Late last week, the Treasury Department and the Federal Reserve released the preliminary results of the “stress tests” to representatives of our nation’s 19 largest financial institutions—information of incredible value to investors that will not be made public for another week. In the interim, financial regulators must ensure that those familiar with the results—and their friends and family—do not profit off that information.
We encourage the Securities and Exchange Commission, the Treasury Department, and the inspector general for the Troubled Asset Relief Program to take heightened measures to monitor the securities markets over the next week to ensure the integrity of our capital markets. As described in a press release by the Fed, the stress test results represent the findings of over 150 examiners and other staff who conducted a rigorous analysis of bank capital levels and potential losses. The general public won’t find out the results of the stress tests until May 4, as these financial institutions have reportedly been issued a “harsh gag order” to prevent them from leaking any information about the test results to the press in the interim.
To be fair, Obama administration officials have made some information available to the public. Those of us not privy to the results of the stress tests can review the 21-page document released by the Fed outlining the methodologies used. Or we can mull over White House Chief of Staff Rahm Emanuel’s statement that the stress tests will reveal a “gradation” of results, with some banks being “very, very healthy” and others needing assistance. Or we can look at Treasury Secretary Timothy Geithner’s testimony before the Congressional Oversight Panel, in which he stated that the “vast majority” of banks were well capitalized.
But this information, while welcomed, is not nearly at the same level of specificity provided to the insiders. How weak is our financial system? How deep are the potential losses? Which banks, if any, will need additional capital injections, and how much? Bank insiders have access to this information, while those of us on the outside have but a few tea leaves to read as best we can.
Now there are perhaps good reasons for Treasury and the Fed to proceed carefully. The Obama administration is understandably concerned about a run on banks, which—while unlikely in the case of federally insured depositors—may be a real possibility among bank bondholders and other key providers of bank liquidity and capital. Secretary Geithner and Fed Chairman Ben Bernanke have repeatedly noted the importance of maintaining investor confidence in the financial system, and the premature release of the stress test results could jeopardize the administration’s apparent goal of trying to get the private financial sector to stand on its own two legs and avoid more intensive government intervention. Any delay in releasing these results publicly gives the administration more time to develop remedies for the weaker banks.
But at the same time, it is clear that the information provided by these stress tests is highly valuable. One need only note the reaction from the stock market to rumors related to the stress tests to understand how important these results are to investors. A blog from the host of a small radio show on Sunday, April 19, claiming that 16 of the 19 banks undergoing the stress tests had failed, led to an 11-percent fall in financial stocks in the Standard & Poor’s 500 index the next day. And speculation by a Barclays analyst on April 23 that three financial institutions could fail the stress tests resulted in the share prices of those three companies falling 5 percent to 10 percent in early trading the next day. One can only imagine what the results might have been if any of this information had been based on the actual stress test results.
It is perhaps fitting that the stress test results were selectively released to the 19 banks the day after TARP Inspector General Neil Barofsky appeared before the Joint Economic Committee of Congress, warning that the complexity of the various programs created out of the $700 billion TARP fund made them “inherently vulnerable to fraud.” In the absence of stringent and extraordinary measures by the Treasury and the Securities and Exchange Commission, the selective disclosure of these stress tests results poses an additional huge fraud risk, particularly with respect to any insider trading that might occur among bank stocks and bonds, in addition to derivatives tied to those stocks and bonds.
Until May 4 there is a high risk that those who have access to the results of the stress tests could potentially make enormous profits through trading securities related to these 19 banks at the expense of the general public, which was not privy to these results. Although trading off of the stress test results is presumably illegal under the federal securities laws prohibiting the purchase or sale of securities based on material nonpublic information, the potential profits are enormously high, creating a large incentive to possible wrongdoers. This should be a serious concern to federal regulators—particularly given the potential difficulties in monitoring and catching such trades today.
In today’s financial markets, sophisticated investors need not simply buy or sell exchange-traded stocks. They can sell short the stocks of these financial institutions, they can trade bonds, and they can trade complex structured products such as credit default swaps. Much of this trading can be done over the counter, and because federal regulators do not directly oversee OTC trading, detecting fraudulent OTC trades is challenging.
At the same time, insider trading is a particularly difficult type of fraud to detect and prove because regulators must be able to show that the trading was tied to inside information. Furthermore, public reports do not identify which individuals received the stress test results or what proscriptions were placed on the communication of this information, other than that there was a “gag order” against leaks to the press. We don’t even know who was in the room when these results were released.
Were there outside lawyers or accountants or other advisors? If so, what were these people told about whether and to what extent they could communicate the stress test results, or trade on them? If a bank executive received the results, can those then be passed on within the organization, and if so, to whom? To the board of directors? To a secretary? What about to people outside of the bank? What about family or close friends?
These details may have been fleshed out already and simply not reported in the media. Yet the notable omission of the SEC or TARP inspector general in any of the discussions around the stress test results is worrisome. For federal regulators to be able to detect insider trading, they must be able to identify who is receiving the inside information.
The SEC and TARP inspector general should recognize that these bank stress test results constitute valuable information in the financial markets, and they should take the appropriate steps to ensure that this information is not abused for personal gain. At a bare minimum—to the extent they have not already done so—they should receive a detailed list of the recipients of the stress test results, and any specific instructions these recipients were given on the noncommunication of this information.
They should also step up their monitoring of trading this week as an additional safeguard against the possibility that some insiders or their confidants might try to utilize these stress test results to garner a personal windfall. They should be on the lookout for unusual trading patterns, and as a deterrent measure enforcement resources should be publicly committed to detecting and prosecuting insider trading.
It is worth noting that in 2000, the SEC passed Regulation FD, or Fair Disclosure, which barred the selective disclosure of material nonpublic information to some investors and not others if valuable inside information is given by a company to some investors. Reg FD requires that the information must be disclosed to the general public. A stated rationale for Reg FD was this:
We believe that the practice of selective disclosure leads to a loss of investor confidence in the integrity of our capital markets. Investors who see a security’s price change dramatically and only later are given access to the information responsible for that move rightly question whether they are on a level playing field with market insiders.
While Reg FD does not itself apply to the selective disclosure of the stress test results by Treasury and the Fed, we agree with its governing principle that fairness and investor confidence argue in general against selective disclosure. In the short term, current circumstances may warrant a selective disclosure of the stress test results to buy time to remedy the problems of financial institutions, as well as to avoid a market panic. But the SEC, the TARP inspector general, and other financial regulators ought to take countervailing measures to ensure continued investor confidence in the integrity of our markets. Such measures are necessary at a time when too many people in this country—and frankly around the world—unfortunately believe that Wall Street insiders are calling the shots.
David Min is Associate Director for Financial Markets Policy at American Progress and Joshua Picker is a Research Associate. Please see the Economy page of our website for more of our recommendations on this topic.