Big Wall Street banks have until 2022 to comply with the Volcker Rule and unwind their in-house hedge funds. They spent untold sums on lobbyist to fight the Volcker Rule and protect their hedge fund and proprietary trading operations. A research paper on insider trading by hedge funds, soon to be published in the Journal of Financial Economics, may shed some light on what the banks fought so hard to protect.
The authors of the paper noticed a sharp rise in short selling of stock of companies that borrowed money from hedge funds shortly before the loans or loan amendments were announced. By contrast, companies that borrowed from banks experienced no such short selling spike.
“Hedge fund lenders, like banks, are ‘quasi-insiders’ and thus privy to private information about the performance of borrowing firms,” the authors explained. “However, hedge funds are not subject to the same degree of oversight and regulation as banks.”
The authors, all academics, tracked the trading of 105 U.S. companies that borrowed money from hedge funds between January 2005 and July 2007 (in July 2007 regulators began demanding more information about short selling). Companies that borrowed from hedge funds saw a 74.8% spike in the volume of short sales during the five days before announcement of the new loan, as compared with the volume of short selling 60 days before the deal.
On the other hand, 255 similar companies that borrowed from banks saw little change in the volume of short selling during the five days before the announcement of new loans.
Short selling also jumped 28.4% before the announcements of amendments to existing loans from hedge funds, compared with a drop of 17.4% in short selling before the announcements of amendments for bank loans.
Post announcement short selling is expected, as investors and lenders hedge their exposure or bet against a company taking on debt at a high rate. But pre-announcement short selling indicates that the very firms lending money may be trading or tipping others on nonpublic information gleaned from the loan application process.
“It’s impossible to know if it’s hedge funds that are doing the shorting, but our study raises important questions about regulating hedge funds when they make loans,” Debarshi Nandy of York University’s Schulich School of Business in Toronto, one of the co-authors of the paper, was quoted as saying. The other researchers are Nadia Massoud and Keke Song, both also at York, and Anthony Saunders, at New York University’s Stern School of Business.
The SEC’s newly-established division of risk, strategy and financial innovation is examining the area, according to the article.
Another research paper, by Victoria Ivashina of Harvard Business School and Zheng Sun of University of Calfornia, Irvine, found suspicious outperformance by hedge funds that negotiated loan amendments and also held the borrowers’ shares.
Hedge funds that consider lending to companies usually (but not always) sign nondisclosure agreements before examining confidential financial information, according to the article. Thus hedge funds that engage in pre-announcement short selling of their borrower’s stock may be guilty of breach of contract, as well as insider trading.
There are reasons why a hedge fund might bet against shares of a company while also lending it money. Even if the hedge fund believes the company will repay the loan, it may anticipate and capitalize on a temporary decline in the stock’s value when it becomes public that the company turned to a hedge fund for a high-rate loan. Another situation could be that the hedge fund rejects the loan application and then shorts the company’s shares.
During the persistent credit crunch, companies have been forced to resort to the shadow banking system, which includes Wall Street and its hedge funds. According to the article, some hedge funds are raising money to make new loans. Part of the reason may have to do with the proprietary trading opportunities such lending creates, however illegal that is.