I just read an article on Zero Hedge about how a hedge fund company called RenTec made billions using an elaborate scheme involving basket options to avoid payment of federal tax via a tax loophole. Most of the information in the article admittedly uses jargon and flow diagrams I don’t completely understand, so I’ve tried to make sense of the general idea it is trying to convey here, like I am a six-year-old.
A basket option, according to Investopedia, is basically the same as other options that get traded, except that with a basket option, a holder is able to buy or sell underlying assets, which might be things like commodities, securities or currencies, together as a group. The way I am interpreting this is, instead of just having apples in one’s basket, there are lots of other fruits like bananas, pineapples, pomegranates and kiwis that can be traded along with the apples. The price of the whole basket is based on the average prices of all the fruit. This is good for hedging because if the price of kiwis drops, there are still other valuable fruit to sell in one’s basket. But I digress.
If I understand properly without knowing all of the details, RenTec was able to use basket options to its advantage by involving large banks like Deutsche Bank and Barclays Bank, both of which had the infrastructure to sell the options, ahem, fruit baskets. In effect, the banks leased their “buildings” to RenTec so it could package the “fruit” into baskets. The banks loaned out their “delivery trucks” to RenTec too, so it could deliver the fruit baskets. The banks just said, “as long as you’re paying us, here are our buildings and trucks, but we don’t want to know what you’re doing with them, even though we actually know what you’re doing with them, but we’ll pretend we don’t, ‘nome sayin’?”. RenTec in turn gave these banks part of its very good profits to lease the buildings and the trucks.
Whatever profits RenTec made from selling baskets to its customers were given to another RenTec dummy “advising” company. After the dummy company took its share, it gave “investment advice” and some control back to the banks (kind of like drug dealers hiding money with “managers” in offshore bank accounts, but we all know that the drug dealers ultimately control the drug trade…).
Then the basket “packaging/delivery” cycle happens all over again. Except that in this case, the delivery step happened really fast, like on the order of seconds, so RenTec could sell a lot of baskets really, really fast, because lots of people liked their fruit baskets and wanted to buy a lot of them quickly. There is nothing wrong with this scheme, except that RenTec was calling the profits it made long-term capital gains when it fact these gains were made in the short-term. The tax rates on short-term gains are substantially higher. RenTec instead generally paid the lower tax rate.
This scheme had been in operation since 1998 until 2013. While the Great Recession happened, these guys were literally laughing all the way to the bank. I am not quite sure why the scheme stopped functioning in 2013, but I am guessing the heat was on them, so they stopped (kind of like the cops wiretapping the drug dealers in “The Wire”; the dealers have to come up with increasingly more sophisticated ways to deliver their goods…). So, today there is a U.S. Senate Subcommittee hearing regarding the RenTec issue, but, unlike drug dealers, what RenTec did is in a legal grey area, apparently.
What is laughable is that the U.S. National debt continues to increase like crazy. The only time the U.S. federal debt has been higher as a % of Gross Domestic Product, was during WWII. The guy who created RenTec, Jim Simons, happens to be one of the richest people in the world. I have to give him credit for his tax-avoiding creativity; in developing a scheme which provides absolutely nothing of value to the advancement of the human race. While his bank account grows, so does income inequality for the rest of us. I also have to congratulate all the lawmakers who can’t seem to keep this stuff under control. Good job all, and good luck with the hearing!
Cleverly found the loophole, but didn’t get any marks for the incorrect answer.