One of the world's most wonderful inventions, the six-pack of beer cans, is
held together by what appears to be fairly feeble plastic that is variously
called a six-pack yoke or six-pack ring. Whenever the yoke is faulty, carrying
a six-pack to a game or picnic or even from the fridge to the television room -
my idea of exercise - becomes rather a tiresome chore.
Going to economic matters, the six-pack yoke holding markets together has
suddenly been sliced apart, and as is often the case with such shenanigans, the
perpetrators are none other than the officious government types expected to
police the market in the first place. I am referring to the slew of
restrictions being unveiled against financial short sellers in the US and other
Western countries, all of which would likely create price distortions and
eventually fare no better than the ill-fated moves in Karachi to place curbs on
daily movements on stocks.
Responding to what they perceived as market manipulation, the US Securities and
Exchange Commission (SEC) this week imposed new rules for anyone intending to
"short" certain financial shares - that is sell securities they did not own.
The measures were unveiled over the weekend by Chris Cox, the head of the SEC.
The roster of firms thus restricted from short sellers includes the most
important financial institutions operating in the US securities market, most of
them being US financial firms including investment and commercial banks.
Included in this grouping are the two stocks that were most likely the entities
that the US government set out to protect, Fannie Mae and Freddie Mac (see
And now, for Fannie and Freddie, Asia Times Online, July 12, 2008).
The ostensible purpose of the SEC move was to avoid panic-led selling of the
shares of financial institutions that in turn could create a multi-level panic
effect on the rest of the US economy. The reason to lump these important two
mortgage-guarantor agencies (their importance explained in my article referred
above) along with the other entities in SEC restrictions is most likely to
avoid giving the impression that the US government could be discriminating in
favor of these two (which of course it is and always has been). Famously, many
hedge funds admitted to being short the shares of Fannie and Freddie once the
US housing bubble broke.
It is not only hedge funds - today's favorite whipping boys for anything that
goes against government interests, be it falling stock prices or rising oil
prices - that are being targeted. Even the saintly firm of Goldman Sachs (and I
use the word saintly in the sense of describing a firm that has not been
dragged down into a death spiral in the current crisis, showing a bit more
character and leadership that investment bankers pride themselves on but rarely
deliver) has been dragged into the morass - newspapers have revealed "fly on
the wall", that is leaked, conversations conducted by heads of beleaguered
firms such as Bear Stearns and Lehman Brothers with their counterpart at
Goldman.
Chief executives of the beaten-up firms allegedly questioned the role of
Goldman Sachs in prompting share-price declines and withdrawals of business,
according to these reports.
While Goldman Sachs denied any role in pushing its competitors down the
slippery road to bankruptcy (in the case of Bear Stearns) or consolidation
(possible for Lehman), the term "witch hunt" suddenly became all too relevant.
In that situation, everyone who sells shares in such nationally vaunted sectors
becomes an enemy, and evaluated in that context the SEC move is clearly
intended as protective - but who exactly is the new short-selling law intended
to protect?
The SEC, with its broad regulatory powers, exists mainly for the benefit of
investors. Unlike the Federal Reserve or the US Treasury, it is not directly
concerned with the integrity and safety of the US financial system per se.
Thus, the primary motivation must be to protect individual investors. Given
that many banks have fallen by over 50% - and some over 75% - over the course
of this year, it stands to reason that the SEC believes that short sellers have
pushed banks below their intrinsic worth, thereby penalizing investors who
owned the shares.
If it actually believes that to be the case, the SEC has added a new area of
responsibility, namely securities valuations, to its roster in what must truly
constitute a revolutionary change. No longer do investors have to watch CNBC or
read lengthy research reports, because the SEC will monitor stock prices and
determine their appropriate levels for all concerned.
Unfortunately, that will not be the case, as everyone knows the siren absence
of the SEC, the Federal Reserve and the US Treasury during the multi-year bull
run in US stocks when many companies - financial and otherwise - boasted
stratospheric valuations. Surely the SEC doesn't intend to promulgate a law
against "naked long" positions in a future rally should one ever again occur in
the US?
Let us leave aside though the sheer futility of any such efforts on an
intellectual basis and look instead at the logic behind allowing short selling.
The arguments can be divided into three parts:
Why US financial shares fell in the first place
The role of a short seller
The experience of market controls in other countries
Capital and liquidity
The first element of dispelling with the spurious logic of the SEC is perhaps
the easiest. Shares of US financial firms fell because the business model was
over-leveraged, with capital being insufficient to absorb any meaningful
losses. The examples of Fannie and Freddie are stark - both firms boasted
equity capital over total mortgage assets of around 1.5%.
While this level would have been more than sufficient in a situation of zero
loan losses, that is with homeowners not defaulting on their mortgages, in the
current environment most financial firms expect 1-2% annual defaults on their
mortgage portfolios. In simple terms, that means the entire capital of the
firms could be wiped out within one year. Is it then any surprise that their
share prices fell sharply?
The bigger question is perhaps trying to explain why these firms are still
worth over $20 billion, when the possibility of a complete wipe out of capital
remains. That suggests a certain degree of irrational optimism, rather than
pessimism in their stock prices.
The second factor, namely the role of short sellers, is quite important for any
regulatory body to properly understand. To understand the role of a short
seller, readers should remember that while losses on buying a stock (long
positions) are limited to what you put in, potential losses for selling short a
stock can be significantly more.
For example, buying a share at $100 means you can only lose a maximum of $100
if the company goes bankrupt and shares become worthless; on the other side
maximum gains can be quite large, if for example the share price gallops to
$500. In contrast, selling short a share at $100 means your maximum gain is
$100, while maximum losses are unpredictable - for example if share prices go
to $500, the short seller loses $400, or four times what he sold (and now has
to buy to deliver on the contract).
Given that return profile, the mere existence of short sellers can be a miracle
in many markets as the oft-held principle holds that in the long run stocks
rise in value if for no other reason than due to inflation. Short sellers thus
increase the total liquidity available in any market, by selling when everyone
wants to buy (the infamous mob mentality) and buying back when everyone wants
to sell. They take irrationally high risks by going against the mentality of
mobs - thereby helping in large doses to keep market valuations as close to
reality as possible.
The infamous tulip mania of the early 17th century is an example of prices
skyrocketing because of the absence of short sellers (you couldn't sell a tulip
bulb that you didn't own). Similarly, the house-price bubble of the US over the
past few years can be traced to an absence of short sellers - houses, being
physical assets, cannot be shorted easily. My neighbor would probably mind a
fair bit if I sold his house believing its price would fall, in order to hedge
the price of my own residence falling. That said, it would create some
amusement.
The last reason for not intervening in shorts is the recent examples of Britain
and Pakistan. In Britain, reeling from the aftermath of the Northern Rock
debacle starting last year, the country's Financial Services Authority
introduced rules intended to force immediate disclosure of short positions in
companies raising capital - that is, for all practical purposes, financial
firms, as no one else in the Western world needs capital this year. As a
result, overall short sales have declined, but interestingly enough, there
hasn't been any real recovery in share prices of financial firms.
Even more interestingly, due to the "restrictions", it has become harder for
financial firms to raise capital. HBOS, a large British lender, has struggled
with its recent capital raising as the inability to short shares has meant
excessive risks for anyone contemplating investments, thereby scaring too many
investors away.
Pakistan is a better example in explaining the sheer futility of such actions.
Karachi stock exchange authorities imposed a rule last month restricting
declines in the stock market to 1% or less. This pushed prices down every day,
and once restrictions were lifted the Karachi stock exchange fell more than 5%
every day.
On Thursday, after many such down days, investors reacted by throwing stones at
the stock exchange. My only regret about that story is that stones thrown in
Karachi couldn't possibly hit the SEC building in the US. Give it a few months
though and there will be enough people looking around for things to throw at
the SEC.
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