700 Billion Little Birds

Could $700 billion create some moral challenges?

Lady Justice. Source: Wikipedia

In the midst of the financial crisis, Congress passed the TARP program—originally designed to buy troubled assets from banks, but actually used to provide additional capital to the banks. It didn’t buy CDOs-squared and mortgage-backed securities backed by NINJA-loans—mortgages to people with no income, no job, and no assets. Instead, the TARP program mostly bought preferred shares issued by banks, injecting capital directly into the banking system.

Not every bank took TARP money. Some banks didn’t need the funds. And the government’s money had some strings attached: dividends couldn’t be raised; many banks had to cut their dividends to a penny; the preferred shares had a 5% dividend which jumped to 9% after 5 years. But a lot of banks—small, medium, and large—did participate in the program. Healthy people don’t need a doctor, only the sick. And sick banks needed the TARP money. It gave it the government’s stamp of approval. It meant that if the bank failed, the government would lose out.

JP Morgan dividend over the past 10 years. Source: Bloomberg

So banks had to apply for program funds. If they were accepted, their shares rose. If they were declined, their shares fell. Presumably, a lot of people knew about those approval decisions before the information became public. So some researchers looked at publicly disclosed trading data from 7,300 bank directors and officers at nearly 500 companies to see whether the insiders profited from the information.

And what the researchers found was informative. Insiders who had close political connections—publicly disclosed prior employment with a bank regulator—tended to trade in just the right way to make a profit or to avoid a loss. Politically connected folks who bought shares in the thirty days before their firm received a TARP investment saw returns of 4.4%. If they sold stock, shares fell 5.1%. It’s hard to see this as the actions of just a few bad eggs. After all, the researchers looked at 7,300 insiders over a 5-year period. If a little bird told them when to buy or sell, it must have been a busy little bird.

Insider trading around TARP infusions. Source: Jagolinzer, et. al.

The Wells Fargo scandal shows that when there are significant rewards or punishments, people will rationalize all kinds of bad behaviors. If banking insiders used their connections to game the system—extracting rents, corrupting markets—they deserve all the public shaming our system can muster. And we need to think hard about incentives.

Markets only work when there’s a high degree of confidence that the game isn’t rigged. If Preet Bharara can’t get indictments because the insider trading law is too vague, it’s time to write a new law. And get out the tar and feathers.

Douglas R. Tengdin, CFA

Chief Investment Officer

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