Opinion

Felix Salmon

The cost of the insider-trading investigation

By Felix Salmon
November 26, 2010

It’s not just small shops like John Kinnucan’s Broadband Research which have been put out of business merely because they’re being investigated by the FBI. Multi-billion-dollar hedge funds are faltering too: the latest to suffer devastating redemptions is FrontPoint partners. Max Abelson says it’s “on death’s door”, while Henny Sender reports:

Already senior staffers of FrontPoint are interviewing for jobs with other firms, one person with direct knowledge of the matter adds.

“It is difficult for an entity to keep going because at a certain point the business ceases to be viable whether it has crossed the line or not,” said the head of one firm which invests tens of billions of dollars in hedge funds on behalf of clients.

“The regulators effectively put them out of business.”…

Investors in these hedge funds say they have no choice but to pull their money at the first hint of trouble.

“If I get even a whiff of an investigation, I want to get out before the next guy, especially if I know they have illiquid stuff or I don’t know what they have,” says the head of one fund of funds.

The FBI’s insider-trading investigation, then, has already caused hundreds of millions* of dollars in damages — the value of FrontPoint alone has probably fallen a good $200 million since its involvement in the investigation was made public. And of course to date no one’s been convicted of anything.

This makes investigations very difficult: the FBI cannot be certain, when they start investigating a company, that it’s guilty of insider trading. That’s why they need to investigate it. But by the time any conviction actually happens, the damage has long since been done — and indeed will have been done even if there’s an acquittal or no charges at all.

I don’t know if there’s any way around this: certainly the FBI has to be able to investigate companies it suspects of wrongdoing. But does the existence of those investigations need to be made public, at least before any charges are brought?

*Update: I meant hundreds of millions of dollars, but originally posted hundreds of billions of dollars. Apologies, my bad. Thanks to Sean Matthews for noticing.

Comments
11 comments so far | RSS Comments RSS

Are you really comfortable with the Feds conducting widespread, ongoing, secret investigations? They’ve done that in the past, and it’s never pretty.

Posted by ARJTurgot2 | Report as abusive
 

You make it sound like the social costs have been in the hundreds of billions of dollars, which is ridiculous. These are just redemptions. Maybe there are fire-sale inefficiencies from the changes in position, but it’s not at all clear how big this effect is. This money is probably just moving from one hedge fund to another.

It sucks to lose your business as a result of investigations like this, but I think there’s a net social gain. It doesn’t suffice to just focus on the costs.

Posted by absinthe | Report as abusive
 

Most of these hedge funds have terms and conditions so that they don’t have to send a check out for the entire withdrawal the next day unlike a mututal fund. Everybody involved in them knows that there will be some illiquidity that can backfire if the transactions need to be done quickly, but they are all big boys and girls and should be positioned to deal wit hthe consequences.

In the end, it is necessary for people and entities to believe that if they do something wrong there is a reasonable likelihood that they will be found out an punished. That by itself is a significant deterrent to bad behavior.

One of the biggest problems on Wall Street today is a belief in complete impunity as we are seeing with everything from Ponzi schemes, to the AAA subprime CDOs to the flouting of the law in the foreclosure processes. Until people in those various financial sectors really start to see businesses and people going down in investigation and bankruptcies, their interest in following the law instead of making a buck will be miniscule. While Sarbanes-Oxley is largely a toothless tiger with respect to the financial sector, I think the memories of Enron prosecutions etc. have prevented many regular businesses from sailing too close to the wind on financial issues.

Posted by ErnieD | Report as abusive
 

Furthermore, it seems like in many cases the companies are self-disclosing the investigation’s existence, not the FBI. And, of course, if the FBI arrests someone, it be comes public record rather quickly.

Posted by DaDaDan | Report as abusive
 

Hundreds of billions of damages? Isn’t that a bit strong. That implies that hundreds of billions of dollars of actual real-world value has been destroyed, where, at most, hundreds of billions of dollars of claims on real value have been redistributed. That value has either been redistributed from one bunch of rent-seekrs to another, or it has been redistributed into the real economy. The first, I am indifferent about, the second, I think is a good idea.

[yeah, I know this is simplistic, but it is a valid observation to a first approximation]

Posted by seanmatthews | Report as abusive
 

Felix, you seem to have an entirely uncharacteristic and unwarranted bee in your bonnet concerning police/FBI investigations involving financial firms. Perhaps I can add some perspective. There are tens of thousands of businesses outside of the financial industry that are dependent in whole or in part on their reputation. Such businesses, and individuals involved in those businesses are questioned by authorities on a regular basis. It has happened to me. How they manage their relationships with their clients/customers determines how well they fare as a result.

To say that the regulators put them out of business is factually incorrect, and on other occasions you would have called them on it.

It seems as though you are implying that financial businesses should get privileges in investigations not available to other businesses because, well, I’m not sure why. But if that is the case, you have become part of the problem. I would not have expected it.

Posted by Curmudgeon | Report as abusive
 

Felix–

So the problems at FrontPoint are the FBI’s fault???

You must be kidding me!

If investors won’t stick with them until they’re proven guilty, that’s their problem. Since the FBI doesn’t move off the dime until it has a conviction in the bag, you can bet they will be found guilty.

Hopefully, people go to jail.

Posted by Lilguy | Report as abusive
 

Announcing investigations ahead of time does seem to take away some of the schadenfreude pageantry of it all… Imagine how much more captivating it would be if a news copter had live footage of a low speed police chase of hedge fund partners on a zamboni driven by al cowlings through the streets of greenwich.

Posted by wolphkaat | Report as abusive
 

“But does the existence of those investigations need to be made public, at least before any charges are brought?

These investigations are typically quite discreet for precisely that reason.

Remember it was Kinnucan himself that publicized that there was an FBI investigation, and that was clearly after a lot of work by the FBI anyway, by his own admission. I don’t recall seeing that the FBI had a press conference.

Posted by AnonymousChef | Report as abusive
 

Are there any innocents involved in this story anywhere because I sure don’t see anny ..

Posted by Woltmann | Report as abusive
 

These are billionaries, Who gives a damn that they loose money with crocks!

They cheated so they got what they deserve!!!!!!!!!!!!!!!!!!!

Posted by skeptic2 | Report as abusive
 

Post Your Comment

We welcome comments that advance the story through relevant opinion, anecdotes, links and data. If you see a comment that you believe is irrelevant or inappropriate, you can flag it to our editors by using the report abuse links. Views expressed in the comments do not represent those of Reuters. For more information on our comment policy, see http://blogs.reuters.com/fulldisclosure/2010/09/27/toward-a-more-thoughtful-conversation-on-stories/
  •