Is there justice in Finance?

May 16, 2011

Financial markets are full of rules and regulations. Those found breaking the rules usually face tough penalties. So it may come as no surprise to many this week, to learn of hedge fund manager Raj Rajartnam, who was convicted of insider trading.

Raj Rajartnam ran a hedge fund named Galleon Group, based in New York. He had been accused of gathering inside information from companies about their earnings results before they were released publicly. He was estimated to have made USD 64 million from insider trading, and his net worth totaled USD 1.3 billion. Upon conviction, he will now spend the next 15-20 years in prison.

Insider trading is certainly a serious crime. It undermines the integrity of financial markets, leads to market manipulation, and gives insiders an unfair advantage, at the expense of outsiders. Nonetheless, it is difficult to determine the extent to which others are negatively affected by this crime. However, some crimes in finance have a much larger negative impact.

One of the famous mortgages responsible for starting the financial crisis was known as the subprime teaser mortgage. This mortgage usually went out to low-income individuals with poor credit history and a low capacity to repay. Their main selling point was a 'teaser' interest rate for the first two years. The interest payment in the first two years was low, and after that would become much higher. It should come as no surprise that a high proportion of these mortgages went into default.

The banks also played in large part in exacerbating the crisis. Risky mortgages were bundled together with safer mortgages into collateralized mortgage obligations. Rating agencies gave these securities high credit ratings, and banks marketed these products as safe investments. Of course we know how this turned out.

While these criminal activities taking place in the financial world went ahead, everybody else suffered. Most countries either went into recession or saw a slowdown in growth. Unemployment increased and public debt increased, as taxpayer funds were used to bail out banks. What started out as a banking crisis has now turned into a sovereign debt crisis across Europe and the USA, as private debts became public.

The real issue here is that the people who caused the most harm have more or less gotten away with it. There have not been bankers, mortgage brokers, rating agency professions, or other culprits of the financial crises that have been convicted of any crimes. While the insider trader, whose actions, while wrong, have not caused considerable damage, got 15-20 years in prison, the people who caused the crisis and recessions around the world are still at large. Many commentators have taken the view that Raj Rajartnam's conviction is evidence that justice has been done in the financial world. Sure, it is a good thing he was caught and convicted. But there is certainly no justice in finance.

Disclosure: I do not hold the currency/commodity discussed in this report.