Inside The House Of Money: Top Hedge Fund Traders

This is FRESH AIR. I'm Dave Davies in for Terry Gross, who's off this week visiting family. Remember when you made your first 10 million It's a ridiculous question for most of us, but to the most successful Wall Street hedge fund managers that's just not a lot of money. Our guest, Sheelah Kolhatkar, writes that in 2006, the lowest-paid person on the list of the top 25 earning hedge fund managers made $240 million just that year. One of the top earners was Steven A. Cohen, whose firm was at the center of a massive insider trading scandal Kolhatkar writes about in a new book.

It's a story of a hedge fund managers spreading cash around to get information and government investigators running wiretaps and leaning on traders to help them crack down on what they suspect is widespread cheating in the financial sector. And it's a story of inequality in financial markets and the economy and what that means for the country.

And, you know, he really has a sort of rags-to-riches story that people in the financial world love. He grew up very middle-class in Long Island. They were certainly not poor, but they were not wealthy. And I think that growing up, he was surrounded by a lot of affluence in Great Neck. And he was motivated early on to make money. He was a very, very talented poker player in high school. And then he went off to Wharton, studied business there. And then he launched his hedge fund, SAC Capital, in 1992 with $25 million and very quickly achieved enormous success.

DAVIES: There are a lot of jobs in the financial sector, and it's confusing to people. There are bond traders and stock traders and people who are in - work for investment banks and private equity people. Steve Cohen made his fortune with a hedge fund. What is a hedge fund

KOLHATKAR: Hedge funds were originally conceived as these very sort of bespoke products that catered to wealthy investors. So if you were a very rich person, you know, a CEO of a company, you had a vast fortune, you were trying to figure out how to manage all that money, you might have parked a slice of it in a hedge fund where the idea was that it would be sort of protected from the general swings of the market. So you would be paying very high fees to a hedge fund manager, and in exchange you were granting that person flexibility to sort of invest the money however they saw fit.

And because hedge funds only accepted money from very wealthy and sophisticated investors, they were given a longer leash by the regulators to take risks in the market. They were allowed to borrow money to invest at much higher levels than a regular mutual fund, for example. They were allowed to short stocks, which is essentially borrowing a stock and selling it and betting that it will go down. It's actually a very high-risk activity. Not everyone does this. But hedge funds, because they were only taking money from investors who could afford to lose the money, they were given this extra freedom. And in exchange, they charged very high fees.

DAVIES: Right. So what was originally these kinds of companies that would - you'd park some of the money as a hedge against a market downturn - became a huge thing in and of itself. And they're just - they're traders. They trade in everything and get big returns and charge fees for it. You write that when it was at its height, when it was - you know, had - what - $15 billion that it was managing, his own money and other people's money, that there was a feeling in the business on Wall Street that these guys had to be cheating, using inside information to beat the market. Why did people think that

KOLHATKAR: Well, a very good way to explain it is to sort of explain the title of this book, which is \"Black Edge.\" So you need to understand that Wall Street and hedge funds in particular are driven on information. And when you're out there in the market, trying to make money every day, trading stocks, buying and selling things, the better information you have, the more money you're going to make. And the incentives for having good information are very high. You can make many millions of dollars if you have good information.

DAVIES: You tell this book in part through the experiences of the FBI investigators and other government investigators. And you describe how when they started listening to conversations of people in hedge funds and traders and they talked so casually about trading this illegal inside information, it made them wonder - does everybody do this Is this just the way it is You worked in a hedge fund early in your career. Did it seem that way to you

KOLHATKAR: ...(Laughter) SAC Capital. But yeah - in fact, at the time, you end up in these jobs and whatever's going on around you just seems normal, and you don't even necessarily know to question it. And it was only later, looking back on what I had done earlier in my career as a hedge fund analyst that I realized sort of what it was. I was trying to get edge, too. I spent my days trying to sort of analyze our different investments and get information about them. I certainly didn't venture into any areas that would've qualified as black edge, for example, but I didn't really know the difference. And it was generally understood that you wanted to get the best intelligence that you could. It's true that the FBI really was a bit oblivious to a lot of this.

The FBI securities unit, which is responsible for policing the market, among other things - if you walk into their office in lower Manhattan, the stark contrast between the FBI and their resources and what the hedge funds have at their disposal is very obvious. I mean, FBI is working out of a ratty office. The walls are sort of drab. They have ancient computers. There are guys sitting in there on headphones listening to, you know, wiretapped calls.

If you walk into one of the best hedge funds in the world, one of the most successful funds like SAC, everything is state-of-the-art. It is filled with spectacular artwork, the best technology you can possibly buy. They are spending money on, you know, hiring people to watch truck traffic in and out of manufacturing facilities in China. They're studying satellite imagery of parking lots in Wal-Marts across America because they are trying to piece together the health of various companies that they're investing in. And they are willing to spend money to gain any type of advantage or to take advantage of any resource possibly available. I mean, they literally will hire people to install their own fiber optic cables so their trades can be executed faster.

One day, one of the FBI supervisors sort of came in and said to one of his best agents - B.J. Kang, who's a character in my book - he said, listen, hedge funds are huge. There's a lot of money in these things, and we have no idea what is going on. We need to get on this. It was a bit of a wild West environment. You know, they started investigating and it started to seem like there was sort of rampant crime going on at this time. And not coincidentally, this was the period leading up to the financial crisis. I mean, I think there were a lot of things going on in the financial world that were not legal, not ethical.

And they decided that they were going to try and approach the hedge fund industry the way they had the mob. So they were going to use wiretaps. They were going to use informants. And they were going to approach it like organized crime. And that's what they did.

DAVIES: I want to come back to something you said a moment ago. I read this in the book, and it fascinated me. These hedge funds had enormous resources for research, but what would they learn from looking at satellite photos of a Wal-Mart parking lot

So if Wal-Mart's parking lot is just packed every single day, that is going to be a very strong indicator to you that their earnings are going to be very strong. If the parking lot is empty, you might decide to be more cautious. You might sell some of your Wal-Mart shares. So these are the kinds of things that the biggest and most successful hedge funds have available to them.

KOLHATKAR: So this is another thing that was going on for years before regulators, law enforcement, even the general public had a clue about it. You know, some clever entrepreneurs figured out that hedge fund investors were very hungry for information about different industries. So if you're a hedge fund trader or an analyst, you might come into work one morning and your boss, the powerful, you know, portfolio manager at your hedge fund might say, hey, I want you look at, you know, XYZ's stock. They make microchips. Figure out if we should buy some.

So expert network firms rose up to kind of meet this demand. They realized that these hedge fund traders had a lot of money to spend on research and they had a constant, rapacious need for information and intelligence about all sorts of different companies in different industries. A lot of them tended to be in the medical pharmaceutical field and also in technology because both of those area's stocks tend to move very dramatically based on the news and the earnings. The - you know, the businesses themselves are very complicated. The products are complicated. It's hard to understand if you're not an expertise, you're not a medical doctor.

So these expert network firms rose up and they kind of peddled themselves to hedge funds and they said, listen, for $1,000 an hour, we will connect you with a middle manager at Caterpillar who can talk to you about, you know, how they manufacture their big farm machines and, you know, how things are going and what kind of parts they need and where they buy them. And so you could call these experts and, you know, quite legitimately just educate yourself about these different industries and companies.

KOLHATKAR: A number of people have said to me, how is that possibly legal And, you know, from the outside, of course, it sounds like it's going to lead to a lot of illegality. And in fact, that is what the FBI thought when they first learned about this as well. BJ Kang, who was one of the star FBI agents who worked on this case, you know, he kind of said to himself at one point, how is it possible that hedge funds are going to spend all this money on these experts and these consultants if they're not getting anything valuable 59ce067264

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