Our Millionaire Congress & the Top 1%

FORECASTS & TRENDS E-LETTER
by Gary D. Halbert
January 10, 2012

IN THIS ISSUE:

1. Trade as I Say, Not as I Do

2. What is Insider Trading?

3. A Penny for Your Thoughts

4. Congress to the Rescue?

5. Congress and the 1%

Introduction

I hope you enjoyed the holidays and are ready for the prospects of another year. In the investment business, the start of a new year is a magical time because all of the year-to-date numbers go back to zero and money managers get a fresh start. Considering the large upward move in the market on January 3, my bet is that most money managers at least started out on the right foot.

As I noted in last week’s E-Letter, the beginning of the year is also a time to return to a more normal writing schedule. The new year always seems to bring fresh stories, new ideas, new opinions and challenges and opportunities to write about, not to mention a presidential election that you can be sure I’ll weigh in on from time to time in 2012.

This week, my focus will be on a group of individuals that everyone seems to dislike – members of Congress. According to a recent Gallup Poll, only 11% of Americans approve of the way Congress is doing business, and a whopping 86% disapprove. Today’s E-Letter will give you even more reasons to be counted among the 86% who disapprove.

Over the past couple of months, there have been major disclosures regarding the financial well-being of our elected officials, as well as an apparent loophole in securities laws that may have helped them get there. So, while Americans are struggling to make ends meet, your Congressmen are doing quite well through thick and thin. This will make for interesting reading, whether you love your Congressman or not.

Trade As I Say, Not As I Do

Some people consider the Holy Grail of investing to be achieving returns greater than those of the overall stock market, generally measured by the S&P 500 Index. While I have written in the past that merely beating the S&P 500 doesn’t necessarily mean you don’t lose money, it is just a benchmark that many investors use to judge the value of a particular money manager or mutual fund.

That being the case, most Congressmen should immediately become money managers upon their retirement. Why? Because studies have shown that they routinely beat the market. And not by just a little bit. Analysis of Congressional investment returns have shown that, as a general rule, members of Congress outperform the market by a significant margin of anywhere from 6% to 12%. Note that these are returns over and above whatever the stock market indexes achieved.

Think of it, our elected officials have a mountain of things to do, including sponsoring legislation, making speeches, attending committee meetings, etc., etc. Yet they still have enough spare time to analyze the market and come up with a market-beating strategy. Or do they? Let me explain.

A November 2011 “60 Minutes” report offered up another possible reason why our Representatives and Senators do so well in the market. It seems that members of Congress are not subject to the same “insider trading” rules that you, I and the other 300 million people in the US are governed by. That’s right, an elected official can attend a hearing, work on legislation or sit in on a regulatory briefing not open to the public and then go trade on any information he or she may have gleaned from the meeting. No kidding!

Representative Spencer Bachus (R - Alabama) seems to have become the poster child of the Congressional insider trading scandals. Sitting in on a special briefing by Bush Treasury Secretary Hank Paulson and Fed Chairman, Ben Bernanke, Bachus reportedly heard Bernanke say, “It is a matter of days before there is a meltdown in the global financial system.”

So what did Bachus do? Spread the alarm to his home state officials? Contact major banks in his state to determine their condition? Nope, he shorted the stock market, a trade that makes money when stocks fall. In other words, he used this non-public information to enrich himself, and obviously, he’s not the only one.

What is Insider Trading?

The “60 Minutes” report focused on what is known as “insider trading,” but it’s important to note that there are two kinds of insider trading. One is perfectly legal and involves the purchase of a company’s stock by its own management. As long as the decision to buy is made on public information and the trades are reported to the Securities and Exchange Commission (SEC), there’s nothing improper about the transaction.

The other type of insider trading is illegal, at least for you and me. This kind of trading involves using insider information not yet available to the public to trade securities. The SEC wants all investors to be on a level playing field, so trades should be based only on information known or available to the public. The “60 Minutes” report and other articles since then have claimed that basing trades on non-public information is illegal for the vast majority of Americans, but not for members of Congress.

The SEC has a different opinion. In a response to a recent Wall Street Journal editorial about Congressional insider trading, SEC Enforcement Division Director, Robert Khuzami, noted that his written testimony recently submitted to Congress included the following excerpt:

“…there is no reason why trading by Members of Congress …would be considered ‘exempt’ from the federal securities laws, including the insider-trading prohibitions.”

So do members of Congress get a pass on insider trading or not? The answer is that it depends on what kind of insider information you’re talking about. As Mr. Khuzami correctly states, members of Congress are subject to laws governing trading based on information from corporate insiders, just like everyone else. It is only in regard to information gained as a member of Congress that the insider trading rules do not apply. How convenient!

Let’s take an example for clarification. You may recall that private citizen Martha Stewart spent some time in prison for insider trading. Her problem began when Stewart was tipped off prior to a public announcement that a drug maker in which she owned stock (ImClone) did not receive FDA approval of its new drug. To avoid the drop in share price sure to come when this news was announced publicly, Stewart traded out of ImClone stock and avoided a loss but was later found guilty of illegal insider trading.

According to the SEC, had a member of Congress received the same timely tip from a corporate insider, it also would have been deemed to be illegal insider trading. However, had a member of Congress learned of the ImClone failure to get approval in a closed-door briefing with the FDA, it appears that trading on this information would have been perfectly legal.

As a financial professional, I can tell you that the SEC takes insider trading by private citizens very seriously. We have annual staff training on the rules governing insider trading, complete with case studies. And the SEC’s rules don’t just include financial professionals and company management. If even a part-time file clerk overheard a conversation between company executives and used the non-public information to make some money, that person could technically be charged with illegal insider trading.

A Penny for Your Thoughts

Actually, lots of pennies. Related to the exemption from the insider trading rules discussion above is the matter of so-called “political intelligence consultants,” or PICs for short. Under current law, hedge funds and other financial services providers can legally engage well-connected Washington insiders to arrange meetings with elected officials and their staff for the purpose of gaining inside information that might affect investments.

Think about it, if a hedge fund manager knew ahead of time whether pending legislation was likely to pass or not, or that regulatory action was nigh, it could be worth literally millions of dollars in investment gains for the fund’s investors. Yet, this sharing of insider knowledge does not currently violate insider trading rules.

A December 20, 2011 Wall Street Journal article detailed how a group of hedge fund managers were told about a compromise on the public option in the ObamaCare health care law before a public announcement was made. Obviously, this news would mean big money to stock traders who had the time to adjust their positions to take advantage of ObamaCare’s passage.

Growing numbers of power brokers in Washington are forming these groups to engage in the lucrative practice supposedly designed to “bridge the information gap between Washington and Wall Street.” Some members of Congress also say that the meetings set up through the PICs do serve a useful purpose. According to the WSJ article, Republicans value the meetings because “they seek the views of hedge fund managers to help shape laws that spur investment.”

Democrats, on the other hand, feel that these meetings “…lead to better public policy because investors tell them about loopholes, inefficiencies or unseen consequences of existing laws.” Yeah, right. What’s really happening is that valuable non-public information is being sold to the highest bidder by Washington politicians. The more things change, the more they stay the same.

Never fear, Congress is Here.

Due to the massive negative publicity surrounding the November ‘60 Minutes’ report and subsequent online articles, Congress dusted off a bill first introduced in 2006 that supposedly addressed insider trading by members of Congress. The “Stop Trading on Congressional Knowledge Act” (H.R. 1148) would make it illegal for members of Congress or their staff to buy or sell securities based on certain types of non-public information.

As with many pieces of legislation, the devil is in the details. The particular detail of importance in this bill is the phrase “certain types of non-public information.” Elected officials are privy to all kinds of information that may not be known by the public. Yet the proposed legislation only prohibits trading on information related to pending legislation. Returning to our Spencer Bachus example, it would appear that information gained from an agency briefing would be exempt, so he would probably still avoid prosecution for insider trading even if the new law is enacted.

The Stop Trading bill would also target the political intelligence consultants discussed above and make them conform to the same rules now governing lobbyists. The legislation would also require members of Congress and their staff to disclose securities trades over certain amounts within 90 days. Of course, that’s in the current version of the bill before these PICs and lobbyists start arranging meetings that could result in less restrictive rules, or none at all.

In reality, the Stop Trading bill appears to be yet another case of form over substance. Congress wants it to look like something is being done as a result of its dirty little secret being aired, but they don’t want to stop the gravy train. One article I read said that the author expected insider trading by members of Congress to actually increase if the Stop Trading bill passes since the rules would then be clearer and have a much narrower focus.

Congress and the 1%

The Occupy Wall Street (OWS) movement seems to have now been omitted from the news cycle, but still continues on in many cities across the US, including Austin where I live. They claim to want to draw attention to the wealthiest 1% of the population who are, according to the OWS website, “…writing the rules of an unfair global economy that is foreclosing on our future.” The occupation began in the Wall Street Financial District but, according to recent reports, perhaps they should take up residence outside the Capitol Building in Washington, D.C. I’ll explain why as we go along.

Up to this point, I have discussed the special treatment that our elected officials in Washington enjoy in regard to their investments. Is it any wonder then that recent reports show that members of Congress enjoy a higher level of wealth than the rest of the country?

A recent New York Times article noted that the median net worth of members of Congress rose 15% from 2004 to 2010, while the net worth of the richest 10% of US households remained flat. Even worse, for all American families, net worth dropped 8% over the same time period.

A number of theories have been advanced as the reason that members of Congress were able to swim against the tide of shrinking portfolios during the Great Recession. Some include profitable real estate deals (perhaps using the same insider information discussed above), inheritances and even marriage to a wealthy spouse. Others note that the increasing cost of running for public office is resulting in only the wealthy being able to mount a campaign.

However, I think it’s pretty clear that stock picks based on non-public information and cozy relationships with hedge funds can also explain a lot of what might be called the Congressional wealth gap.

Here are some other Congressional wealth statistics gleaned from various sources that may be of interest to you:

At least 10 members of Congress are worth $100 million or more;

Almost 50% of members of Congress have million-dollar net worths (excluding primary residence), compared to only 1% of all Americans (see illustration below);

In 2010 (latest information available), the estimated median net worth of a US Senator was apprx. $2.6 million;

About 11% of all members of Congress have a net worth of more than $9 million;

The median net worth for members of Congress is apprx. $913,000, compared to around $100,000 for the average American;

57 members of Congress are among the wealthiest 1% of Americans;

Congressional wealth is bipartisan according to the Center for Responsive Politics. Of members of Congress reporting net worth in excess of $1 million, 110 were Democrats and 140 were Republicans; and

The current salary for a rank-and-file member of Congress is $174,000 per year, with House and Senate leadership positions earning slightly more.

Some believe that having the wealthy so well represented in Congress is a good thing since they feel voters would want their representatives to be smart and successful, which also usually includes financial gain. It has also been pointed out that some members of Congress have built businesses from the ground up, so they are participants in the American dream.

Others, however, fear that wealthy members of Congress cannot relate to the plight of the average American. They ask, “How can a representative know how it feels to be unemployed with no cash reserve or have a home foreclosed on when they have never lived through such an event?”

Such thinking among voters can be dangerous for re-election hopes. Recall the fabricated story about George H.W. Bush being “amazed” at everyday supermarket scanners. Even though it turned out not to be true, the Clinton team used it to claim Bush was out of touch with Americans’ everyday economic struggles, and we all know what happened in that election.

While all of the analysis is interesting, I don’t think there is much we can do about the number of wealthy individuals in Congress. Going back to the founding of the US, many representatives were wealthy landowners. Later on, industrial and oil dynasties were represented and today we have those who made their fortunes in financial services and technology, and the legal profession has always been well represented. Being a member of Congress is a position of power, and power has always attracted money.

Conclusions

Of all of the information discussed above, I am most disturbed by the fact that self-interest seems to take center stage for members of Congress. Why else would they propose to fix the insider trading problem by actually making it easier for them to trade on non-public information, and then only after a "60 Minutes" report exposed their activity?

Even worse, these are the leaders we have chosen to get us out of the economic malaise we are currently experiencing. Since members of Congress seem to be most concerned with getting re-elected, how can they vote to make painful cuts in spending when it is much more popular to do the opposite?

The information we covered today also makes it easier to believe the stories of Congressmen who went to Washington with virtually nothing and came back multi-millionaires. However, I don’t want to paint every member of Congress with the same brush. To be fair, there are some members of Congress who do not attempt to profit from insider information. Others place their money into blind trusts and have little or no knowledge of or influence on securities bought and sold in their accounts.

The bottom line is that not much is likely to change in Congress. As the cost of running for office continues to escalate, we may find an even higher concentration of wealthy individuals as our representatives. That would be fine were it not for the blatant self-interest that seems to permeate both Houses of Congress. As a result, Congress’ 11% approval rating may get a lot worse before it gets better.

I also encourage you to check out my “Between the Lines” blog at www.garydhalbert.com. My latest post covers a variety of economic reports, several of which appear to be looking up. However, the situation in Europe remains as a possible spoiler, no matter how good the economic news on this side of the Atlantic might be. I also weigh in on the recent “recess” appointments by President Obama. He must have missed class the day they talked about constitutional checks and balances.

Wishing you a Happy New Year!

Gary D. Halbert