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The Real Insiders

By James H. Nolt

Last week I explained how the broker’s book gives systematic insider information to big brokers, not by way of any extra effort involving conspiracy or cheating, but merely as a normal consequence of their routine business activity.

The same is true of bankers. For ordinary investors, trading on inside information is a crime. Financial interests have some legal boundaries too, but much of the proprietary information they use to make business decisions is in fact inside information available only to those in powerful roles within finance.

Bankers trade money for information, whether as investment bankers, organizers of initial public offerings (IPOs), or as lenders; banks do not make loans without getting proprietary information from their customers in return. This is called due diligence. Banks offer money; clients tell their secret business plans. It sure sounds like insider trading, but it is just their ordinary business routine.

A large part of finance and currency law can be easily understood if you remember that its intent is to keep non-bankers from doing what bankers do without a license to bank. It is illegal to impersonate a bank, but if you legally are a bank or other financial company, lots of information falls into your lap that outsiders cannot acquire legally. This gives banks, especially large ones with many powerful clients, a strategic view of the economy and its near future that few can rival.

If banks only used this information to trade securities, they could do very well, but they do more than that with it. They also make credit decisions that affect everything. Broadly there are two sorts of credit: loans and securities (e.g., stocks and bonds). Both types require two types of decisions: who deserves credit and at what price.

Banks not only accumulate strategic information about the economy unavailable in public markets, they also centralize the power to make decisions about credit. This is an awesome power. If credit is given generously, prices will rise since there will be more purchasing power allocated to investors than there is real output. This is bullish. If credit is curtailed, purchasing power contracts and prices fall. This is bearish. Throughout history, banks have usually held more power than governments in determining which direction credit conditions move.

In general, banks might fight for opposite policies, i.e., some may be bullish and some bearish, working at cross purposes. This happened, for example, during the run up to the Panic of 1907. At that time, the bulls were financed primarily by the new, fast-growing, and less regulated trust companies. The more bearish established players were the great banks led by J. P. Morgan & Co. Some of the most aggressive bull plays included cornering copper company stocks. Bearish independent brokers, most famously Jesse Livermore, detected that a corner was in play and that it was vulnerable to a bull squeeze. He and others borrowed as many stocks as they could from bullish brokers, some even willing to lend shares they did not own themselves, but rather were holding for others. Shorts like Livermore quickly sold their borrowed stock at high prices offers that were engineered by the bulls conducting the corner. The bears immediately borrowed more stock and sold it again. Eventually their selling pressure overwhelmed the buying power of the bulls, and key stocks started to tumble. Since all the bulls had been buying stock with borrowed money, they had to panic sell in order to recoup the funds they needed to repay the loans. Prices tumbled further. Bears saw that many bullish investors, stockbrokers, and the trust companies that financed them were in trouble and would soon fail. Since the general public had little idea why the bull market was suddenly collapsing, many ordinary investors also began to sell their stocks, even solvent stocks, contributing to the overall market decline.

J. P. Morgan and the other big banks did not much mind that their more reckless competitors were failing in droves, but they were worried when the panic started to spread to the more conservative institutions they superintended. Morgan himself called a Sunday meeting with the top New York bankers and demanded they all contribute capital to a kitty to rescue those they chose to save when the markets opened on Monday. Many of the bankers were reluctant, but Morgan strong-armed them and got his way.

The Panic of 1907 led to a worldwide recession that was the most serious during the decades from 1893 to 1929. Some economies took years to recover. But it also illustrates very directly, in ways we do not always easily see, how the bankers literally met and decided which institutions would be rescued with fresh infusions of credit and which would be allowed to fail. Credit power is seldom so obvious. Similar meetings took place in 2008.

Morgan and his fellow big bankers were not the most aggressive bears since they ultimately put a floor under the market and forced the retreat of bears like Livermore, who cashed in his short positions as soon as he saw Morgan and company intervene. He had the good sense not to maintain his bearish positions beyond that. In any case, he and other bears made a fortune when they did close their positions since they had borrowed and sold stocks near their peak prices and then bought them back cheaply after the crash and returned the depreciated shares to their disappointed owners.

Morgan was pleased because many of the big banks’ most bullish and fast-growing competitors were chastened if not bankrupted. Morgan once again showed himself to be the indispensable leader of American banking. Within a few years, the firm would cash in on this successful coup to become indispensable to the Allied powers during World War I, syndicating nearly all their private loans and becoming the sole purchasing agent for Allied powers in America, gaining immense influence to dispense both credit and contracts.

Morgan’s sometime rival on Wall Street, John D. Rockefeller, tried to counterbalance this demonstration of Morgan power by sponsoring the creation of the Federal Reserve with the help of his brother-in-law, Senator Nelson Aldrich. This effort to federalize power over “money” creation has been hailed as a success by economists, but has actually done little to restrain or regulate the credit power of large financial institutions. Next week we will see though how the creation of the Federal Reserve System helped economists promote the Myth the Money Supply, the idea that government agencies, more than private banks, regulate prices.

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James H. Nolt is a senior fellow at World Policy Institute and an adjunct associate professor at New York University.

[Photo courtesy of Wikimedia Commons]

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