Free Lunch (33 page)

The key to Professor Thorp's success at gaming the
stock market was a little loophole in the rules governing investment funds. Most Americans own stocks through mutual funds,
which are plain vanilla compared to the 31 financial flavors in a single scoop of the hedge funds run by Thorp and those who
followed his path. Mutual funds are regulated. Under the government's rules they can trade as often as they want, but they have to
trade with money that investors gave them, not funds borrowed at the bank.

The loophole
through which Thorp slid his profits was not available to most Americans. The loophole exempted his hedge funds from the rules
against using borrowed money. The rules also specified that hedge funds were open only to the already rich. The theory behind
this exemption was that anyone who is seriously wealthy must either be sophisticated enough not to need protection from
financial predators or so rich that they could survive big losses.

Back in 1982, the threshold for
being eligible to invest in a hedge fund was a net worth of at least $1 million and an annual income of $200,000. Only a tiny fraction
of 1 percent of households qualified. Today the only real barrier to opening an account at a hedge fund is whether the investor has
enough money to make the recordkeeping worthwhile for the fund managers.

This wide-open
and unregulated world has attracted plenty of geniuses and serious investors. But it has also drawn financial sharks. Cases
alleging that more than 60 supposed hedge funds were really swindles were brought by the federal government between 2001 and
2006.

During the stock market bubble in the late 1990s, hedge funds began to attract growing
numbers of the newly rich as well as charitable endowments, including those at Harvard, Yale, and other wealthy institutions of
higher learning. As much as $300 billion from state and local government pension funds is invested in hedge funds, putting every
taxpayer at risk because they are obligated to provide the pensions earned by civil servants even if the funds are lost through bad
investments.

The promise of hedge funds is that they make money in any market, up or down.
This made them even more attractive after the collapse of the Internet bubble on Wall Street in 2000, which wiped out $7 trillion of
wealth, a sum greater in real terms than that lost in the 1929 crash. By 2007 the broad stock market gauges had only begun to
return to their previous highs, and that was without considering the effects of inflation. But many hedge funds during those years
generated double-digit returns. The long sag in stock prices made many investors more susceptible to pitches promising a big
upside in any market.

Investing in hedge funds quickly took on an aura of financial
sophistication in wealthy circles. Anyone living in the tonier neighborhoods of Manhattan, Washington, Los Angeles, Silicon Valley,
and the other great centers of wealth in America was sure to hear at every business lunch and wine tasting from those whose
hedge-fund statements showed fat profits despite a languishing stock market.

Those who
made out best, however, were not the hedge-fund investors, but the managers. Hedge funds charge stiff fees, under a system
known as two and twenty that some of them trace back to Queen Isabella of Spain and Christopher Columbus. Isabella was no fool.
She did not sell her jewels to pay for the explorer's journey. Instead, Isabella made the city of Palos provide for free the use of two
ships for a year as tribute. She raised some of the money for the 1492 voyage from bankers in Italy. And she made a deal with
Columbus that would make him rich, but only after the Queen got back her investment and most of the profit. Columbus died a
wealthy man (although not before he spent some time in chains, something the royal court dismissed as a little
misunderstanding).

In the modern version, most investors pay 2 percent of the amount in their
account each year as a management fee. Hedge funds that turn a profit then take a fat slice off the top, every fifth dollar of profit.
This is not unlike the Texas Rangers deal that made George Bush wealthy. Instead of 2 percent, Bush and the other general partner
got salaries. And instead of 20 percent of the profits, they got 15 percent.

For comparison,
some Vanguard mutual funds charge investors less than a dime per $100 invested. So on a million-dollar account with no change
in the balance, Vanguard would be paid $900, the typical hedge-fund manager $20,000. And if the account doubled in value the next
year, Vanguard would charge $1,800 while the hedge-fund manager would pocket about $240,000.

Simons charged even higher fees. His management fee was 5 percent annually. And he keeps 44 percent of
the profits. Why would anyone pay such fees? Because even after paying fat fees to Simons, a former government code breaker,
they made a lot of money. A thousand dollars invested in 1990 in the Standard & Poor's 500 index, which covers about 85
percent of the value of all American stocks, would have grown to less than $5,000 by 2005. The same sum put with Simons would
have become $77,000.

Simons does not tell anyone, including his investors, precisely how he
does it, but the broad strategy is known. Those computer programs his PhDs write look for pricing gaps or anomalies in the market
and then these arbitrageurs act decisively. Simons has let loose one detail about his strategies. He stays away from exotic
derivatives, like those that promise to pay the square root of the change in the value of the Australian dollar compared to the Thai
baht between today and six months from now.

What makes such huge returns possible is not
just computer programs that spot pricing gaps. What fuels hedge funds is debt. Lots and lots and lots of debt. Hedge funds and
banks have become joined like algae and fungus to form financial lichen. And just as attractive lichens can be poisonous, so can
this financial symbiosis, with its attractive investment returns, turn toxic.

A home buyer who
makes a down payment and then borrows four times that amount with a mortgage is using leverage. Because hedge funds are not
regulated, as mutual funds and banks are, much of what they do is secret. But from the few cases where records have become
public it is known that UBS, the big Swiss bank, has a policy of lending to hedge funds at a ratio of 30 to 1.

That kind of leverage is what allows tiny pricing gaps to produce billions in profits. If an investor has to put up
only a dollar to invest $100, and whatever the hedge fund bought doubles in price, the investor makes out like a pirate capturing a
galleon laden with gold. Even after paying the two-and-twenty fees, the investor's one dollar has grown to $77.

Of course, if things go badly, the investor can be wiped out. Banks foolish enough to lend so much can also
suffer huge losses. If the banks have no idea how many intertwined, cross-connected deals their money is in, and something
unexpected goes wrong, it could wreak havoc with the global financial markets.

Being free
from the regulations that govern mutual funds is in itself a form of subsidy, for it allows hedge funds to take risks that may be borne
by others. The easing of government rules on bank lending is another form of government favor that benefits the few. And then
there is the 1999 federal law that repealed the Glass-Steagall Act, a New Deal–era law that required commercial banks, which make
loans, to be separate from investment banks, which underwrite stocks and bonds. The Glass-Steagall Act was a barrier to mingling
the money in people's checking and savings accounts with the risky capital used in underwriting new stocks and bonds. Only time
will tell if the replacement law, the Gramm-Leach-Bliley Act, will lead to the temptation that spells ruin for people who just wanted to
pay their bills by check or save a few dollars for a rainy day.

While hedge funds come in all
sizes, styles, and quality of managers, they have in common an eagerness to acquire, however briefly, any asset that can produce
a profit. One way to make a profit is by creating tax shelters that make profits appear to be losses.

Tax sheltering is one of those activities that civilized people usually carry on behind closed doors. Hedge
funds are legally organized offshore, the favorite spot being the Cayman Islands. A narrow spit in the Caribbean, the Cayman
Islands are home to more bank deposits than the financial capital of the world, New York. Of course nothing is really there except a
brass plate in the lobby of a law firm and a secretary whose job is to gather up any mail and periodically send it off to the real
hedge-fund offices in the United States. But by going offshore, the hedge funds get secrecy from the American tax authorities;
accounting rules that let them build up huge fortunes while reporting no income; and, for the income the hedge managers do
report, a tax rate of just 15 percent, less than half the top tax rate on wages.

Most hedge-fund
managers have never even been to the Cayman Islands, making the headquarters arrangement a farce. They put their businesses
there, at least on paper, because of its extreme secrecy laws. Anyone can operate in secret through a Cayman Islands shell
corporation. All it takes is paying a small fee to the island government and bigger, but still modest, fees to the local lawyers. They
work bankers' hours and live very well. This secrecy is as useful to Al-Qaeda, Hezbollah, and drug lords as it is to hedge-fund
managers. But the doors to one room in the House of Mammon were thrown open by a lawsuit that revealed how hedge funds flout
the law. It even came with a real-life
Perry Mason
moment.

The revelations came from Long-Term Capital Management, the hedge fund that nearly caused the global
finance system to melt down in 1998. Federal tax auditors concluded that the firm had cheated the government so brazenly that
stiff civil fraud penalties were warranted. The hedge fund took the government to court, insisting its tax deductions were all
proper.

One July morning in 2003, in the Federal Courthouse in New Haven, a few miles from
Greenwich, a career government lawyer faced off against one of the hedge fund's partners. The two men seemed ill matched for a
game of intellectual chess. Charles P. Hurley was a career trial lawyer for the Justice Department, tall and ramrod-straight but
otherwise just another government-issue lawyer in a cheap suit. The witness was Myron S. Scholes, who shared a Nobel Prize for
devising a technique to value stock options. He brings to numbers the same kind of elegance that Titian brought to
painting.

At issue was whether some securities the hedge fund bought for $4 million could
generate $375 million in tax benefits. They came via a long and complicated history of tax dodges involving offshore leasing deals
that were themselves tax shelters for Advanta, Electronic Data Systems, the Interpublic Group of Companies, Rhone-Poulenc
Rohrer, Wal-Mart, what is now Bank of America, and the computer-leasing arm of General Electric. Scholes's challenge was to find
a way to recycle these securities so they could be used a second time to short the government.

Under questioning by his own lawyer the day before, Scholes had coolly explained that he knew the
securities had to have economic substance beyond their value as tax deductions in order to qualify as a proper tax shelter. Without
this rule smart people could just move symbols around on pieces of paper, fabricating deductions until business profits appeared,
to the taxman, to be losses.

Hurley's first question sought to impeach Scholes. “Am I correct
that yesterday you described yourself as a layperson in regard to taxes?” Hurley asked.

‘'I said
I was not an expert with regard to taxes,'' Scholes said, setting the tone by quarreling with the question.

“You did, in fact, write this book?” Hurley asked, pulling from behind his lectern a copy of
Taxes and Business Strategy
, a $130 text used at Stanford Graduate School of Business
whose primary author was Scholes.

Again and again Mr. Hurley went to the book, quoting from
chapter headings and plucking a detail from page 457, each answer revealing the sophisticated knowledge Scholes possessed yet
about which he claimed to lack expertise.

Hurley framed many of his questions to elicit a
simple yes or no. Scholes would argue with the question, then navigate a maze of potentials, prospects, possibilities, and
expectations before coming to a one-word conclusion.

Hurley: ‘'I think the answer I wanted
was in there—no.''

Scholes: ‘'Yes, and I wanted to explain why.''

At one point, Scholes parsed a seemingly simple question into three parts, two of which had two subpoints
each, and turned it all into a seamless soliloquy that lasted more than two minutes, without a single pause or “um,'' before reducing
his own words down to one: yes.

After many rounds like this Hurley shifted tactics. He eased
up in his style and began taking apart various dimensions of the potential profits and risks in the tax shelter, all the while pacing
back and forth at the lectern, his suit coat buttoned, his right hand deep in his pocket. He appealed to Scholes's ego, flattering him
at key moments, Scholes lapping up every syllable of praise.

Scholes explained how he had
become aware of these securities with enormous potential value as tax deductions and how he had worked hard to imbue them
with economic substance, ordering analyses, soliciting legal opinions, and even flying to London to meet with one of the three
owners to make sure, he said, that they were not people who would bring disgrace on Long-Term Capital.