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Insider Trading On The Universe

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Here are some things that are happening:

-Oooh correlation is one oooh.

-The SEC has proposed rules that would ban banks from “betting against” securitizations that they create for one year after marketing them, a sort of anti-Abacus rule.

-The SEC is also investigating whether people traded on inside information ahead of the S&P’s downgrade of the U.S. Amusingly:

It isn't clear if securities regulators also are looking at trading of U.S. Treasurys. Inside information might not have been a blessing with these securities. Investors who bet against U.S. government debt suffered losses immediately after S&P's downgrade because rattled stock investors retreated into Treasurys as a safe haven. Such losses wouldn't be a defense against accusations of insider trading, lawyers said.

-Raj Rajaratnam may be going to jail for a million billion years for talking to some people about some stuff and then buying and selling some stocks. The Times is seeing him off with this bizarre quote:

The question is whether such a sentence — longer than the average federal prison term for murder — is appropriate. “Given the magnitude of the crimes, it’s hard to feel any pity for him,” said Harlan J. Protass, a defense lawyer …

These things seem puzzling - with the puzzle being, what do we want out of our capital markets?

Some smart people believe that insider trading should be legal and find it puzzling that our legal system considers it worse than murder. But if you are going to make insider trading a crime, you probably do so on some sort of theory of fairness: the little guy reading 10Ks and watching Jim Cramer should have just as good a chance of making money as the big mustachioed guy who gets calls from corporate directors as soon as they get out of board meetings. This is kind of a nutty theory but we seem to like it. It may be related to our theory that all Americans should have the same opportunity to invest their own retirement funds or make their own decisions about future healthcare needs.

But that theory gets murkier when you talk about shorting broad indices because you think that someone is going to say something negative about USTs which, by the way, will go up on the news. Here there's no "real" corporate event that will make earnings go up or down - there's just a self-interested, conflicted, quasi-competent market participant saying some words about a debt issuer, which apparently people used to make money trading securities of different issuers.

Similarly, the public perception of the anti-Abacus rule is kind of hard to argue against – OMG, you BUILT A SECURITY TO FAIL, then you BET AGAINST IT – but the reasoning is sort of puzzling to me. Let's grant that banks shouldn’t be able to stuff a CDO with mortgages chosen for their poor underwriting and general dodginess, sell them to clients, and buy naked protection on them. But what if you built a securitization of, like, every subprime mortgage? Or maybe only the top 10% best-underwritten subprime mortgages? And then you bet against it – because you believed that all subprime mortgages were going to get whacked by house price declines and rising unemployment? That would have been more or less a winning strategy.

Is that a conflict of interest? Well, yeah, sure. You had clients who bought something on macro thesis X (no one bought Abacus because they especially liked the underwriting of its loans), and you sold it/bought protection on it based on macro thesis Opposite Of X. If you were their fiduciary they’d be all “WTF, you told me macro thesis X, and you didn’t believe it?” But you’re not. You’re just selling stuff. They can take their own counsel on the world economy. It's no different than betting that gold or the Swiss franc or interest rates will go up, or down. Some people will take the other side, and that's their business. You may have better insights than them - in hindsight, I guess, someone will always turn out to have had better insights - but it's hard to imagine how you could be an insider on a macro bet. Or why your conflict of interest - your taking the opposite position from your customers on a macro question - should prevent you from making the trade.

I worry that the regulatory-and-political response to the financial crisis too easily conflates the micro and the macro - and that the everything-is-correlated effect makes it easier to do that. The packaging of Abacus seems to have been shady - investors were apparently misled about the roles of Paulson and others in picking mortgages to put into the CDO, and those mortgages seem to have been cleverly selected for dodginess - but basically the long investors in that trade lost money because the mortgage market went to shit, not because of the selection of the loans. People made money after the S&P downgrade not because the S&P is correct about the declining credit quality of Treasuries - it would be weird if that were true since rates went down on the downgrade - but because there continues to be a lot of uncertainty in the global economy and the S&P downgrade was one small symptom of that.

Banning "betting against clients" and investigating "insider trading" on the S&P downgrade suggests a mindset that no one should have an unfair advantage not only in corporate/earnings/M&A news, but also in having macro knowledge about the universe. And that seems like a hard thing to regulate.

And poor Raj. He seems to have made money mostly by doing a lot of research and making good bets on stocks. Some of that research - his lawyers say less than 1% - involved calling up directors and saying "hey, got any inside information for me?" So, not good. But in an all-correlations-to-one world, anyone arrested for garden-variety shenanigans like that becomes a symbol of Wall Street Evil and you-stole-grandma's-house. Which is not great for sentencing.


After The STOCK Act It Will Still Be Legal To Trade On Congressional Inside Information*

Here's a sort of touching monologue from David Einhorn's call with Punch: If you’ve done the analysis, and come to the conclusion that on it’s own, the company is not going to make it, it makes all of the sense in the world to raise equity at whatever the price is, so that you can know that the company, you know, is – is going to make it. Now, what that brings to my mind though is, you know, obviously we haven’t done your analysis, we haven’t done -- signed an NDA; I don’t know that we’re going to sign an NDA, because we prefer to just remain investors, but from my perspective, and I’ll be just straight up with you, is that gives a lot of signalling value. And the signalling value that comes from figuring out the company has figured out that it’s not going to make it on it’s own is that we’ve just grossly misassessed the -- you know what’s going on here. And -- and that, that will cause us to have to just reconsider what we’re doing, which is not the end of the world to you. You will continue on even if we don’t continue on with you. You could sort of see why the FSA read that to mean that he was insider trading. Like ... (1) You have told me something with signalling value. Sorry - "a lot of signalling value." (2) I will now act on that signal. (3) Don't be mad. "Signalling value" sure sounds like it means "material nonpublic information," doesn't it? Now as we've discussed before, trading on that information would not be enough to make Einhorn guilty of insider trading in the US, though maybe it wouldn't be exactly a great idea here either. Why? Because in our weird but sort of sensible insider trading laws, it's just not illegal to trade on material nonpublic information. It's only illegal to trade based on material nonpublic information that was obtained in violation of some sort of duty of confidence. Since Einhorn didn't sign an NDA, he had no duty of confidence. And since the Punch CEO and bankers weren't tipping him for nefarious purposes, but were instead sounding him out on the company's behalf as a shareholder and potential investor in a new capital raise, they weren't breaching their duty of confidence. You could quibble with the details of that but it's basically the law here. In England not so much. That also seems to be the law for our friends in Congress, who recently passed a law making it illegal for them to insider trade, which is worrying some people who make their living from trading on Congressional inside information: