On July 21, 2008, Hank Paulson, the then US treasury secretary, met around 15 major hedge fund managers at the offices of Eton Park in New York — itself one of the biggest hedge funds in the world. At least five of the 15 who attended were ex-Goldman Sachs, the firm that was headed by Paulson before he became the treasury secretary.
That very morning, Paulson had spoken to The New York Times reporters and editors and had assured them that the government was looking into the book of Fannie Mae and Freddie Mac, and that this would calm the markets that had been fearing an imminent bankruptcy of these firms.
But in the meeting with the hedge funds later that day, Paulson sang a completely different tune: he revealed in precise detail (according to someone who attended that meeting) what the government proposed to do with Fannie and Freddie. He told the elite group, whose sole business was to profit from any superior knowledge and analysis of events, that the government planned to seize the two firms, and place them into “conservatorship”: a move that would allow the firms to stay in operation, but would wipe out the equity holders.
This was material, non-public information, being selectively disseminated to a group of people whose jobs were to profit from such information. And, by no less than the serving treasury secretary. (Imagine the brouhaha if something like this were to happen in India.)
Those who attended were the who’s who of Wall Street: Taconic Capital, James Chanos of Kynikos Associates (a known short-seller), Steve Mandel of Lone Pine Capital, Dinakar Singh of TPG Axon, GSO Capital (part of Blackstone group), Daniel Och of Och-Ziff and Roger Altman of Evercore Partners.
Seven weeks later, on September 6, the government did indeed take over Fannie and Freddie and put it into conservatorship, wiping out the equity holders. Their stock prices fell 85 per cent from September 5 to September 6, i.e. overnight. Precisely as Paulson had told the hedge fund group.
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The government gave scanty information on the names of those present at the July 21 meeting to Bloomberg, who sought this information under the Freedom to Information Act. Paulson’s press secretary told Bloomberg to refer to Paulson’s book on the financial crisis, On the Brink. Except for the little inconvenient fact that there is no mention of this meeting in the book at all.
Now, here is an interesting thing: the fund manager who recounted this tale to Bloomberg, was already short the stock at the time of the meeting. And, he did not cover his short position after this meeting because Paulson had clearly informed the group that the government was going to “wipe out the equity holders”. So, by not cutting his already short position in these names, that fund manager ended up profiting handsomely, by riding the short position all the way to the bottom… all based on Paulson’s generous advice.
And, what is even more significant is that given the negativity surrounding Fannie and Freddie at that time, it is almost given that nearly all those who attended that Paulson meeting would have been short these stocks. The whole world was short Fannie and Freddie (for the record, short interest in both these stocks rose after the July 21 meeting to hit a yearly high on July 24). Paulson revealing the government’s hand made the decision very easy for all these funds: “Don’t cut your shorts, since these stocks are going to zero.” Perfect.
What is even more curious is: why would Paulson reveal this to a bunch of hedge funds? Revealing this to commercial bankers would probably have some minuscule sense attached to it, i.e. to get them prepared for an impending catastrophe. But, hedge funds? And, an even more damning question arises: why would Paulson reveal negative information to these hedge funds, i.e. that the equity investors would get wiped out by the government takeover? This sort of information from a regulator/government official is unheard of: they are supposed to give out generally positive information, not catastrophic, unsettling information like this. Paulson’s information could lead to only two trading outcomes: one, hang on to your shorts in Fannie and Freddie, or, two, go short some Fannie and Freddie. This short-trade generating advice coming from a regulator, and that too a seasoned pro like Paulson, is extremely suspicious, to say the least.
If this is not giving out material, non-public information, then what is? If Rajat Gupta is guilty, why isn’t Paulson? If Gupta had given Raj Rajaratnam information that Goldman Sachs was going to get an investment from Warren Buffett (and suppose, if Rajaratnam had not sold an already long position in Goldman stock based on this material, non-public information), would this have amounted to a criminal offence on Gupta’s part?
Of the many things I don’t like about this Rajat Gupta affair, one is the Indian media’s sickeningly fawning portrayal of the American justice system as one that “doesn’t spare the rich and powerful, unlike ours where the well-connected get away”, and “how justice is dispensed speedily in the US”, and so on.
Nothing could be farther from the truth. The US protects its own rich and powerful better than we can ever do. Paulson got away clean. Not even an investigation. No investigation by the Securities and Exchange Commission into the trading by these attendee hedge funds. Nothing. Just a conspiracy of silence.
Then, we have the strange case of David Sokol. He was Buffett’s No. 2, and was widely tipped to take over from the old man. Sokol bought shares of Lubrizol, prior to getting Buffett to buy the company outright. After the deal was done, Sokol told Buffett of this purchase. Buffett waved it aside, saying it was no problem. No problem? Sokol traded on inside knowledge of material, non-public information, and Buffett joined him in keeping this a secret.
When the problem came out, Sokol resigned, Buffett shrugged. And, that was it. The cover up had happened. Because any serious investigation would have led to Buffett himself becoming a party to any offence, since he chose not to report this to the authorities. Consideration for his old age? Well...
PART TWO
Shankar Sharma: American idolatry in the US legal system
The writer is Vice-Chairman and Joint Managing Director, First Global
This is the first of a two-part series. Read the second part