Free Lunch (32 page)

The time was used to get
votes through cajoling and threats. President Bush made predawn calls to some representatives. Off the House floor, the drug
industry lobbyists were thicker than ants on sugar, their numbers estimated by some at more than 1,000, a figure that strains
credulity; but if a careful count turned up a third that many, it conveys a sense of the resources poured into the
effort.

“Bribes and special deals were offered to convince members to vote yes,”
Representative Nick Smith, Republican of Michigan, later wrote to his constituents. “I was targeted by lobbyists and the
congressional leadership to change my vote, being a fiscal conservative and being on record as a no vote…. Secretary of Health
and Human Services Tommy Thompson and Speaker of the House Dennis Hastert talked to me for a long time about the bill and
about why I should vote yes…. Other members and groups made offers of extensive financial campaign support and
endorsements for my son, Brad, who is running for my seat. They also made threats of working against Brad if I voted no…. I told
all those urging a yes vote the same thing: this bill will lead to explosive new costs and huge unfunded liabilities that will unfairly
burden future generations.”

Later, in a radio interview in Kalamazoo, Smith told listeners that
an unnamed Republican leader told him, “Some of us are gonna work to make sure your son doesn't get to
Congress.”

Nearly a year later the House ethics committee admonished DeLay, who admitted
that he offered to endorse Brad Smith in return for his father's vote. The ethics committee also chastised Nick Smith for telling his
constituents what happened in such bold language because that “risked impugning the reputation of the House” with statements
that “failed to exercise reasonable judgment and restraint.” In such ways do those whose job is to protect the reputation of
Congress reveal that their real job is to protect Congress from the consequences of voters learning the truth about how it really
operates. On many matters, the representatives act like servants in the House of Mammon, squabbling over how much free lunch
to serve up to their masters that day.

Smith, whose son lost the election a year later, turned out
to be right in his belief that the bill was more costly than the supporters were saying. The prescription drug bill was legislation by
deceit.

Foster, the Medicare actuary, had given Scully the 10-year cost estimates, as requested,
months before the vote. The estimate was $500 billion to $600 billion. Later, it would come out that even these numbers were
misleading because of the time period used to make the estimate. Foster was told to estimate costs from 2004 through 2013, even
though the drug benefit would not become available until 2006.

The Bush White House finally
put out the real numbers, but not until more than a year after the vote. The estimate was made public in February 2005, three
months after the president won a second term in an election where he campaigned for the votes of older Americans, citing the
prescription drug benefit. The real cost? Was it $400 billion, as promised? Or even the estimate of up to $600 billion over 10 years
that Scully hid from Congress? No. It was $720 billion. That is 80 percent more than the number Scully and everyone else working
under White House direction insisted was solid.

Chances that the House would have passed
the bill with its requirement to pay the drug companies top dollar had the $720 billion figure been known? Zero. Value to the drug
companies of hiding the costs? Many tens of billions in profits beyond what the market could ever provide, not to mention all the
increases in executive and lobbyist pay. Contribution to the president's winning a second term? Priceless.

One way to look at the ban on the price negotiations provision in the drug benefit bill is how it affects the flow
of funds through the economy. The government will pay far more than the market would require for these drugs. That means the
drug companies will make above-market profits, further enriching their executives, whose compensation is tied to company
performance, whether it results from the market or government gifts. So what the bill produced was a redistribution scheme. It
takes tens of billions of dollars each year from the many and funnels them to the few. Those little weeds of subsidy to Wasserman
and Gumbiner grew into fortunes for Schaeffer and McGuire and became mighty forests of giveaways.

The cost of this plan is so high that it will soon force change. It may be that the ban on price negotiations will
be set aside. It may be that taxes will be raised to pay for the benefit. And it may be that the costs will kill Medicare, which many of
the peoplists believe was the real purpose of hiding the costs. By their reckoning, the rising costs will force a crisis that will end in
an effort to kill Medicare. That seems hard to imagine given the political clout of seniors and of the drug industry, but without a
doubt the costs will create instability and a battle over the future of Medicare, its outcome uncertain.

However the future turns out for Medicare and for seniors who need prescription drugs, those who hid the
facts did very well. Before Scully was named to head Medicare in 2001, he was the chief lobbyist for the Federation of American
Hospitals, an organization of 1,700 for-profit hospitals. A month before he ordered Foster to withhold the real cost figures from
Congress, Scully somehow obtained a waiver of ethics rules that bar high-level officials from negotiating for private-sector jobs
that conflict with their official duties. When he ordered Foster to withhold information, Scully was already negotiating with law firms
and investment banks for his next job. Three weeks after the drug bill passed with 220 votes, two more than needed, Scully
resigned to take a new job. President Bush held a ceremony to honor Scully, saying “I appreciate Tom Scully, the administrator of
the Centers for Medicare and Medicaid Services, for his good work.”

Scully's new job: as a
lobbyist working out of the Alston & Bird law firm, whose roster of drug company lobbying clients runs from Abbott and
Aventis through Merck to ZLB Behring.

A few weeks later Miles D. White, chairman of Abbott
Laboratories and the trade association called Pharmaceutical Research and Manufacturers of America came to Washington for an
announcement. White said that the industry had hired Representative Tauzin, the Louisiana Republican who was part of Thomas's
backroom “coalition of the willing,” to pass the drug bill, as its new chief lobbyist.

“This
industry understands that it's got a problem, it has to earn the trust and confidence of consumers again,” Tauzin said, White
agreeing with him. In his new job as chief Washington lobbyist for the industry that will collect $720 billion in 10 years because the
government is barred from negotiating for lower prices, Tauzin will do quite well. His salary, it was widely reported, is more than
$2.5 million per year. And to keep on getting free lunches from the taxpayers, Tauzin will have a budget of more than $100 million a
year to lobby Congress on behalf of the drug companies.

T
O APPRECIATE HOW GOVERNMENT POLICY IS ENRICHING THE
ALREADY
rich and putting everyone else at risk, it is worthwhile to visit Greenwich,
Connecticut, the richest little town in America. For most of a century, it has been favored by the wealthiest for three reasons.
Greenwich is an easy commute to Manhattan. It offers acres of space for mansions along with views of Long Island Sound
unmarred by industrial reality. Most important, other rich people live there.

In the Roaring
Twenties, when huge fortunes were made in unregulated stock markets, Greenwich was home to the brand names of industrial
America. They included the mattress maker Simmons and founders or heirs to fortunes made in oil, steel, sugar, banking, and even
condensed milk. Among the old-money residents was Senator Prescott S. Bush, grandfather of George W. Bush.

Greenwich residents vied to show off just how much opulence they could afford.
Vanity Fair
reported that in 1910 an heir to the Phelps Dodge mining fortune “had a
sixteenth-century Tudor manor house taken apart in England; then, wainscot by wainscot, peg by hand-carved peg, it was packed
into 688 numbered cases, shipped across the Atlantic to Greenwich, and re-assembled.”

Among the magnificent homes of Greenwich, the one that is most revealing of the community's aspirations is
a replica of the Petit Trianon, the private palace at Versailles that Louis XV built for his mistress in the 1760s. The original later
became, ever so briefly, the hideaway for his son's teenage bride, Marie Antoinette. The Petit Trianon was built in an age when
government policy determined one's economic fate. The land, and much of the commerce, was secured for the already rich by
French law in such a way that success in life depended almost entirely on one's choice of parents.

The Petit Trianon was designed to separate the royals from everyone below them. One of the unusual
features of the original made the servants invisible. A mechanism connects two rooms through the floorboards. On the lower floor,
the dining table was set with the finest food the royal chefs could prepare. The table was then to be raised through the floorboards
into the
salle à manger.
This would allow the royals to eat, drink, and be merry without
any contact from those of lesser station. Before the table could be finished, however, a revolution intervened.

Still, in its social purpose the design is not unlike that of the luxury boxes at commercial and college sports
stadiums. These boxes connect to private corridors so that the rich need not encounter those of lesser station, at least until they
leave the sports palaces for their waiting limousines.

Today a new race is on to build mansions
whose servant quarters equal in size, though not opulence, the mansions of old. Homes of 20,000 square feet, one with an antique
carousel and another with its own indoor ice rink, are all around in Greenwich. There may be some limits, however, as the
hedge-fund manager Joseph M. Jacobs discovered. Neighbors complained about his proposed 39,000-square-foot family home.
The house was too large for a plot of only 11 acres, they said. Jacobs gave up.

The town's
parking spaces are filled with exotic cars, including the occasional Maybach 62S, the $400,000 German sedan. The merchants of
Greenwich sell the same baubles found in the finest stores in Manhattan at the same prices. These merchants also pay the same
rents per square foot. Office space, however, rents for more than on Wall Street or midtown Manhattan: such is the demand created
by the hedge-fund trade. Greenwich has become to hedge funds what Madison Avenue is to advertising.

There is no official definition of a hedge fund. It refers broadly to any pool of money invested aggressively.
The word hedge comes from the idea that some of the money is invested to limit risk, often by buying options so that if a particular
investment suddenly loses most of its value, the fund can unload its shares at a minimum price.

Because of hedge funds, the fortunes made in Greenwich today more than compare to the riches of those
who competed to build the great mansions of the Gilded Age and the Roaring Twenties. But they derive from something far less
substantial, and much more dangerous, than mining, manufacturing, or even banking.

There
are just 23,000 households in Greenwich. The Forbes 400 list includes four Greenwich billionaires. There are certainly many more.
Steve Forbes assembles his list on the cheap, getting maximum publicity for the least possible expense on journalism. While
widely cited, the list is so poorly constructed that it has often included poseurs while failing to identify the majority of families
whose net worth statements come with three commas. In Rochester, New York, where I live, for example, Forbes lists a single
billionaire. Yet public records, interviews with those whose job it is to know where major wealth lies, and conversations with some
of the wealthiest reveal that there are at least four billionaire families in the Rochester area and probably seven.

That Greenwich has more billionaires than the four that Forbes lists is certain for many reasons, but just one
fact will suffice. It is how much hedge-fund managers make.
Alpha
magazine, a trade
publication for these unregulated investment pools, reported that the top 25 hedge-fund managers made on average $570 million
each in 2006. That is not their combined total pay, but the average compensation
per
manager.

The highest paid hedge-fund boss that year was James Simons. He
calls his company the Renaissance Technologies Corporation, though the name belies its practices. Simons runs a kind of
supersophisticated arbitrage operation from his offices in Manhattan and in East Setauket, which looks toward Greenwich from
Long Island. Simons made $1.7 billion in 2006, a fact that is known because the hedge-fund managers like to brag about their
success as a way to attract new investors.

The rarified world of hedge funds may seem distant.
It is not. Just because you never wrote a check to a hedge fund does not mean you are not invested in one. The chance that you
contributed to the gargantuan payday of at least one hedge-fund manager is 100 percent. If you live in America you are in a hedge
fund. But what is far more significant is that you are at risk for losses, possibly decimating losses, when a single hedge fund, or the
entire industry, encounters the inevitable losing streak.

The concern that a hedge fund could
put a big dent in your net worth, or even wipe you out, comes from no less an authority than Alan Greenspan. He had the Federal
Reserve intervene in 1998 during the unraveling of a single hedge fund, Long-Term Capital Management. By today's standards it
was not even a big hedge fund. Yet the Federal Reserve and Treasury Department intervened a decade ago because Greenspan
feared that this one fund's recklessness had the potential to cause a worldwide economic collapse.

Hedge-fund managers make their money by taking risk. In theory, the more risk, the more reward is needed to
compensate for it. But there is no lockstep matching of risk to reward, as Simons likes to tell his clients. One can take on lots of risk
for little or no reward. And a host of studies shows that, over time, managers cannot beat the market. That is what a government
study concluded in 1962. This was an affront to many on Wall Street who assume that, as professional investors, of course they
can beat the market. It was left to legendary investor Benjamin Graham to explain in a speech to securities analysts that “neither
the financial analysts as a whole nor the investment funds as a whole can expect to ‘beat the market,' because in a significant
sense they (or you) are the market.” It is this fundamental aspect of investing that inspired the low-cost index mutual funds, the first
of which John Bogle devised while a graduate student, an idea that grew into the Vanguard Group of mutual funds.

So if hedge funds are beating the market, then other factors must be at work that let them defy the principles
of economics. Could it be that unscrupulous employees are paying for inside information, say about news that will drive the price
of a stock up or down once it is formally announced? That would be illegal, but logical. After all, people have been known to
commit murder for hire for less money than an hour's interest on a hedge-fund manager's pay.

Hedge funds are deeply intertwined with banking because hedge funds succeed only by leveraging the
money investors give them with borrowing. Long-Term Capital at one point had $5 billion from investors, against which it had
borrowed $95 billion more. Stock market investors can usually borrow 50 cents for each dollar of stock they own. These guys put
up one buck and borrowed $19 more. Not even the bankers realized what they had done until a series of unpredictable events ate
away at the strategy that Long-Term had devised, revealed a risk they had not contemplated and that they certainly had not hedged
against. The coup de grace came from the Russian government, which in 1998 stopped paying interest on its bonds and returning
capital to buyers whose bonds had matured.

Hedge funds are not like the mutual funds that
most Americans are familiar with, many of which engage in lots of trades in an effort to produce greater returns than the market as
a whole. Over time the seactively managed mutual funds produce results no better than the market because they can't. Certainly
this or that fund manager can go a long time beating the market, winning gushing coverage and attracting more money to manage.
But those managers who consistently underperform the market offset these winners. They are less visible, getting little attention in
the business press and virtually none on the television financial shows. Add up the performance of everyone and you can get only
one result—society overall gets the market performance.

Hedge funds also are not like private
investment pools or venture capital pools, which put money into existing or new companies to make them successful in the hope
of turning a profit. Hedge-fund managers buy and sell stocks, bonds, pork bellies, scrap steel, stock options, interest rate futures,
and anything they think they can make money buying and selling. With rare exceptions, they are not investors, but
speculators.

James Simons employs about 80 PhDs at Renaissance Technologies, which has
200 employees in total. Many of his workers write computer programs that spot anomalies in the market prices for stocks,
commodities, options, and even the expected rate of interest a week from next Thursday in Timbuktu. The computers then execute
trades to capture these gaps in prices, which are often momentary.

If this sounds like
gambling, it should. Hedge funds trace their history to a math professor who figured how to make money gambling in Las Vegas.
That is a neat trick, since every game comes with rules that give the house an advantage or add a fee, called
vigorish,
guaranteeing that overall the house wins and players lose.

Back in 1962 this professor of mathematics and statistics at the University of Southern California, Edward O.
Thorp, published a book called
Beat the Dealer
. Thorp showed that anyone smart
enough to keep track of all the cards at a blackjack table, and who always made the choice with the greatest probability of winning,
would walk away a winner. The gains were slim, though. A card counter could take the house for as much as a nickel for each
dollar bet, but more likely it would be less, as little as a fraction of a penny.

The Vegas casinos
quickly caught on to this strategy. They persuaded the Nevada regulators to let them toss out anyone suspected of counting
cards, a rule in force everywhere there are casinos in America. At Binion's, a downtown gambling house started by a man who was
convicted of one murder, charged with two, and suspected of blowing up an FBI agent, some card counters were beaten within an
inch of their lives. At least once the punches extended an inch too far.

Professor Thorp was
smart enough to know there were other ways to apply his statistical knowledge and eliminate the risk of violent reprisal. Seven
years after publishing
Beat the Dealer
, Thorp started an investment firm called
Convertible Hedge Associates, later renamed Princeton-Newport Partners. Thorp and a half dozen or so associates used early
computers to look for differences in the price of stocks, buying low on one exchange and selling high on another.

It was classic arbitrage with a high tech boost. The professor quickly proved that he could beat the stock
market, too. Some years his investors reported gains of nearly 50 percent while the market moved in single digits. It was also easy
pickings. Back in those days, most stocks were owned by individual investors, the opposite of today when mutual funds, pension
plans, charitable endowments and, more recently, hedge funds hold most of the shares. Professionals are much more efficient
traders than amateur investors. Back then most shares were traded through face-to-face negotiation on stock exchange trading
floors. Gaps in prices were the norm.

Increasingly, trades are automated, software programs
deciding when to buy and when to sell. And price gaps are measured not in the blink of an eye, but at the speed of light. That was
what prompted Dave Cummings to move his TradeBot Systems from Kansas City to New York, as discussed in an earlier chapter.
He improved profits by shaving 19/1,000 of a second off the time it takes a sell or buy signal from one of his company's computers
to reach the automated trading market.