Ongoing Corruption On Wall Street Saps Investor Confidence On Main Street

couple of days ago, I caught an episode of the American Experience on my local PBS station that covered 1929 stock market crash. The episode in question had premiered in 1990, and featured first-hand accounts - as well as interviews - with historian Robert Sobel and economist John Kenneth Galbraith. It has an interview with Patricia Livermore, daughter-in-law of trading great Jesse L. Livermore and the subject of the annotated version of ”Reminiscences of a Stock Operator” that I just completed. (Publication date is Jan. 10).

Be sure to see the PBS show if it plays on your local station.

One of the most memorable quotes of the broadcast comes from gangster Al Capone, who - in the midst of the 1920s bull market - called the guys on Wall Street “crooked,” and decided to invest his racketeering profits into Prohibition-era booze smuggling, instead of stocks. Say what you will about Capone, but recent events have proven him right.

We continue to see fallout from the Galleon Group insider trading allegations, as I discussed at length in my Strategic Advantage letter last week. Rumors of corruption emanating from Raj Rajaratnam’s hedge fund complex are spreading through Manhattan and Silicon Valley. Consulting giant McKinsey & Co. has begun an internal probe after a senior partner was charged with securities fraud. Now there are reports that Hector Ruiz, the former chief executive officer of chipmaker Advanced Micro Devices Inc. (AMD), may have leaked confidential information about his company to Galleon operatives.

All of this undermines investor confidence in the financial system, and is absolutely not good for the tone of the market. Investors don’t expect a completely level playing field, but they hate it when the really sleazy stuff leaks out into public.

And unfortunately, it’s getting worse. Late Wednesday, we learned from the The Financial Times that Galleon may have spent as much as $250 million over the past few years to receive non-public information from the trading arms of its prime brokers, particularly JPMorgan Chase & Co. (JPM) and Goldman Sachs Group Inc. (GS).

The plague of sleaze is not just spreading here in the states. Across the Atlantic, German fund of funds K1 Group on Wednesday was linked to a money-laundering scheme. The firm has left its prime brokers and lenders, including Barclays PLC (BCS), JPMorgan, BNP Paribas SA, and Societe Generale SA with some $400 million in unexpected losses from suspected fraud.

I’m told that K1 may have used the money in the hedge funds it held as collateral to get margin loans at each of these four banks. If that’s true, in addition to any normal selling that transpired late last week due to an overbought condition, we probably saw some forced selling by hedge funds who needed to raise money to meet unexpected collateral calls.

Again, this is terrible for investor confidence, and puts an undue burden on securities prices. The hedge funds probably owned risky assets like technology stocks and emerging markets stocks. So if they were dumped willy-nilly to meet margin calls it would explain why these regions’ markets have fallen with such blinding speed. The one bright spot here is that forced selling eventually ends - and typically does so quite abruptly.

Yet these events are not happening in a vacuum. The revelations come as government policymakers consider new financial regulatory schemes. If bad vibes encourage more stringent capital requirements, stricter securities law, and dampen financial innovation, then the road back to sustained profitability for banks will be even longer and more treacherous than originally believed.

This couldn’t come at a worse time given fragile investor sentiment, and could very well serve, sadly, to take the expected fourth-quarter “beta chase” that I’ve written about right off the table.

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