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.

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.

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 investors.

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 regulation.

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.