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How Hedge Funds ride herd in America
Let me try to connect some dots. I think this adds up to an interesting
comment on how things get done in the good old USA. This example does
not pass my “smell test”.
Start with something called a “Safe Harbor”. This is a legal
designation that is established by the IRS. The activities of entities
inside the Safe Harbor are free from taxation. The critical variable in
determining whether Safe Harbor status is granted is if the activities
of those seeking tax-free status are conducting trade or business in the USA.
I will go you two extreme examples. Toyota, a foreign corporation, has
plants and retail outlets in the USA. They are clearly conducting trade
or business here. No Safe Harbor status for Toyota. On the other extreme
consider an individual in Europe who owns some US Treasury securities
as a passive investment. They are not conducting trade or business, so
the interest income is tax-free.
These two examples are pretty clear-cut. The problem is that everything
in the middle of these two extremes is not so clear. Those who want the
benefits of tax-free status, but have a question mark as to whether they
in fact deserve the favored treatment, have to petition the US IRS and
get a letter ruling to clarify their status. If they get a favorable ruling, they are off to the (tax-free) races.
Next consider this article (Link) from the NY Times June 8th. This article discusses a new phenomenon in US finance. Hedge Funds are becoming lenders. They are acting as banks. They have customers, they loan money to them. This is becoming a big deal. From the article:
Hedge fund managers have been called plenty of names. Now, they can add another: local banker.
Middle-market companies, which generate $6 trillion in revenue a year and employ 32 million people in the United States, are borrowing billions of dollars from the hedge funds for product development, strategic acquisitions and even day-to-day operations like payroll and utilities.
Okay, we have two distinct issues. Safe Harbor status and hedge funds who are actually bankers. Now the dots that connect these two.
Consider the role of Managed Fund Association (“MFA”). MFA is the D.C. lobbying arm of the hedge funds. They make that pretty clear in their web site:
MFA is the voice of the global alternative investment community. Our members are professionals in hedge funds.
So what is MFA doing to promote business and make money for the hedge funds? They are doing everything possible to get Safe Harbor status for inward lending to the hedge funds for offshore money.
Hedge funds want to make loans to US companies; they will finance this
activity with untaxed money from abroad. Consider this letter (link) sent to Treasury (the IRS) by MFA on 6/1/11.
From the letter:
For the
reasons discussed below, we respectfully request that guidance under
section 864(b) of the Internal Revenue Code be included in the
forthcoming 2011-12 Guidance Priority List.
MFA
continues to be concerned that the absence administrative guidance under
section 864(b) of the Code concerning whether certain activities by
otherwise passive non-U.S. investors, including (but not limited to)
activities involving the acquisition of loans and other debt securities as well as the receipt of certain types of fees, will be treated as falling outside the safe harbors.
The guidance can be issued in the form of clear safe harbors and
there is no doubt that guidance of the type requested will reduce the
potential for burdens on, and controversy between, the IRS and
taxpayers.
What’s this about? Hedge funds who make loans need financing for
the loans. They have no deposit base, so where will they get the money
to make the loans? The answer is: From offshore. The process of raising money is made much easier and cheaper if there is a private letter from the IRS that insures that the activity of offshore lenders is deemed tax free in the USA. That’s why the big push from those nice folks at the MFA.
Here’s the rub however. Community banks in the US pay income tax on
their lending to US customers, and so do US investors in bank loan
mutual funds, partnerships, etc. So the proposal by the hedge funds
(MFA) would give them a leg up against traditional lenders. They would get a tax break on their activity, while everyone else would suffer.
What’s the downside to giving tax breaks to hedge funds? From the NYT article:
These lenders typically charge interest rates that are several percentage points higher than banks.
The lending force also poses a significant risk to the companies and the broader economy, given the unregulated nature of this shadow banking system.
Another worry is that funds will trade on nonpublic information they receive as lenders. A March study in The Journal of Financial Economics found a spike in investors betting against the shares of companies that took hedge fund loans.
My bet is that the hedge funds and the MFA will get their way. Another
big tax break will be created that benefits few and costs everyone else a
bundle. How could that possibly happen? Easy. The hedge funds have clout, and they are using it:
MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.9 trillion invested in absolute return strategies.
If you want a good example as to why the recently passed FINRA
legislation is just a joke, this is the perfect example. If you have
money and power in this country you can do damn near anything you
please, and you can also do it without paying any taxes.
Notes:
-Lending activity within our boarders has always been deemed as
conducting trade or business. So this carve-out for hedge funds
constitutes a significant change in policy.
-The powerful NY Bar Association has weighed in on this issue and fully supports the position of the MFA. Why? Because the NY lawyers would make a bundle promoting and setting up the safe harbor activity. Can you say “enlightened self interest”? The NY Bar on this topic (link).
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ZARJAD makes the exact point of contention. This is just a very sophisticated method of money laundering to avoid taxes by the big corporations. They can't bring it into the country free, so they lend it to some MFA (MutherFuckingAsswipes) who lend it back to them for a fee. From there you can play any trick you want from default to writing off the interest.
I'm sure the MFA will get their 'Safe Harbor' declaration in writing, after all, its coming from the desk of Timmy 'Dr. Strangelove' Geithner who should be wearing an orange jump suit with his butt buddy B. Baranke, Hymie Dimon, L. Blankenfein, and 'Hank' I love Predatory Birds-Paulson.
http://seekingalpha.com/article/196221-will-plug-in-vehicles-be-obsolete-before-they-are-profitable?v=1270311395&source=tracking
Sorry Bruce! it wasnt you that censored me it was John Petersen Comments (7815) I owe you a BIG! and / or HUGE!! I am Sorry Sir!!I went back and searched for why I was pissed becuase I was gonna bash you with it.. and sure as shit I have my foot in my mouth..When I am wrong, I admit I am wrong.. I will say that considering you must have been confused as to why I was so hot! but at the same time why didnt you ever just say that it wasnt you?I maybe an asshole for drilling the wrong guy but you never said it wasnt you? how many people have you censored over in Alpha land?thats not my business.. I am Sorry for pegging the wrong person, whether you censor others and thought it was you is a whole other issue for someone else.Good Luck!
No problem. I didn't get it either.
b
This country has historically done everything it can to attract foreign capital. Not taxing portfolio income has been a big part of that. If foreigners want to own stock, lend money to banks or businesses, nobody says boo.
So the question now is when a hedge fund is involved, can they do the same thing, and under what terms?
The discussion that needs to occur is whether the benefit of the additional foreign capital coming in is outweighed by the detriment of having the income stream accrue to foreigners rather than domestic interests.
Over time, the answer to that question changes. What is helpful in one decade may be poison in another.
The discussion should take place without prejudice against the foreigners unless we know that some foreigners have improper motives for what they're doing.
Actually it may not be as straightforward as "making loans" vs "aquisition of loans".
Usually, those asset based lending hedge funds are structured in such a way that the legal entity which is making the loan to the SME is not the fund itself but another entity that can be US domiciled. Then the offshore based fund is probably "aquiring" loans from the US entity and then channeling performance to offshore investors.
but that needs to be double checked
When does this activity fall within the description of "Trade or Business"? Making loans and servicing them is 'doing business' in my book. That is the rules for the Comunity Banks and other classes of investors.
Why a 'carve out' that benefits hedge funds and stimulates the expansion of a new unregulated debt market?
Don't know about hedge funds, but CLOs often have both an on-shore (usually a Delaware corporation) and an off-shore (usually Cayman) issuer. It is driven by a tax issue, but I don't think it was the trade or business issue. I can't remember the details on that one. But in the case of our CLOs the US entity was irrelevant. And there was never trading from one entity to the other. I'm not even sure that was possible. I assume we were representative. But the key to that question is the purpose of the on-shore entity. It might be to make it possible for a pension fund to invest and avoid UBTI. Just can't recall
Bruce, I don't think you are interpreting this right, at least based on the excerpts you provided.
The letter refers to "acquisition" of loans, not "making" loans. There is a huge difference.
In fact, I am surprised they are asking at all. This safe harbor is what makes CLOs possible. CLO managers do not make loans to corporations. They buy them on the secondary market. Since they are buying loans that are trading, CLOs are deemed not to be in a trade or business in the US.
This is a critical point. The safe harbor has been around since at least the mid-90s when CLOs began. I don't know about before that.
The problem is, these loans are allocated to investors on the secondary market almost immediately upon closing (there is a slight delay given lawyer's concerns about this issue). The safe harbor provision also requires that the "investor" not be involved in negotiating the terms of the loan. However, analysts, PMs, and traders have huge impact in the structure of the loan by indicating whether they are interested in purchasing a loan. They might say, "I would be, ecept that I don't like covenants x and y". The banker will take the order book into account and adjust the loan provisions to make sure the loan will clear the market.
So technically, the investor is not negotiating loan provisions, but since this is all done before closing, it has the same effect.
When I first got involved in CLOs, I remember running across this, because it seemed to me that we were lending. I found that the distinction was based on legal opinions made about a safe harbor. However, as I recall, there was no clear guidance from the IRS or Treasury about whether they agreed. There might be a No Action Letter, but I don't think so.
Since a failure of the safe harbor would put the CLO into an event of default and require immediate unwind (since it would become a taxable entity), it seemed to me we should request IRS guidance. I was told the provision had been around for years and had countless opinions from attorneys that it was ok, and no one wanted to risk the possibility of an adverse opinion.
So I can understand why the hedge funds are seeking guidance. Given the risks to the managers, it seems reasonable to ask, IFF they do not have loan exposure already, or they are very confident the opinion from the IRS will be favorable. Otherwise, they risk blowing up the entire loan market.
If the IRS rules against the safe harbor, CLOs cannot buy. If CLOs cannot buy, the corporate loan market will implode.
So getting the opinion would not change anything, it would just eliminate the risk (as long as the opinion confirms the safe harbor assumptions) of an adverse opinion from the IRS changing what already exists.
But if the opinion goes the other way, it would be chaos. Is that the rationale?
You and the MFA want this. You want clarity and certainty that the funding source is tax exempt forever. Why do you want this?
Does enlightened self interest come into play? I would think so.
I ask you how you can support this at the same time there is a completely different set of rules for the nation's smaller banks. You want another leg up on them?
Every day there is another example of how the financial system gets ginned to the benefit of a few. To me that IS chaos. But thanks for your input.
bk
I'm not in that business now, so no self-interest on my part, but I know the background. HF could have a different angle, but I doubt it.
The issue is not avoiding taxes, but avoiding double taxation. The investor will pay taxes on the fund. But there is not reason to have the fund pay taxes and then the investor to do so.
And again, technically the fund is not lending. My personal opinion is that it is because the effect is the same, but legal reasoning has been that it is not. So the attempt at clarification appears to be to take away the uncertainty. There is certainly nothing wrong with that.
Doing anything with uncertainty as to regulatory requirements adds unnecessary risk and invites abuse. I'd rather play football with a known set of rules, even if I did not like them, than to have so much grey area I never knew what I could or could not do at a given moment.
Since I am not involved in this anymore, I don't know the MFA motivation for bringing this up. Since it is a sea change from prior stances, the rationale may be different. It could be that some hedges would profit from loan market declines and so are hoping for an adverse opinion. Don't know. Possible, but that's idle speculation.
As to competition against smaller banks, it is not exactly the same thing. It is more like a mutual fund and getting similar tax treatment. While I do agree in that substance the CLO is lending (though there is also significant true secondary market investing), that is not the CLOs reason for being, so in that sense it is different from a bank.
FWIW, my personal opinion is that there should be no corporate taxation at all, and everything should be taxed at the personal level. It is much more transparent and leads to better allocation of capital. You would have to have some sort of regulation to ensure that SOMEONE is paying the tax, but the corporate level is the worst place to do it.
Just want the credit market needs, more credit. The hedge fund loans (herein referred to "Frank-Dodd fine print") still pale in comparison to; terms of the bailout loans, AIG rescue loans, Friends of Mozillo loans, etc.
Shocking news that if you open a less-regulated channel for financing, then fincancing via that channel is cheaper, and those can find a way to access it do.
Next up: Hedge funds as insurance companies.
Health Default Swaps
You laugh. There is already active trading in certain kinds of life insurance contracts.
Nice way to repariate overseas profits for IBM, GE, Microsoft, Google, etc.
Borrow your own money laundered via hedge funds. High interest rate? No problem, nice deduction in the States and our overseas branch makes good money.
And your personal profits are taxed at just 15% as "carried interest."
don't see what's new here. Hedge funds have been engaged as lender of last resort since quite a while, the strategy is called asset based lending and hedge funds managers have already figured out how to make this activity tax free using cayman / delaware based fund companies.
True. But as the NYT points out this is rapidly becoming big business. The letter from MFA is dated 6/1. This is not the first time they have requested the Safe Harbor status. (See MFA's letters from 2007 and 2008 below)
What is different and important today is that MFA is going to get what it has been asking for over the past four years. Why? Because they have power to do it.
So this is a new (latest) twist on an old story. But it's the same old story; isn't it?
MFA to treasury: http://www.managedfunds.org/downloads/Distressed%20Debt%20Letter%20-%20Final.pdf
MFA to treasury: http://www.managedfunds.org/downloads/MFA%20letter%20on%20IRS%20Priority%20Guidance%20List.pdf
I think this specific market is a lot more mature in Europe. I was shocked by the private loan options when I arrived here. If you have money, it is very easy to borrow more, whether for a house, starting a business, or trade finance, especially if you have significant unencumbered euroclear-eligible assets. The varieties of loans I was shown were all minimum 5-10M loans. However, the terms were extemely competitive, if not better than a traditional bank loan - if you accept the published rate on the branch wall. The biggest problem is that they are relatively complex since they are leveraging the institutional borrowing capability of the issuer, and might incorporate spread or collateral valuation risk for the borrower that is otherwise assumed by the lender- so evaluation is not just an issue of what is the borrower's paid in capital and interest rate. If basic investors are generally incapable of properly evaluating suitability of variable rate interest-only mortgages, and institutional investors are likewise generally incapable of properly evaluating suitability of CDOs, then this doesn't well... especially since borrowing in the US doesn't carry the stigma that it does in certain parts of Europe.
nature abhors a vacuum...while Dimon whines about excess capital the hedgies plot to take away his business.
These lenders typically charge higher interest rates that are several percentage points higher than banks.
Isn't the bigger story: Why are firms seeking loans from hedge funds that charge higher rates than banks?
Mortgage rates are low right now too but it turns out you have to make a large down payment, have stellar credit and buy PMI forever - raising the real cost to the borrower.
I'm not wild about "shadow banking" either but maybe this is where the real market for money is right now - where loans are actually being made and priced to accurately reflect reality.
this comment hits spot on. I recall from another ZH article that the global banking sector is still $200 Trillion in the hole. If I understand this correctly, does this mean the banks are still inherently insolvent, even though they have $400 Trillion to work with? I would guess that banks are very selective about their lending activity because the last thing they want is to make climbing out of the pit they are in more difficult.
Yes. Hedge Funds are built to exploit opportunities and acting as a lender and at the same time shorting the weaker operations is certainly clever.
Banking in it's current form, is a total lie, and I hope it becomes the unsecered debt collector of the future, because banks and that market deserve each other.
If the banker's ran a legit operation, they would not need to hide behind a ponzi scheme of collecting on dead mortgage notes trying to re-attach them to the collateral and use laon mods as the glue.
The hedge funds seem to be either displacing the banks or making a market, or both, for the good portion of the banks to play in and the bad portion of the banks to collect in.
Just the point I was gonna make. These are sub prime business loans. Maybe they reflect the reality of the credit market, ie it is still frozen for smaller companies.
I do have a problem with the tax free status. Perhaps we should all create foreign corporations to do our trading as individuals, and take advatage the same way.
awesome idea!
It would have to be more than 50% foreign owned. America treats its own citizens the shabbiest.
In addition to this being more banker bollocks, it is a recipe for disaster in the event of credit market instability.
It would be fittingly ironic if Caribbean-domiciled hedge funds used (domestic) available leverage on AUM held at DTC to round trip dollars right back to the US credit markets bypassing the taxman and the regulators.
I thought the Dumb–Fuck Wall Street Reform and Consumer Protection Act was supposed to reign in the shadow banking sector.
"..Hedge Funds are becoming lenders.."
Geez, Brucie, this has been going forever, and I do mean fooooreeevver...
Word up, Bruce, under the Investment Company Act of 1996 (Amended), there can be an unlimited number of investers in each hedge fund. Add that to the rest of the numbers out there. "I thought the Dumb–Fuck Wall Street Reform and Consumer Protection Act was supposed to reign in the shadow banking sector."Negative, that bill moves the CDS conduit from AIG over to the clearinghouse, which can then be automatically bailed out by the Fed without going before congress -- a distinct improvement for the banksters.
Truly connecting the dots means realizing that the top banks are owned by other banks and hedge funds, which in turn are owned by other banks and hedge funds, a circular ownership ring, which exactly replicates the old interlocking directorates of yore. And who owns the top banks????There is a nice presentation on the FT.com blog about HF performances vis à vis a standard 60/40 equity-bond portfolio, before and after the 2008 meltdown. In essence, the HF outperformed the 60/40 benchmark much more before crisis as high leveraging was enough to outperform the market standard. Since 2009, they still outperform but less and less, the gap is smaller. It has even reversed lately as the steam has run out from their collective wings; the conclusion being that only the smart ones with a true business model will survive in these bearish times. Whence the herd instinct and the "insider" instinct which is now obsessively prevalent. It's now a question of survival...the devil WILL take the hindmost as in 2008...
More free money for Soros to redistribute to the Dummo Party.
"All large scale crime is always an inside job."
-Slim Pickens, Rancho Deluxe (1975)
Well he should know being a texan...Viz; 22 November 1963...
Slim Pickins was from California.