Is Wall Street profiting from political insider information?

By Felix Salmon
January 18, 2013
WSJ article on political-intelligence shops, and one called Marwood in particular, is a bit of a peculiar fish, and I'm very glad that it comes while Matt Levine's great post yesterday on SEC insider-trading investigations is still fresh in our minds.

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Today’s WSJ article on political-intelligence shops, and one called Marwood in particular, is a bit of a peculiar fish, and I’m very glad that it comes while Matt Levine’s great post yesterday on SEC insider-trading investigations is still fresh in our minds.

As Levine shows, in a fantastic take on Sheelah Kolhatkar’s Businessweek cover story about the hunt to nail Stevie Cohen, the SEC is extraordinarily diligent when it comes to insider-trading investigations. It will look at literally millions of phone calls and other communications whenever it thinks that insider trading might have taken place, and it seems to work from the assumption that if a hedge fund takes a large position in a stock before a big piece of news is announced, then that’s prima facie evidence that something fishy might have been going on, and is probably worth investigating.

In this case, clients of Marwood — a political-intelligence agency featuring various members of the Kennedy clan — received a prescient note just before a very important FDA announcement which sent shares in Amylin Pharmaceuticals tumbling. A less diligent agency would simply stop there, and say OK, the note explains why various Marwood clients might have shorted the stock in the run-up to the announcement. But the SEC has kept on going, and has now issued subpoenas to Marwood, trying to work out whether it might have had inside information.

The WSJ story paints a pretty compelling case that Marwood was just smart, rather than insidery — that it genuinely earned its money in this case. But of course the SEC is going to be dogged here, and look under every rock, before allowing itself to come to that conclusion.

Still, as Levine reminds us, “SEC investigates run-up to big stock-price move” is not much of a story. So instead the WSJ zooms out a bit, and is running with a different headline entirely: “Buying ‘Political Intelligence’ Can Pay Off Big for Wall Street”. And here’s where the WSJ starts getting into much rockier territory. Sure, in this one case, Marwood came out with some very smart and valuable intelligence — although it only made money for Wall Street if you took the right action, and not all of Marwood’s clients did that. But beyond this one event, the WSJ actually presents no real evidence at all to buttress its headline. Instead, it basically rests the entire non-Marwood part of its thesis on this one thin paragraph:

The political-intelligence business has expanded rapidly over a decade as government decisions have come to play a growing role for some on Wall Street. Investors spend more than $400 million a year for such intelligence, according to Integrity Research Associates, which follows the research industry. Its founder, Michael Mayhew, said hedge funds tell him the “single largest source of gains for them has been what’s going on in Washington.”

It’s surely true that hedge funds pay a lot more attention to Washington today than they did a decade ago. But the WSJ never defines what it means by “political intelligence”, and I suspect that a huge amount of the business is just shops like Eurasia Group or Medley Global Advisors, thinking deep thoughts about political realities and charging their clients large amounts of money for them.

There’s that big number, though, too: would hedge funds pay $400 million a year for something if it didn’t give them a slightly bigger edge than that? Well, the fact is that they don’t pay $400 million a year for political intelligence. Michael Mayhew, the source of that number, is talking his book here, and the WSJ should have been much more skeptical. Because here is where the $400 million comes from:

Based on Integrity Research’s analysis, the global market for policy research and political intelligence services generated an estimated $402 mln in revenue in 2009. This is comprised of the following:

Between 40 to 50 independent research firms generated approximately $120 million in sales of monetary and legislative policy research in 2009.

Between 30 to 50 law firms, lobbyists, strategic consulting firms, and accounting firms also supported ancillary advisory practices for buy-side investors. We estimate that this segment generated slightly more than $36 million in revenue in 2009.

In addition, hundreds of broker-dealers or investment banks produce central bank and legislative policy research for their clients. Integrity estimates that approximately 1.5% of the total research revenues generated by investment banks should be allocated to this type of research. This would represent $246 million in equity commissions globally from institutional customers for policy research and political intelligence services.

While the number of independent firms that produce this type of research grew moderately from the 1970′s, growth in this segment has accelerated by almost 160% since 2000.

The first thing to note is that all of these numbers are generated by an Integrity Research black box, and there’s no particular reason to trust them, given that Integrity Research has every incentive to exaggerate them. The second thing to note is that the number of research shops isn’t growing, which means that any growth numbers have to be based on estimates of what total revenues were in 2000. Those estimates are unlikely to be particularly accurate.

But most importantly, some 61% of the total — $246 million — comes from what Integrity Research hilariously calls “total research revenues generated by investment banks”. Now I’m sure that Michael Mayhew isn’t a complete idiot, so he knows that investment banks’ research arms are loss centers, not profit centers. In fact, they don’t have any revenues at all. What he’s actually looking at is a completely different number: banks’ “equity commissions globally from institutional customers”. And then he’s saying that 1.5% of those institutional-customer equity commissions are attributable to the “central bank and legislative policy research” the banks put out.

This is just laughable. The commissions are paid for trades, not for policy research; no one thinks that a sell-side research note on the new Bank of England governor, say, is really worth any money at all. It’s just part of the service that banks provide their institutional clients.

If you strip out the fictional $246 million, and then apply a few grains of salt to Mayhew’s other numbers, the WSJ’s $400 million starts looking more like $100 million — spread between “40 to 50 independent research firms” and “30 to 50 law firms, lobbyists, strategic consulting firms, and accounting firms”. (The vagueness of those ranges is also worrying: how can Integrity Research estimate total revenues if it doesn’t even know how many political-intelligence shops there are to start with?)

Washington, pretty much by definition, is full of Washington insiders. Many of those insiders look at hedge funds’ budgets and see a road to huge riches. But I don’t see much evidence of that here: if the typical political-intelligence shop has more than two or three employees, they’re not making much in the way of profit. And it’s far from clear that their clients are actually making money from them, either.

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And so…Wall Street, then is NOT profiting for political insider information?

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