Political Connections, Insider Trading, and Stock Performance

Ever been curious for some statistical data on how political connections influence insider trading and stock performance in highly regulated industries whose regulations are informed by the politics of the moment?

Well, Professors Jagolinzer (U. of Colorado), Larcker (Stanford), Ormazabal (IESE), and Taylor (Penn) sought to do just that, and have released a paper concluding that insider trading from finance industry insiders didn’t predict future stock performance before the financial crisis or during it prior to the launch of the Troubled Asset Relief Program (TARP). However, during the disbursement of TARP funds, the insiders in the financial industry that were well-connected politically were able to make trades that did indicate informativeness of future events, suggesting that regulators indicated which banks would be the survivors and the bank executives invested heavily when the stocks were trading at liquidation value.

I attach parts of the essay that help state their case, and encourage you to read the article here: “Political Connections and the Informativeness of Insider Trades”:

“Our paper examines the relation between political connections and informed trading by corporate insiders within the context of the 2007-2009 Financial Crisis. The unprecedented magnitude of government intervention during the Financial Crisis, the substantial impact of the intervention on firm value, and the political nature of the intervention provide a powerful setting to examine the relation between political connections and informed trading. It is now well known that deliberations on government intervention largely took place in private meetings between government officials and insiders at leading financial institutions; details regarding the application and qualification process for funds from the Troubled Asset Relief Program (TARP) were not publicly disclosed; and political connections appear to have played a role in the allocation of these funds (e.g., Duchin and Sosyura, 2012). Thus, politically connected insiders at leading financial institutions were in a position to be disproportionately privately informed about the scope of government intervention, how this intervention would affect their firm, and details of any forthcoming TARP monies…

Consistent with the notion that corporate insiders were unable to predict the effect of the forthcoming Crisis on their firm, we find no evidence that insider trades predict future performance over the 24 months leading up to the Crisis, or during the Crisis before the creation of TARP (i.e., prior to October 2008). In contrast, over the nine months after the creation of TARP, i.e., the period in which TARP funds were dispersed, we find that the predictive ability of insider trades for future performance is greater than during any other period in our sample. Over the entire sample period, we find that the average one-month-ahead future return following insider purchases (insider sales) is 0.23% (–0.82%), a difference of 1.05%. However, during the period TARP funds were dispersed, we find that the average one-month-ahead future return following insider purchases (insider sales) is 1.84% (–2.87%), a difference of 4.71%…

Consistent with the increase in the informativeness of insider trades relating to private information gleaned from political connections, we find that the increase is concentrated entirely among the trades of politically connected insiders. Prior to the Crisis, we find the difference in one-month-ahead future returns between purchases and sales of politically connected insiders is economically and statistically insignificant, –0.37%. However, during the period TARP funds were dispersed, the difference in one-month-ahead future returns between purchases and sales of politically connected insiders is both economically and statistically significant, 8.89%…

Collectively, our findings suggest that political connections provided corporate insiders with an important information advantage during the Financial Crisis, that a significant portion of this advantage related to knowledge about government intervention, and that some insiders traded to exploit this advantage. We contribute to the academic literature by documenting one channel through which politically connected insiders can extract rents from shareholders; by documenting the relation between insiders’ political connections and information leakage; and by documenting an important characteristic of directors’ social network that influences their trading decisions.”