Big Banks in Washington: Insider Trading or Legitimate Research?

I haven't seen any evidence backing this up, but many have pointed out the not-so-subtle decline in the performance of major hedge funds that occurred as soon as the government began cracking down on insider trading. I'm not accusing anyone of anything, but you can connect the dots.

How big is insider trading? Last week I asked Ron Suskind, a Pulitzer Prize-winning author of five books. His latest, Confidence Men, explores President Obama's first two years in the White House, which provided Suskind with a unique view on the relationship between Washington and Wall Street.

Here's what he had to say (transcript follows):

Morgan Housel: We were talking upstairs about the relationship between large investors -- investment banks and hedge funds -- and Washington, and how they have an informational advantage. They have contacts in Washington where they can get the inside scoop before anyone else and make fortunes off of it. Is that a legal form of insider trading, or is it legitimate research?

Ron Suskind: [Laughs]. I think it is a legal form of insider trading. I really do.

Morgan Housel:�How big an advantage is that over the little guy?

Ron Suskind: I've had friends of mine who run Wall Street banks who say�Goldman Sachs (NYSE: GS  ) basically has an eighth of a point advantage on many of its lines of business over its competitors. Because the view, rightly, is Goldman has the best informational advantage from its Washington sourcing.

Is that something that's real, in terms of social or economic value in a transparent economy? I don't think so. You know, Goldman's clients say, 'I don't care whether you think it's legitimate or not. I want that advantage so I'm gonna go with Goldman. I don't want to know how they get it.' That's part of the way it works. 'Don't give me too many details. Somehow Goldman gets this. They know. That's why I'm sticking with them.'

And I think that's part of the problem, is that as we see more and more of that and we see the investment banks profiting from informational advantages, often ill-gotten in my mind, I think it's killing off the participatory vigor of the small investor. The person sitting in their den in Des Moines. The guy going to the Merrill Lynch office in Council Bluffs. They're like, 'I'm disadvantaged. The market is being moved by noisy, immaterial gusts of information. What does that have to do with my company that I invested in? What does that have to do with something that I know must be true?

Well, the fact is it's ruling the day. And for the big players, might makes right. So if Goldman is profiting from immaterial shifts and movements of the current, then I go with Goldman. I don't want to know any more than I need to know. I think that's a problem for the way the economy ought to work, and actually work more efficiently by virtue of more transparency, where everyone is on a level playing field.

Morgan Housel:�So how do you fix it?

Ron Suskind: You fix it with prosecutions. Plain and simple.

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