Political connections: evidence from insider trading around TARP

Barcelona GSE Focus

On the third Monday of September 2008 Lehman Brothers failed. The financial markets worldwide collapse under the skeptic eyes of those whose imagination could not have possibly conceived the dimensions of the crisis. Four weeks later, the Department of Treasury of the United States announced an unprecedented investment in financial institutions through a $700 billion Capital Purchase Program (CPP), also referred as the Troubled Asset Relief Program (TARP). Each financial institution could request a specific amount of TARP funds, but it was Treasury’s decision to decide whether to grant the bank a bailout.

The bailout generated social outrage by using taxpayers’ money to help revitalize financial institutions. It also confirmed that banks are, indeed, too-big-to-fail, too-many-to-fail or too-important-to-fail. This is in addition to a well-known fact that is also raising public scrutiny: the connections between the financial sector regulators and bank top executives. The U.S. financial sector is by far the largest donor to political campaigns. It also spends substantial amounts on lobbying, and benefits from a fast spinning “revolving door” between the Federal government and Wall Street.

Given these tight links, this paper explores whether private information was leaked by regulatory officials to top bank executives before decisions about the bailouts were taken. Albeit lacking information about the unequivocal email or phone call that explicitly captures this illegal information leakage, the authors use an indirect way to evaluate the hypothesis: they track the insider trading behavior of bank executives and ask the following question: did bank executives with a political connection in Washington adjust their trading strategy during the months between the announcement of the general TARP program and the bank-specific TARP injection date? In other words, compared to bank executives lacking this connection, did executives in connected banks adjust their portfolio position in a way consistent with having received leaked information about future TARP decisions?

This is exactly the information that Özlem Akin, Nicholas S. Coleman, Christian Fons-Rosen and José-Luis Peydró collected for the Barcelona GSE Working Waper (No. 935), “Political Connections: Evidence from Insider Trading around TARP”. Using insider trading data, the authors explore whether political connections lead to private information flows from regulators to bankers before bank-specific TARP bailout decisions were made public.

To recover the information about the TARP receiving banks, the authors use the U.S. Treasury’s TARP Transaction Report that provides a full list of TARP receiving banks, the amount they received, and the date at which the injection was announced. Yet the report does not disclose information on the amount of TARP funds requested by bank. To recover this information, the authors proceeded through a Freedom of Information Act (FOIA), which provided them a unique and unexplored dataset.

Under the Securities and Exchange Act of 1934, corporate insiders are required to report, timely, their trades. The Thomson Financial Insider Filings Database contains information about the corporate insiders’ acquisitions and dispositions of the stock of the company where they work, including date, amount, and transaction price.

Finally, the political connections were recovered using the previous employment history using the BoardEx database. The authors defined an insider as connected if he or she had previously worked in government. Likewise, a bank was defined as connected if at least one of its board members was connected.

With this information, the authors explore whether the insiders’ trading behavior is consistent with political connections giving them access to private information about forthcoming bank-specific TARP decisions.

Results of the study

Among connected banks, institutions whose insiders bought more shares in the pre-TARP period experience positive and higher abnormal returns in the post-TARP period. This correlation is not present for unconnected banks and results are not driven by differences in buying amount in the pre-TARP period across banks. Moreover, connections to financial branches of government are the ones driving the results, suggesting that government connections per se are not key; rather, having access to bank regulators is the driving factor.

When looking at connected vs unconnected individuals within the subset of connected banks, the authors find that connected executives buy more shares during the pre-TARP period in banks that experience positive abnormal returns in the post-TARP period.

These results provide suggestive evidence about the fact that the “revolving door” between banks and public institutions not only happens in terms of employment but also in terms of information sharing. Overall results suggest that connected banks were receiving private information about their bank-specific TARP deal beforehand.