Basket Options: Wall Street Launders Again!

Have you noticed that the financial wizards of Wall Street tend to implement the same strategies over and over again?

During the late 1980s, for instance, financial institutions turned high-risk “junk bond” debt into a staple of corporate finance. And two decades later, many of the same organizations churned out “sub-prime” mortgage debt securities.

Here is another example: during the 1990s and early 2000s, investment bankers helped American corporations reduce their tax burdens by advising them to move their headquarters to nations with lower rates of taxation. Today, of course, their “tax inversion” acquisition strategy is following the same path.

And a few days ago, the United States Senate held an investigatory hearing into yet another questionable Wall Street strategy. This one, called the basket option, operationalizes the time-tested principles of money laundering.

Money laundering? Isn’t that illegal? Well, when firms launder funds through intermediary organizations to hide criminal activities, it is most certainly illegal.

But what does “money laundering” mean? For a simple example, let’s assume that the owner of a criminal syndicate earns significant amounts of cash from illegal narcotic or prostitution activities. Let’s also assume that the owner decides to purchase an empty strip of land and operate a parking lot.

Why would he do so? Because parking lots are cash businesses. The owner will deposit his illegal business cash receipts into a bank account that serves his legitimate parking business, while attributing those receipts to parking services. In essence, the owner will use the parking lot to “clean” (or “launder”) his “dirty” illegal money by attributing it to a legitimate business.

Wall Street’s basket option strategy utilizes the same principle. Instead of trading securities on a continuing basis, an American investor will contract with a financial institution to create a “basket” of securities that trades frequently on his behalf. The investor will also hold an option to purchase (or sell) the basket, and will exercise that option on an infrequent basis.

How infrequently? Invariably, he will exercise his option less frequently than once a year. Why not more often? Because more frequent trading would defeat the purpose of owning the basket option.

You see, if an American investor sells a security that is owned for less than a year, he would pay a relatively high “short term capital gains” tax rate on his profit. But if he sells a security that is owned for more than a year, he would pay a much lower “long term” rate.

Thus, by relying on a different entity to make short term trades while transacting with that entity on a long term basis, the investor can utilize the entity to “launder” those short term trades and redefine the resulting profits as long term profits. And by doing so, the investor can reap the benefit of the lower tax rate.

This laundering strategy, incidentally, is reminiscent of an incorporation structure that Goldman Sachs proposed to Facebook before the social media giant “went public” in an Initial Public Offering. Apparently, Facebook’s corporate officers decided to go public because the firm was about to expand its investor roster to more than 500 individuals, a level at which any American firm must accept (by law) the regulatory burdens of public ownership.

Goldman, however, proposed to create a Special Investment Vehicle (SIV) to serve as the sole owner of Facebook stock. This holding company, according to Goldman, would then resell that stock to far more than 500 investors.

Such a strategy, in essence, would have permitted Facebook to rely on a new entity to “launder” large numbers of investors into a single unit for the purpose of avoiding the responsibilities of public ownership. To its credit, Facebook declined to accept Goldman’s offer and decided to launch its Initial Public Offering instead.

Nevertheless, this strategy of “laundering” transactions through an intermediary entity appears to have been employed again in the form of today’s basket options. Apparently, Wall Street’s wizards of finance cannot resist the temptation to utilize intermediary organizations to “clean” transactions, a strategy that they implement over and over again.