Hedge fund paid terminally ill people to sign up for "death puts"

A "death put" on a certificate of deposit means that the bond matures immediately upon the bearer's death, rather than when its term runs out: they're used as a form of life-insurance, cushioning the blow to loved ones from unexpected death, and they can be held jointly, so that the bearer's heirs and a third party get a payoff on death.

This created an arbitrage opportunity that was spotted by Donald F. "Jay" Lathen Jr. who runs a hedge fund called Eden Arc Capital Management. Lathen sent talent scouts into nursing homes and hospitals, looking for terminally ill patients, offering then $10,000 cash to sign up with Lathen as the beneficiary of the bond.

The SEC isn't happy about this, though they've had to really dig deep to find some basis for punishing Lathen and Eden Arc. The dying people got $10K they wouldn't have gotten, the hedge fund investors got payouts, and Lathen didn't exactly lie to the bond issuers. The only thing the regulators have come up with is that Lathen may have committed an impropriety by having the money flow through a personal account on the way into and out of Eden Arc's coffers, though he apparently did a lot of paperwork to make sure that this was as above-board as possible.

As Matt Levine points out, the real problem with this arbitrage scheme is that it will destroy a socially useful insurance plan that genuinely benefits terminally ill people of modest means, to the advantage of incredibly wealthy hedge-fund investors.

The death put is a form of insurance, a way for people to smooth out the financial harms of unexpected catastrophe. If a married couple buy bonds as a long-term investment, and then the breadwinner dies suddenly and the survivor needs ready cash, it's nice if the bonds can be redeemed immediately at 100 cents on the dollar. It's a little bit of a financial cushion that the issuers are willing to provide, for a price. And the issuers presumably had some reason for pricing the risk of death the way they did; they presumably did some actuarial calculations about how many people would die and how much it would cost them in death puts. And those calculations were presumably based on, you know, normal people. They didn't assume that everyone buying their bonds would have months to live, or that they'd be funded by a secretive hedge fund trying to profit from inefficiencies in the price of death. If they had, they'd have priced the survivor option differently, or not offered it at all, and its insurance function for regular people would be lost. A survivor option priced correctly for death-put arbitrageurs would lose its insurance function for the rest of us. A world where ruthless hedge funds can profit from death options is a world where no one else can.

Hedge Fund Manager Profited From Death Arbitrage
[Matt Levine/Bloomberg]

(Image: A tombstone with Sue Rangell's name on it, Sue Rangell, CC-BY-SA)