WASHINGTON - In recent years, the Senate Permanent Subcommittee on Investigations, which I chair, has exposed tax avoidance by profitable corporations and wealthy individuals. We also have examined reckless behavior that has put the stability of the financial system - and by extension, the U.S. economy - at risk. In late July, we released a report and held a lengthy hearing on a situation that combines those two important issues.
We focused on how two banks and a handful of hedge funds developed a complex financial structure to engage in highly profitable financial market trading while claiming an unjustified lower tax rate and avoiding limits on risky trading with borrowed money. This structure worked well for the banks, which earned hundreds of millions of dollars in fees. It worked well for the hedge funds, which made billions of dollars in profits. But it didn't work for average taxpayers, who had to shoulder the tax burden these hedge funds shrugged off with the aid of the banks. And it didn't work for the financial system, which is ill-equipped to withstand another shock from risky deals gone wrong.
Central to this fiction was the use of something called a "basket option." Together, the two banks - Deutsche Bank AG of Germany and Barclays PLC of Great Britain - sold 199 basket options to hedge funds that used them to make over $100 billion in trades. Two of the largest basket option users were Renaissance Technologies LLC, known as RenTec, and George Weiss Associates.
The arrangements were complex, but the basket option basics worked like this: The bank sold its hedge-fund client a financial product, labeled an "option," whose payoff equaled the profits generated by a "basket" of securities such as stocks and bonds held in a designated account at the bank. The account technically belonged to the bank, even though the hedge fund controlled all the securities trading and reaped all the profits. One hedge fund used the account to make 30 million trades or more a year.
In addition, the fictional option was structured so that it could be exercised more than one year after it was created. That's important because our tax code gives a reduced tax rate to profits from the sale of assets held for more than a year as an incentive for investors to put their money into long-term investments that help grow the economy.
The hedge funds claimed that trading profits from the account were long-term capital gains and thereby qualified for the reduced long-term capital gains tax rate, even though the basket account often bought and sold assets that it held for days or even minutes. Subcommittee staff estimates that from 2000 to 2013, RenTec avoided paying more than $6 billion in taxes.
Tax avoidance through financial engineering wasn't the only problem. The banks and hedge funds also used basket option accounts to circumvent regulations designed to limit systemic risks to the banking system posed by excessive leverage that is, excessive lending to finance stock trading.
Had the hedge funds involved in these transactions been using normal brokerage accounts, they could have borrowed only $1 for every $2 of their own money in the trading accounts. That limit exists to keep traders from borrowing lots of money, experiencing big losses and, if they fail, dragging down the banks that lent them money which, by extension, could once again put our entire financial system at risk.
But because the basket option accounts were opened in the name of the banks, the banks pretended to be depositing money into their own accounts instead of loaning money to the hedge funds. That fiction allowed the hedge funds to borrow up to 20 times as much money as they normally could have, which allowed them to profit much more from their trading strategies but also risked big losses for them and their banks.
The basket option arrangement was built on an interlocking series of fictions. It is another example of financial institutions playing fast and loose with the rules while offloading billions of taxes onto the backs of ordinary taxpayers. Congress and financial regulators can and should work together to stop the abuses.
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Carl Levin is the senior U.S. senator from Michigan.