Wordsmoker

I work for money managers. (I see you yawning, VwS, I’m still looking for boob pics of Meredith Whitney!). If you thought the SEC not catching Madoff was bad, commence laughing or crying now – because he was blatantly obvious. Had a trained monkey followed up on contradictory statements the SEC themselves noted in that 477-page mea culpa – he would have been caught. That they didn’t catch him means the rest of the asset management world quietly carries on cutting corners.

Here’s what happens when the SEC comes in. It’s never a secret, with doors being kicked in and everyone told to “FREEZE!”. All firms have security (guards, locked doors with cardreader, bored attractive receptionist reading Marie Claire) – and a legal team, most of whom are ex-SEC themselves. So we all know when the feds are going to show up. We have to keep our desks neat and if spoken to, must always have a company lawyer with us; if a document is requested, we only give the part they ask for (not the whole thing or even the whole page), and the company lawyer vets it first.

Not that much of that matters. The SEC lawyers look like they just came out of law school, their suits have the tags from Mens Wearhouse still on them, and they look – well, scared. They don’t want to be SEC lawyers forever – they want to be in-house at a firm just like this one and make some real money.

They set up camp in one of your conference rooms, use your kitchenette and bathrooms, and basically are guests in your home and made to feel that way – in a “you’re here at our pleasure” way and not in a “we’ll do whatever we can to make you happy” way. They tend to ingratiate themselves. Periodically, they pop up like meerkats and ask a question.

They can’t possibly go through all trading records for all funds at any firm, so they pick and choose a couple of orders. “Why did you buy X on this day?” and you tell them you thought the stock looked undervalued, or oil looked liked it was heading up so you bought options.

Sometimes it’s more pointed: “You were supposed to be restricted” (not allowed to buy or sell a particular stock, because of regulations – you had material inside information, owned more than 5% of the company and had to file a 13-G, that kind of stuff “restricts” you), “so why was a buy order for XYZ executed on April 5th?” You can give them any answer, they basically just have to check off a box that they examined a particular fund, and asking a few questions allows them to do so. What the answer is is basically of little import.

Sometimes the meerkats catch something – like the head of the firm buying a stock first for his personal account (the much-talked-about “PA”), or a fund where he has a big chunk of his own money invested. Later – once the stock price has gone way up – he’ll buy it in the rest of his clients’ accounts. This serves to drive the price up more. So the head guy’s PA is up 50%, while the clients’ assets are up only 20%. It happens all the time.

If the SEC asks you why the head guy did this, it can be tricky. Why do they ask you and not him? The head guy doesn’t want to talk to the SEC kindergartners: he has someone else do it – he is usually “at a conference” or “out of the office doing research” (probably banging the chick he met in that Vegas strip club). So sorry – but could one of the portfolio managers (PMs) help answer?

You the PM of course would like to tell the truth, but then again – you want to keep your job, and you’re honest in your dealings and it’s not you they’re after. You say something like “we hadn’t finished doing the research on it when it went into the PA. We were not sure it was suitable, from a fiduciary standpoint,” (nb: that “fiduciary” line gets them EVERY TIME! Shows you’re aware and thinking of rules), for our institutional clients. As soon as we did complete that research – as you can see we spoke about it in our morning meeting on May 10th – that is the day we bought it for the institutions.” Then you show them the morning meeting notes from May 10th. Problem solved!

But it’s not really right. Head guy wanted to front-run and did. SEC got its answer, box checked. Clients are happy, they’re up 20%; they don’t know they could have been up 50%.

Here is another fun thing the head guys like to do. Say you have some important “institutional accounts” you want to keep. Big corporate pension funds pay a 1% annual fee on what is usually a big chunk of money (tens or hundreds of millions), which adds up fast. A savvy head guy might buy stock in that corporation. You manage money for GE, you say? Tell your head trader to buy a ton of GE stock in all your firm’s mutual funds and institutional accounts.

This tactic works even better when you manage money for small- to midsize companies, and you can buy a significant ownership stake. A small industrial company like Timken Co. (just as an example, I’ve never managed for them) has $1.6 billion in its pension, yet its ENTIRE stock market capitalization is $2 billion (i.e. you can buy the whole outfit for $2 bil) – so you get a lot of bang for your buck buying into it when they’re paying you to manage their money anyway.

Everything then becomes about mutually-assured benefits. The small company won’t pester you too much on your trading or stock-picking prowess because you are the big (if not the biggest) shareholder; in return, you the head guy won’t make waves and (a) point out that they lost $50 million last quarter or (b) dump the stock. This arrangement can work indefinitely.

The 1% annual fee the head guy gets for managing the pension goes right into his pocket; the money his funds might lose holding onto a 10% ownership stake in a dog of a company comes from his clients’ pockets. See? It’s like corporate “69” where someone else pays the both of you!

It’s not all that challenging to find the managers of a company’s pension and then match that up against its biggest stockholders to see if there’s backscratching – the SEC doesn’t do that, though.

Next time: Tap-dancing when the SEC actually does catch you red-handed.

Image via Businessweek.com