When hedge funds lobby

By Felix Salmon
March 11, 2014

Back in 2000, Warren Buffett published “a fanciful thought experiment” in the NYT, showing just how cheap it was to buy the US government:

Soft money contributions jumped from $86 million in the 1992 election cycle to an expected $360 million in the current one. That’s a growth rate worthy of Silicon Valley: 20 percent annually.

And the game has barely started. For most supplicants, cost still lags ridiculously far behind value. American business spends $200 billion a year on advertising to influence consumers. In many industries — communications, tobacco, banking, pharmaceuticals and insurance among them — political influence can sometimes be of similar commercial importance. It also matters critically to such professionals as lawyers, doctors, and teachers…

Suppose that a reform bill is introduced, raising the limit on individual contributions to federal candidates from $1,000 to, say, $5,000 but prohibiting contributions from all other sources, among them corporations and unions. These entities could still encourage their employees, stockholders, or members to contribute personally, but could do no more — a ban, incidentally, that applied to them until the ”soft money” dodge was introduced in 1978. Such a bill would be far from a panacea for all campaign finance ills, of course, but it would at least be a start. Why should this bill stand a chance in a Congress enraptured with the status quo? Well, just suppose some eccentric billionaire (not me, not me!) made the following offer: If the bill was defeated, this person — the E.B. — would donate $1 billion in an allowable manner (soft money makes all possible) to the political party that had delivered the most votes to getting it passed. Given this diabolical application of game theory, the bill would sail through Congress and thus cost our E.B. nothing (establishing him as not so eccentric after all).

America, it seems, doesn’t have eccentric billionaires — instead, it seems to specialize in the old-fashioned type, billionaires who just want to make even more money. People, that is, like Bill Ackman. And, of course, people like Todd Westhus, as well, who if they’re not billionaires already, aspire to reach that milestone soon. The worrying thing is that the Ackmans and Westhuses of this world have discovered what you might call the Buffett Arbitrage. Rather than investing in advertising or capital stock, they invest instead in lobbying, with the aim of getting very specific legislation passed which will make them very rich.

There’s nothing new, of course, about spending lots of money lobbying the government to get what you want, financially. Steve Coll wrote a 700-page book about just one company’s use of such methods. But what is new, or at least seems to be getting more popular, is the tactical short-term use of political lobbying to create a single windfall gain in the financial markets.

Yesterday’s NYT article about Ackman makes for a great read, partly because of what Jonathan Weil calls the “hilariously inept” nature of the campaign, and partly because Ackman is so open about his tactics:

“The risk we took in making this investment was could we get the world to focus on a company, could it get enough of a spotlight so that the S.E.C., the F.T.C., the 50 attorney generals around the country, the equivalent regulators in 87 countries, if any one of them, or at least any powerful member of that group, could we get them interested?” Mr. Ackman explained at the investors conference in February, 14 months after he made his bet on Herbalife public. “And I think that was the biggest risk we took in going short” on Herbalife.”

In other words, Ackman has a billion-dollar bet that he can bend public servants to his will, and, by announcing an investigation, send Herbalife shares plunging. He’s Buffett’s eccentric billionaire incarnate, except that instead of trying to reduce the influence of money on politics, he’s trying to turn it into a trading mechanism.

The big risk here is not particularly that Ackman’s campaign is going to work. Rather, it’s that hedge fund managers will take the wrong lesson from what he’s doing, and conclude that his big mistake was just being too open and public about what he is trying to achieve. Much more effective to work in the shadows: one of my favorite examples of that is the way that Elliott Associates invisibly lobbied lawmakers in Albany to tweak the rules surrounding compound interest on court judgments, thereby increasing the amount they were owed by Peru from $42 million to $58 million. That piece of lobbying was done so quietly that Peru’s lawyers didn’t even know it was happening until it had already happened.

Which brings me to Frannie, and the massive amounts of money — tens of billions of dollars, maybe more — at stake with respect to seemingly worthless old pieces of paper representing the housing agencies’ preferred and common stock. I wrote about this campaign last year, saying that the main reason to buy shares of Fannie Mae and Freddie Mac is as a bet that well-connected Washington types have inside information about what the government is going to do, and/or are likely to influence the outcome. The campaign has only intensified since then: recently Gretchen Morgenson even devoted an entire column to the plight of the poor hedge-fund managers who bought securities at very near zero and who are now lobbying the government to grant them billions of dollars’ worth of Frannie profits.

There is no good reason why the government should do that, of course — no good reason, that is, beyond what Bloomberg calls “one of the biggest potential paydays in history”. Right now, the agencies are effectively part of the US government, which means that the US government is explicitly standing behind all of their trillions of dollars in liabilities. Yes, the two companies are profitable, for the time being, and are dividending their profits back to the taxpayer. But if at any point in the future they start losing money again, it’s going to be the taxpayer — again — who foots the bill. Since the government is on the hook for all future Frannie losses, it makes perfect sense that the government should keep for itself any possibly-temporary Frannie gains, at least until the agencies are wound down.

But the amounts of money at stake here are so enormous that the Buffett Arbitrage, scarily, might end up working. Buffett was talking about $1 billion; that’s the size of Ackman’s bet, too. But at Frannie we’re talking about at least $33 billion in preferred stock, and possibly even more in common stock. If the government ends up giving the hedge funds any money at all from Frannie’s profits, you can reasonably consider all of that cash to be a direct return on lobbying expenditures. Which will surely prompt any number of similar attempts in future. Buy securities cheap, change the law, see them soar. There are surely dozens of ways that can be done; I suspect we’re still in the very early days of seeing that tactic adopted by the hedge-fund world.


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I read the excellent NY Times article. What I wondered was, who wrote the short?

The short must be written by an investment bank, which is not in the business of losing money and is sophisticated.

The downside of the short is that Herbalife will be worthless if Ackman succeeds. So they loan Ackman $1 billion in stock and he pays it back at zero (e.g., a billion dollar loss).

Finance theory says that you take the $1 billion and discount it back by the interest rate for the period of time you expect and that is the cost of the short. However, if the short costs this much, Ackman will never make any money. So it would be interesting to know the terms of this contract and who wrote it.

Obviously I’m not taking into account the upside, where Herbalife goes up and Ackerman has to pay back the short, with interest, at the higher rate. So you can add another discount for this possibility. But the short should still be really expensive since there’s a significant chance that Ackman will drive Herbalife into bankrupcy.

Posted by FinanceBear | Report as abusive

Mr. Simon,

Regarding Fannie and Freddie, your op-ed only looks at the hedge fund investment here to strengthen your argument. In fact, many investors of GSE preferred shares are mutual funds and private citizens. Should they be wiped out after the taxpayers have been repaid all that has been borrowed?

Posted by jwnoble3 | Report as abusive

A few thoughts.

1) FnF have not been nationalized. This isn’t Argentina, Cuba, or Russia.

2) FnF were reformed in 2008-2009 with FHFA as the regulator and conservator. FnF’s new book of business is sold. There could be another systemic shock 20 years from now, but so what. We can deal with that responsibly when the time comes.

3) FnF are “affected with the public interest” like utilities, and banks, and other regulated firm, but that doesn’t mean that they need to be replaced with a post office type entity. And why would that be better for taxpayers, homeowners, and society generally?

4) Tsy (on behalf of taxpayers) can exercise the warrants to own FnF to own almost 80% of FnF and thereby maintain control after ownership ends. Why not do that? It’s good for taxpayers as FnF have a lot of value now and doesn’t require a taking without just compensation.

5) There are 20 or so takings cases going on, brought by Ted Olson, D. Boeis, Chuck Cooper, all of whom have a lot of experience arguing before SCOTUS. It may need to go all the way there.

6. Preferreds are different from commons. Preferreds were “tier one” capital that community banks were encouraged to invest in. They just get a noncumulative different. Lot different from commons, which get the residual after other claims are paid off.

Posted by fourcentson1 | Report as abusive

Fannie and Freddie could have been treated more like Wachovia or Bear-Stearn’s if that’s what the government wanted. The equity could have been zeroed out and the shares canceled and declared worthless when they were both illiquid and insolvent… That is not what happened.

Now the GSE’s are neither illiquid nor insolvent and I don’t see how the branch of government who the founders envisioned to adjudicate a dispute between citizens and their government, (the courts) can allow the government to continue as they are. This is the mess you end up with when you deal in half measures…. “oh gse debt is a “moral obligation” …what does that mean is it full faith and credit? “No.. not exactly… but…but their really safe… we stood buy them when we had too.” People who use half measures, half truths, and fancy talk get the outcomes they deserve and this is one.

Best hopes for housing reform… I like the idea of a fully gov guaranteed first mortgage up to 100,000 and indexed to inflation once and for-all. That gives the lower and middle class a nice boost getting into the market and it’s still iceing on the cake for higer income folks. After that 100k first lien base it should be all private capital.

p.s. no position… but Herbalife sure looks like a pretty dubious business to me.

Posted by y2kurtus | Report as abusive

Felix has it wrong. He thinks hedge funds are the big winners if F/F survive. Actually it is the US tax payers that stand to see a big win if F/F are allowed to live.

If the Senate plan becomes law:

1) The taxpayers take an immediate loss of $189 Billion. (the senior preferred stock)

2) Taxpayers will lose the ‘upside’ of the 80% stake that they own in F/F. (I estimate this to be at least $100B – Dick Bove thinks it is $300B)

3) The US mortgage market will suffer under the Senate plan:

A – Say ‘good bye’ to the 30 year mortgage.

B – Be prepared for much higher % rates and a stiff pre-payment penalty on all new mortgages.

So under the ‘Felix’ plan taxpayers will drop about $400B – about the cost of the military for a year. This comes to $2600 for every worker in the country.

Great plan Felix…….

Posted by Krasting | Report as abusive