“Give me control of a nation’s money and I care not who makes her laws.”

— Mayer Amschel Rothschild

Let’s observe a moment of silence to mourn the slow demise of capitalism in the U.S.

Our government is now overtly manipulating the stock market. We have “crossed the Rubicon.” We can no longer pretend to be a free market capitalist country while also maintaining confidence in the U.S. dollar as reserve currency. After this panic subsides, the investing environment will be very different.

Make no mistake about it: The last two weeks will go down as one of the most pivotal periods in financial history. The financial landscape has changed so dramatically that few have had a chance to catch their breath. I’ve spent the entire last week reading and thinking through the free market’s ultimate response to this unprecedented, rapidly changing situation.

Last week, the SEC announced a temporary ban on new short sales in 799 specific financial stocks. Short selling is one of the most important weapons in an investor’s cache. It allows the market to react to foul play and sloppy corporate leadership. This is an even more important tool to use against poorly run small caps. That’s why this ban is so significant.

Before I go on, let’s first clear something up: This new ban doesn’t mean that existing short positions must be covered. But many are clearly closing short positions to limit risk anyway. The SEC might well have sparked a panic liquidation in other areas of the market, as hedge fund managers liquidate long positions to offset losses on short positions. As I write, the market is well off its highs just one hour into Friday’s trading day. Odds are good that the SEC will realize that its decision only sucked a huge amount of liquidity out of the stock market and reverse its decision to something more sensible, like reinstating the uptick rule.

While on the subject of the SEC’s new short selling rule, allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on “quant” models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. “Naked short selling” occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement.

“Quant funds” — the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Best regards,
Dan Amoss, CFA
September 23, 2008

Government Regulation of Short Sellers was originally featured on Whiskey and Gunpowder

“You know, you saw subprime go first, and then, on a slight lag, you saw home equity, and now in the lag, you’re seeing prime go. And it’s exactly the same loss factors. But remember, the components of where we are in the states…[are] very different. And we started doing more jumbos in ‘07, so a lot of that is — part of that is ‘07 vintage, which I think I told you at the time we were going to do and grow our balance sheet and gain share. And we were wrong. You know, we, obviously, wish we hadn’t done it.

“So when you adjust for all of those things — vintages, CLTV, stated income, where it’s done — that’s what we’re seeing. You know, it’s very early in the loss curves…

“Prime looks terrible, and we’re sorry.”

— J.P. Morgan CEO Jamie Dimon

The recent financial stock rally has all the signs of panicked short covering, rather than typical buying. Consider how the depository institutions most likely to eventually join IndyMac in federal custody — including Washington Mutual, Downey, and Huntington Bancshares — are rallying the most. So many shares had been sold short that a violent rally was inevitable.

Eventually, though, this rally should prompt two things:

1. Mutual funds selling financial stocks into strength. We’ve finally seen a shift in psychology away from buying financials on the dips. Many managers are preparing for an extended bear market in the sector.

2. Banks with capital shortfalls will announce secondary stock offerings. This will lower the cost of new capital, because higher stock prices allow the banks to issue fewer shares to raise a fixed amount of capital.

The SEC is implementing rules that will make it a bit harder to sell short stocks that are difficult to borrow.

I think “naked” short selling (shorting a stock when your broker has not yet located shares to short) must be stopped. This practice gives legitimate short selling a bad name.

Stock should be located and borrowed before it is sold short, not the other way around. If your broker cannot locate shares to short, you should move on to another idea, or use put options.

But the hysteria about “rumors” bringing down financial companies has gone too far, I think. This is the defense of CEOs who are looking to blame someone for their own incompetence — incompetence that put their firms in a vulnerable position in the first place. Short sellers did not conspire to force Wall Street firms to enter the business of securitizing dodgy debts. Firms like Bear Stearns ruined their own companies with the poor strategic decisions they made. The free flow of opinions is vital for the health of the stock market. One should be very suspicious about executives who try to suppress any negative opinions about the value of their stock. Allied Capital comes to mind.

You can read about Allied’s crusade against David Einhorn in his excellent book, Fooling Some of the People All of the Time.

Allied is still a good short idea looking out beyond a year because it’s running out of attractive assets to sell and finding it harder and harder to issue new equity.

Short sellers need to do their own fundamental research and form their own opinions. Only fools buy or sell short stocks based solely on rumors. Legitimate short sellers are very beneficial for the market. They provide liquidity at market bottoms by buying to cover their positions, and they are often the first to discover and put an end to accounting frauds and stock promotion schemes that siphon capital away from legitimate businesses.

Timing is important in the banking business. Also, as in investing, it pays to be a smart contrarian. Ideally, banks should make as many loans as possible once the economy bottoms. In an improving economy, borrowers can more easily pay down debts.

Loans made with disciplined underwriting guidelines ahead of an economic boom can be both safe and profitable.

On the other hand, aggressively expanding a loan book at the peak of a credit cycle and an economic cycle can lead to disaster.

Once credit cycles turn, loan portfolios, or loan books, become sources of risk, rather than profit. Look at the experience of Countrywide, which just got acquired by Bank of America for a fraction of is peak value. It blew itself up by aggressively expanding its mortgage loan book at the peak of the credit cycle — which happened to coincide with the biggest housing bubble in history.

Regards,
Dan Amoss, CFA
August 21, 2008

P.S.: You want to form your own opinion of a company and ignore herd behavior and rumors. But sometimes that can be difficult. Aren’t we all getting our information from the same places? Well it doesn’t have to be that way. Some people are getting their information straight from the source. They’re called “100-F” documents and they tell you exactly what a stock is going to do.

Short Selling was originally featured on Whiskey and Gunpowder