Two global banks and more than a dozen hedge funds misused a complex financial structure to claim billions of dollars in unjustified tax savings and to avoid leverage limits that protect the financial system from risky debt, a Senate Subcommittee investigation has found.
The improper use of this structured financial product, known as basket options, is the subject of a 93-page report [http://www.levin.senate.gov/download/?id=E6856807-8904-4F09-A5C9-01EAA641EA47] released by the Chairman and Ranking Member of the
"Over the years, this Subcommittee has focused significant time and attention on two important issues: tax avoidance by profitable companies and wealthy individuals, and reckless behavior that threatens the stability of the financial system," said Levin. "This investigation brings those two themes together. These banks and hedge funds used dubious structured financial products in a giant game of 'let's pretend,' costing the Treasury billions and bypassing safeguards that protect the economy from excessive bank lending for stock speculation."
"Americans are tired of large financial institutions playing by a different set of rules when it comes to paying taxes," said McCain. "The banks and hedge funds involved in this case used the basket options structure to change the tax treatment of their short-term stock trades, something the average American investor cannot do. Hedge funds cannot be allowed to have an unfair tax advantage over ordinary citizens."
The report outlines how
The banks and hedge funds used the option structure to open proprietary trading accounts in the names of the banks and create the fiction that the banks owned the account assets, when in fact the hedge funds exercised total control over the assets, executed all the trades, and reaped all the trading profits.
The hedge funds often exercised the options shortly after the one-year mark and claimed the trading profits were eligible for the lower income tax rate that applies to long-term capital gains on assets held for at least a year.
In 2010, the
In addition to avoiding taxes, the structure was used by the banks and hedge funds to evade federal leverage limits designed to protect against the risk of trading securities with borrowed money. Leverage limits were enacted into law after the stock market crash of 1929, when stock losses led to the collapse of not only the stock speculators, but also the banks that lent them money and were unable to collect.
Had the hedge funds made their trades in a normal brokerage account, they would have been subject to a 2-to-1 leverage limit - that is, for every
Using this structure, hedge funds piled on exponentially more debt than leverage limits allow, in one case permitting a leverage ratio of 20-to-1. The banks pretended that the money placed into the accounts were not loans to its customers, even though the hedge funds paid financing fees for use of the money. While the two banks have stopped selling basket options as a way for clients to claim long-term capital gains, they continue to use the structures to avoid federal leverage limits.
Data provided by the participants indicates that basket options produced about
"These basket option deals were enormously profitable for the banks and hedge funds that used them," Levin said. "But ordinary Americans have shouldered the tax burden these hedge funds shrugged off. Those same ordinary Americans would pay another price if the reckless borrowing outside of federal safeguards were to blow up."
The Levin-McCain report includes four recommendations to end the option abuse.
* To end bank involvement with abusive tax structures, federal financial regulators, as well as Treasury and the
* Treasury and the
Tuesday's hearing is at
Download the report, "Abuse of Structured Financial Products: Misusing Basket Options to Avoid Taxes and Leverage Limits" [http://www.levin.senate.gov/download/?id=E6856807-8904-4F09-A5C9-01EAA641EA47]
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