The Credit Crunch and Insider Trading

• DOI: http://doi.org/10.1111/fmii.12015
• Author: Manouchehr Tavakoli,Phillip J. McKnight,David McMillan
• Date: 01 May 2014
• Published date: 01 May 2014

The Credit Crunch and Insider Trading

BYMANOUCHEHR TAVAKO L I ,DAVI D MCMILLAN,

AND PHILLIP J. MCKNIGHT

This paper examines the behaviour and information content of insiders’ trades before

and after the credit crunch and, in particular, examines the extent to which some insiders

anticipated the market crash and took action to protect their positions. In part, the market

crash was brought about by the excessive borrowing of financial institutions. Our results

point to the viewthat a number of insiders, primarily directors, were aware that the excessive

use of leverage by financial institutions would ultimately havea detrimental impact on the

economy. These insiders acted by selling their shares prior to the market collapse and

subsequently buying them back at a lower price. Supportive evidence for the above view

is provided through both graphical evidence and regression analysis. In particular, we

demonstrate a link between insider behaviour and the rapid decline in share values. Further

evidence is also provided of a link between insider behaviour and future risk as measured

by the CDS premium. In short, we argue that this selling was not motivated by liquidity or

other contrarian strategies but was a result of understanding how higher levelsof leverage

and excessive trading in newrisky derivatives could lead to higher levels of risk, an insight

possessed only by a subset of insiders.

Keywords: Credit crunch, insider trading, market efficiency.

I. INTRODUCTION

Historically, insider trading and crashes haveattracted a large amount of attention,

and especially so in more recent years. The central belief is that insiders know

more about their own company than any outsider, including Wall Street analysts.

As such, the demand for credible, yet lawful information that could potentially

help investors predict the future movement of stocks is enormous, evidence for

which can be seen by the number of data vendors, such as CDA/Investnet, who

use insiders’ trades to predict returns for institutional and individual investors

(Lakonishok and Lee, 2001). Studies of managerial decisions suggest that insiders

are indeed better informed about their companies’ prospects and that the market

is slow in adjusting to managerial signals.

It is our belief, however,that not all insiders, and especially not all management,

behave in the same way. Notably a minority of insiders, specificallydirectors and

to a lesser extent senior managers (officers), may be able to anticipate market

movements and, for the purposes of this paper, crash/bubbles better than other

insiders. That is, certain insiders can time a crash and sell their position with a

view to repurchasing after share prices fall. Our results suggest a clear pattern of

insider sales and buys very closely related to the recent crash. This suggests that

some of the insiders’ trading behaviour,especially sales, was motivated by superior

judgement and not solely driven by liquidity needs, diversification, evading SEC

Corresponding author: Manouchehr Tavakoli, School of Management, University of St. Andrews St. Andrews,

Scotland, UK, KY169RJ, mt@st-andrews.ac.uk

C2014 NewYork University Salomon Center and Wiley Periodicals, Inc.

72 Tavakoli et al.

scrutiny or contrarian strategies as suggested in the literature (Fidrmuc et al.,

2006; Jenter, 2005; Lakonishok and Lee, 2001; Marin and Olivier, 2008; Rozeff

and Zaman, 1998). Instead, we argue that it was largely motivated by an insight

common to a select group of insiders predicting a market-wide crash. This is

consistent with the view that well informed insiders pull out of the market prior

to the crash and join again after the crash (Marin and Olivier, 2008).

Following Acharya et al. (2009) the idea presented here is that it can be argued

that the provision of cheap credit to avoid a slowdown in the economy following

the dot.com crisis and the desire of the US government for low income groups to

own their own houses, helped to create the housing bubble. Acting on the gov-

ernment’s desire for higher levels of homeownership, investment-banking firms

borrowed heavily (in some cases 33-to-1) and provided liquidity to the markets

by buying mortgages from mortgage lenders. Interestingly, after 2004 most of

the mortgages purchased by investment-banking firms were subprime in nature.

Through a process of securitization, investment-banking firms combined these

subprime mortgage loans into collateralized debt obligations (CDO). Given the

nature of subprime mortgages, designed with ballooning interest payments, im-

plying that the mortgages would have to be refinanced within a short time frame,

meant that as interest rates rose, which they had to and did in 2004, a wave of

future defaults in the housing market and especially in the subprime mortgage

market was predictable and that a systemic event (risk) affecting other sectors of

the economy was inevitable. This was recognised by a number of insiders, particu-

larly directors, who acted strategically by selling their holdings in their companies

with a view to future repurchase.

Prior US research has examined the relationship between insider trading and

the subsequent behaviour of share returns (Finnerty, 1976; Jaffe,1974; Jeng et al.,

2003; Lakonishok and Lee, 2001; Lin and Howe, 1990; Lorie and Niederhoffer,

1968; Penman, 1982; Rozeff and Zaman, 1998; Seyhun, 1986; Seyhun, 1988). In

addition, it appears that the results can depend on whether the insiders buy or sell.

This is because while an insider buy can convey favourable information on the

firm’s prospects, it is less clear about the information content of an insider sell.

That is, it may represent either unfavourable information about the firm’sprospects

or it could simply be to meet the liquidity needs of the insider (Fidrmuc et al.,

2006). Here we argue that there is another plausible explanation of an insider sell,

namely, that they could anticipate a crash after a prolonged period of growth,with

price rises well above fundamentals. This paper examines the relationship between

insider transactions before and after the recent credit-related crash over the period

2003–2010. Furthermore, we also graphically examine the selling and buying

behaviour of insiders in aggregate and subgroups in the financial sector given its

role in the recent crisis. We also examine whether firmsize is an important factor.

The aim is to assess to what extent insiders anticipated the credit bubble and used

that information to make abnormal profit. We argue that a group of (particularly)

directors and senior managers recognised the build-up of the bubble, and sold

their stocks with a view to buying them back after the crash. This represents

a superior insight and not contrarian trading indicators (e.g., scaled price ratios