification in the form of insider trading.
Okay, you got me,” is how regulators describe the initial phases of Richard Choo-Beng Lee’s confession to FBI agents after a week of tense negotiations with his attorneys, ending with his agreeing to be the latest rat to cooperate. Lee was a prize catch for investigators; he was a technology geek with degrees in science and business and even chip making. He knew Rajaratnam well, having worked with the Galleon chief while they were both analysts at Needham & Co.
More than that, Lee had worked at SAC Capital and he knew Steve Cohen.
Lee had been on the government’s wish list for some time. Investigators simply referred to him as “CB.�
�� He ran a midsized hedge fund named Spherix Advisers, and as the SEC discovered through its maze of records and wiretaps, Lee had traded the same stocks that the Galleon chief had traded, and he had used some of the same illegal sources of information, including the same investor relations consultant who had alerted Khan to the Google earnings announcement.
But in the end, it was a Danielle Chiesi wiretap that finally did him in.
Lee and his business partner at Spherix, a trader named Ali Far, had as many connections as Chiesi in the Silicon Valley tech world, which is why she had kept them in her loop, and they kept her in theirs. Insider trading, the government had discovered, was like any other business in that information as much as cash was the currency that both parties relied upon. It was the quid pro quo that often mattered. With the government listening to various calls, the Lee-Far connection to the broader scheme became evident; both had access to the same Google investor relations executive from Market Street Advisors that Roomy Khan used. Meanwhile Chiesi shared with them tips she got from Moffat.
Kang made his first visit to Lee’s Silicon Valley home and offered Lee a chance to cooperate and avoid jail time. As the Galleon probe progressed, its list of targets and possible cooperators had unraveled in bizarre ways. Far was actually approached first by the FBI, and alerted Lee that the government was starting to ask questions about their trading.
Lee listened intently as Kang explained the situation, providing Lee with a little taste of what the government had as evidence by playing some of the wiretaps. Lee seemed interested but let his attorney work the details before fully committing. When the attorney heard the tapes he gave Lee the following assessment: Cooperate or face jail time.
Lee was considered a great “get” by the government because of his obvious connections to the Rajaratnam circle of friends, as well as to Steve Cohen, for whom he had worked early in his career. Rajaratnam and Cohen might have been competitors in the markets, but they were fellow travelers in the hedge fund business. Far, for example, was a former Galleon executive who remained in regular contact with Rajaratnam. The wiretaps were making the case against Rajaratnam rock solid, even as the case against Cohen had stalled. But Kang considered Lee a possible game changer.
Circle of Friends Page 21