Analyzing the ability of informed stock market participants to foresee the
2007–08 financial crisis, the authors find that financial analysts and
institutional investors showed some perception of the looming crisis by favoring
nonfinancial over financial firms. Conversely, corporate insiders showed no
perception of the approaching crisis. Net insider stock purchases at financial
firms over the crisis period surpassed net insider purchases at nonfinancial
firms. The authors argue that these results suggest that the crisis was at least
partially caused by faulty judgment.
The authors analyze the behavior of informed stock market participants before and
after the 2007–08 financial crisis. Informed market participants are defined
as institutional investors, financial analysts, and corporate insiders. The
authors’ purpose is to investigate whether these informed market participants
anticipated the imminent crisis and took appropriate actions.
How Is This Research Useful to Practitioners?
The authors’ research is the first on whether market participants foresaw a
financial crisis. They use empirical data to show evidence that both institutional
investors and financial analysts went to an underweight position in the financial
sector prior to the impending 2007–08 crisis. They also conclude that net
insider purchases at financial firms outpaced net insider purchases at nonfinancial
firms before and after the crisis.
The analysis also has implications regarding the role of the management of financial
firms and whether the crisis was the result of the abuse of a faulty incentive
system or the result of bad judgment. The authors conclude that the financial crisis
may have resulted more from faulty judgment and poor decision making than from
flawed managerial incentive systems. This discussion point is important for what
type of regulations may or may not be appropriate for financial market participants
after the financial crisis.
How Did the Authors Conduct This Research?
The data on institutional quarterly stock holdings are from the Thomson Financial
Network for the period January 2006–December 2008. Institutional investors are
divided into three groups: short-term institutions, hedge funds, and top-performing
institutional investors. Analyst recommendations are obtained from the I/B/E/S
database. The I/B/E/S recommendation system uses the 1–5 rating scale, where a
1 is a strong buy and a 5 is a strong sell. Insider trade information is from the
Thomson Financial Network Insider database. Transactions relating to executive stock
options are excluded.
The authors outline what they assume the actions of informed market participants
would have been had they anticipated the crisis. They presume that institutional
investors would have reduced their relative portfolio exposures to the financial
sector, that financial analysts would have lowered their recommendations on
financial industry equities, and that corporate insiders at financial firms would
have increased the sales of their firms’ stock.
Several empirical tests are used to examine whether informed stock market
participants anticipated the 2007–08 financial crisis. For institutional
investors, holdings for the 12-quarter period starting in January 2006 and ending in
December 2008 are examined. The authors consider institutional ownership levels of
financial versus nonfinancial firms and changes in those levels over the time period
studied. Their results show that all institutional investors, regardless of group,
did significantly underweight the financial sector versus the nonfinancial sector,
especially in the early portion of the study period. The authors believe this change
in asset allocation shows some level of expectation of the crisis by institutional
Next, the authors examine the recommendations of financial analysts for financial
firm stocks versus nonfinancial firm stocks over the same period. They analyze
changes in ratings using the 1–5 scale used in the I/B/E/S recommendation
system. The results show a significant decrease in the recommendation levels
(increase in hold and sell recommendations) for financial firm stocks over the study
period. The authors believe this downgrading of recommendations shows some level of
prediction of the crisis by financial analysts.
For corporate insiders, the authors look at sales and purchases of corporate stock by
corporate management over the study period. The corporate management group includes
CEOs, chief financial officers, members of boards of directors, and firm officers.
They find that financial firm insiders were net purchasers of their firms’
stock during the pre- and post-crisis periods. Corporate insiders at financial firms
actually made significantly higher net purchases of firm equity than insiders at
nonfinancial firms during the pre-crisis period.
The authors believe this increase in stock purchases by insiders indicates little to
no anticipation of the crisis by financial firm insiders. This finding is
inconsistent with the “knave versus fools” narrative propounded by
Simon Johnson (New York Times 2011), a former economist at the
International Monetary Fund, which characterized financial firm insiders as
calculating knaves (rather than unwitting fools) and supported tighter
This research is noteworthy because of the authors’ findings regarding the
behavior of financial firm insiders over the study period. Often, people closest to
a negative situation can be the most blind to that situation. With these findings,
there is an inconsistency between new and proposed regulations.
Research on the long-term relationships regarding sector weights and recommendations
between financial and nonfinancial firms would have strengthened the authors’
conclusions regarding the actions taken by institutional investors and financial
analysts before the crisis.