Search Box

Monday, November 29, 2010

Insider trading

The recent news about the FBI's current crackdown on insider trading brought to mind what happened to a friend several years ago.

My friend was a very aggressive stock trader, and was always margined to the hilt. In the late 1990's and early 2000's he had done extremely well for himself by staying as leveraged as he could. But eventually he got caught in a short squeeze, and lost most of his money. (Though he still remained quite rich by most standards.)

I'm convinced that he got big enough to attract the attention of a hedge fund, which found out that he was leveraged to the hilt and decided to squeeze him. How would they have obtained this information? They would have bribed a back office employee at one of the brokerages where my friend kept his accounts. If they knew that a large investor was 100% leveraged -- and thus would be forced to buy in if a short position went against him -- they would buy the stock, drive it up, and sell it back to him at the higher prices he would be forced to buy in at.

Put yourself in the position of the person providing the information. Let's say you're a back office employee at Goldman Sachs. Your job is to process the traders' transactions, make sure the (mostly electronic) paperwork gets done the right way, the money gets transferred to the right places, margin calls are met, and all the accounts are in order. Your earn $170,000 a year, a good living by most standards, but you keep reading about how many millions the investment bankers and traders at Goldman are making. You can't help but feel like a second class citizen, and also a little resentful.

You're barely making your mortgage payments as it is, your wife is agitating for a nicer car, and you know your income category will make it hard for your three children to get scholarships to college. But you also know that without those scholarships, you'll be working the rest of your life in order to have a decent retirement. 

Along comes a hedge fund guy who phones you at your home and tells you he wants to meet you, and that it could be very profitable for you. You get the feeling that this may not be completely legit, but the thought of extra money is appealing. You meet the guy, and he tells you that all you have to do is give him a little information: which accounts are 100% margined, and which stocks they are short. He says he'll meet you at a bar in Queens, near where you live, that no phone calls will be involved, and that if the information you give him is worthwhile, he'll pay you a percentage of the profits he makes. In cash. And that it could well run into the hundreds of thousands of dollars. He points out that there will be only two people who know about this arrangement -- you and him -- and that he has as much incentive to keep your arrangement secret as you do.

You think about it. Then you do what most people in your situation would do. You succumb.

I'm quite sure this is what happened to my friend, though I would never be able to prove it. I would also be surprised if this kind of thing does not go on all the time. It's a fairly obvious scam, and I'm sure I'm not the only one who has thought of it.

And employees at non-financial firms who are privy to information about takeovers, or new products, or FDA test results, must be sorely tempted to cash in on that information.

People will do all sorts of things for money, especially if they perceive the risk to be negligible. And hedge funds will do anything for money. Anything at all.

I'm not trying to sound morally superior here. If I were that back office guy, I'd probably do the same.

(Though maybe I'm slightly superior to those hedge fund guys.)

So I'm glad to see them brought in.


Anonymous said...

Corruption and criminality permeate Wall Street. Mostly the rest of us usually don't get too badly injured by it, but the financial crisis has shown that with the concentration of financial power among the Vampire Squid and a few others it has become an existential threat to global economic stability. Financial institutions and markets of course play an important role in the economic system, but it seems to me that we need to completely revisit the role of the monetary institutions, which appear to have become mainly providers of liquidity to leveraged hedge funds and of backdoor bail-outs to failed secondary mortgage institutions.

On a similar theme, here's a quote from Elizabeth Warren on consumer financial protection that Republican lawmakers would do well to reflect on. "When I talk about functioning markets, I’m not using the word “market” as coded
language for a return to the Wild West where companies use deception to pick off every consumer they can get in their sites. A free market is one where consumers have the ability to make well‐ informed choices, where the choices are visible and the terms are clear, and where there are cops on the beat to make sure that everyone plays by the same rules."
The same could apply to the financial markets generally.

I'm not particularly in favor of regulation as the lead solution because regulators are often inept, under-resourced and corruptible. I would prefer to see more emphasis on structural reforms that bust up the power of the oligarchies and make risk takers play with their own money. I think we'd end up with more competitive, more innovative and more positive sum financial markets if we did. And we certainly couldn't do any worse in providing liquidity to main street than where we are now!


John Craig said...

Guy -- Agreed on all counts. I read recently that when the financial industry's share of the GDP grows to a certain percentage (I forget exactly what the percentage was) it almost inevitably portends a national financial crisis.

And yes, "most of us don't get too badly hurt," but we all get hurt a little. It reminds me of what I once heard (a while back) about how the cost of all goods is roughly one percent higher because of Mafia control of the trucking industry. I've heard similar things about the construction industry, and I think that our insurance premiums are considerably more than one percent higher because of insurance fraud. But the people whom corrupt CEOs hurt mostly are their own shareholders and their competitors, not necessarily the man on the street. I'm not sure exactly what Wall Street's "tax" on the national GDP is, but I suspect it's higher than one percent there as well.

I instinctively dislike Elizabeth Warren, but I have to agree with that quote of hers, as far as it goes. The problem is, if she gets her way completely, we'll end up with a nanny state where no consumer is responsible for his own actions and the big bad corporations have to take full responsibility for all the dumb choices and mistakes consumers make.

Anonymous said...

John, Do you ever wonder when an airline employee, perhaps someone in food service or a mechanic, will succumb to a similar kind of temptation? I am sure that those employees make relatively little money, yet are in a position to do great damage if approachedby a terrorist organization.

John Craig said...

Anonymous --
I think most people, while they would do a lot for money, would draw the line at killing people. Then again, it wouldn't be as hard to find someone in a Muslim country who actually wants to kill Westerners as a matter of principle.

My bigger worry about the airlines is that it just can't be that hard to bring a Stinger missile into this country, and there are so many unprotected areas around airports where a jetliner is flying at an altitude of under 5000 or 6000 feet where a guy with a hand held rocket launcher could fire one from. Right now security is pretty tight for passengers, but you don't have to be inside an aircraft to take it down.