Stupidity, populism, and playing to the idiots? It’s evergreen.
Sep 20 2008Where to start?
The short-selling ban that is in place from yesterday through October 2 (or later) is an abomination. Not only is it bad policy in an absolute sense, it’s made worse by the cynical hypocrisy of those who begged for it to be put into place.
It’s one thing for an amiable boob like Patrick Byrne to whine about short-sellers and how they’re killing his company. I’m willing to give Byrne some small measure of benefit of the doubt, since finance isn’t his claim to fame. But when the chairmen of the Federal Reserve and the SEC, along with the former CEO of Goldman Sachs, now Treasury Secretary, start whining out of the same hymn book, they’re not serious, not believable, and are clearly playing to the idiots in the audience.
Short selling, the act of selling shares you don’t own, with the expectation that you’ll be able to buy them back later at a price equal to or lower than the price at which you sold the. Simple, really. And it’s got nothing to do with wanting to harm the company whose shares you’ve sold short. It’s simply an expression of opinion that the shares are overvalued, for one reason or another.
Selling short, then spreading false rumors against a company is an offense for which one can be pursued in a court of law. Funny thing, though - not selling short, then spreading false rumors against a company is also an offense for which one can be pursued in a court of law. If you do the verbal algebra, it becomes clear that selling short has nothing to do with the illegality of false rumors. And the law recognizes this - selling short is, in anything approaching sane regulatory times, not illegal at all.
Selling short can occur for many reasons, in many different contexts. Everyone I’ve read focuses on bets that a stock might or should go down. I’ll go you one better. For instance, to take a random example, let’s just say that the Investment Banking group in Goldman Sachs’ Chicago office were doing a public offering of stock for a client.
Such offerings typically include an underwriter’s option for an additional 15% of the shares being offered as “the green shoe”, to cover overallocations. Since an investment bank typically has no interest, and certainly has no requirement, to be an owner of stock in the companies for which it provides underwriting, if an offering looks successful, and the demand is high enough to make exercising their option for the “green shoe”, the normal action an investment bank takes is to sell short a number of shares equal to the amount of the green shoe, knowing that they’ll be able to replace those shares with the additional 15% for overallocation. If the stock has run up in the aftermath of the offering, better still - they can sell stock that’s more expensive than the offering price, knowing full well that they can replace it at the offering price. But at a minimum, they already know the price at which they can buy the stock in the future, so this isn’t a bet that the stock will go down.
Treasury Secretary Hank Paulson, having been the head of investment banking for Goldman Sachs’ Midwest Region (1983-1988), then managing partner of the Chicago office, followed by co-head of IB for the entire firm, can safely be presumed to know all of this.
Neither SEC Chairman Cox and Fed Chairman Bernanke has any experience in capital markets, but neither of them can assert ignorance of the role that short selling plays in the market.
And who’s been calling loudest for limitations on short selling? The investment banks, solvent and formerly-solvent:
Lehman executives complain that they have been singled out by hedge fund investors that are short selling — or betting against — their stock, and Mr. Fuld has called senior executives at competitor banks demanding that their employees stop criticizing Lehman.
The mood was far different at Morgan Stanley, which lobbied vigorously for the ban on short selling. The bank’s shares shot up 21 percent, to $27.21, on Friday. Analysts said the reprieve might be only temporary, though, because the firm’s business model still requires a big balance sheet and core base of deposits for financing.
…the SEC is this afternoon holding a meeting to “determine if they need to take further steps to curtail what both Mac and [Goldman Sachs CEO Lloyd] Blankfein characterize as improper short selling that is really causing damage to the share price of Morgan Stanley and Goldman Sachs.” Blankfein also spoke with Cox to complain of short selling of their stock, as did New York senators Chuck Schumer and Hillary Clinton, according to Gasparino’s sources.
And so on. Fannie Mae, Freddie Mac, Bear Stearns, AIG, and a host of others, all now functionally dead as public companies, claimed loudly, with much gesticulation, that short sellers, not their crappy business models or abysmal risk management, were the reason for the drops in their stock prices.
Likening such traders to “looters after a hurricane,” New York Attorney General Andrew Cuomo Thursday said his office is investigating “a significant number” of complaints about improper short selling in shares of Lehman Bros., AIG, Morgan Stanley, Goldman Sachs and other financial stocks.
Cuomo said his investigation would use the New York state Martin Act, which subjects violators to criminal as well as civil penalties, to combat the illegal practices.
“The markets need to be stabilized,” Cuomo said. “And one way to bring about such stability is to root out and deter short-selling that is based on the spread of false information.”
Sorry, Spanky - you left one class of people out: Weather forecasters before a hurricane. Deter short selling based on the spread of false information? Sure - go ahead, although there are already laws in place to do that, so knock yourself out enforcing them, with my blessing and encouragement. Disallow short selling itself, as though there’s no valid reason for a non-rumor-spreading trader to do? Utterly stupid. And impressive only to the self interested (the banks) or ill-educated (all other non-bankers who’ve complained about short selling).
Applauded only by the greedy & ignorant? Must be a great plan, then. I’ll take all this addle-pated nonsense about “gangs of people getting together to sell shares of a stock” seriously when several things also happen:
- The same idiots decide to go after “gangs of people getting together to buy shares of a stock” (Cramer - I’m looking at you and everyone like you).
- Someone explains to me the difference between a short seller selling a share of stock and an actual holder of the stock selling a share of stock. The market neither knows nor cares.
- Which raises the question of what’s next? Disallowing down-ticks entirely? Disallowing any sale of the stocks of the protected 799 alleged-financial companies? Even by widows and orphans who actually hold shares? What is this, the Hotel California?
“Issue Two” (please read that to yourself in John McGlaughlin’s voice, for best effect)
The details of the proposed bail-out for the deadlocked financial system are not yet clear, but one among them, the aforementioned short sale ban, has already torched a number of market participants otherwise undeserving of being torched.
Full disclosure: I’m one of the undeserving torchees. While I’m still up more than 25% this year, three weeks ago I was up more than 70%, and my results have suffered from the several recent bouts of unhinged euphoria-despair-euphoria. Lehman’s going bust, AIG might follow? Market crashes. Government may bail out AIG? Market recovers. Government may bail out AIG (yeah, I repeat myself)? Market crashes. Government might bail out the entire decomposing carcass of the financial system, but just for good measure, decides to stop the recognition, if not the reality, of the rot by banning short sales? Market recovers.
And Monday, when the reality of the market-saving gambit by the SEC/Fed/Treasury becomes more clear, the market will definitely either crash or soar. It surely won’t stay still, because whatever plan is mooted, someone will love it, hate it, or see a conspiracy to mulct the taxpayers for the benefit of Wall Street and the Main Street banks.
Put me squarely into the later two categories. For years, the financial sector has been spinning ever-more complex products for sale both the individuals and institutions, and has been paid handsomely for creating the damage from which they now suffer. Please also have a look at the story at Gawker, “It’s The “Absurd Financial Product Some Rich Person Actually Bought” Contest!”, from which the Blue Cow Faceplant picture above came.
Any solution that fails to meet the following criteria, in my opinion, should occasion the modern-day equivalent of street protests with flames and pitchforks in Washington DC:
- Any institution who decides to place “toxic assets” into government care should pay a severe penalty, in terms of the haircut they take on the deal. For instance, when Merrill Lynch sold CDOs to Lone Star, they got 22 cents on the dollar, and provided 75% financing. (see also this, from Fortune). This sets a nice benchmark. An upper benchmark, that is.
- The issue that Cox/Bernanke/Paulson are trying to solve isn’t to restore the banks’ balance sheets to their former luster and size, but instead to remove the shame and stink of the reams of bad assets contained therein, which cause all of the market participants to mistrust each other. They each know how badly they’ve damaged their own financial positions, and what they’ve not yet disclosed or taken write-downs on, and they assume, probably correctly, that all other participants have done the same. Nobody wants to be the first to drop their drawers and embarrass themselves. They should all be forced to fully disclose their positions in everything, market reaction be damned.
- The result of this will be the shrinkage or disappearance of many or all such participants, and any who stay out of the rescue pool will either already be transparently clean and problem free, or will be ostracized like the financial lepers they are.
- This shrinkage of concentration in the financial services market should not only be accepted, it should be encouraged. Many small firms, each small enough to fail without adverse consequences to the economy as a whole, are far preferable to a handful of mega-firms without whom, we’re encouraged to delude ourselves, we can’t exist.
- The final package must be free of the standard Washington give-and-take back-scratching, the sort that has nothing to do with the problem at hand. West Virginia, for instance, doesn’t need any more federally funded assets with Robert Byrd’s name on them, his certain protestations to the contrary. They should get in, fix what needs fixin, and get the hell out.
- The final package must, absolutely must, contain provisions to counteract moral hazard. In particular, these would include things like the warrants for 80% of AIG shares that go with the government’s backstop financing for the ailing insurance behemoth. If AIG’s holders are able to replace the financial backstop (as well they might, given a credit system which again works as it should), then they can prevent exercise of the warrants. But if they can’t, their equity goes poof!, just as it should. Some similar disincentive to sloth must be a precondition for participation on the part of all those who dump toxic assets into whatever cauldron the government provides. Something like Bill Ackman’s prescription for Fannie and Freddie wouldn’t trouble me at all.
I’m old enough now that I should be well beyond hearing simple phrases made up of well-known words but that cause me to say “Yeah. That’s what it is!”. But “privatized profits, socialized losses” is just such a phrase that’s crept into the common lexicon in recent months. For all I know, it’s been in wide use for many years, and I just missed it.
But that’s the problem that the US must avoid, otherwise we’ll turn into a shell of our former economic selves. And we’ll deserve the ignominy.
Overstock used naked short selling in their IPO
The date of this prospectus is May 29, 2002
OVERSTOCK.com, Inc.
3,000,000 Shares
of Common Stock
In connection with the offering, the underwriters may purchase and sell shares of common stock in
the open market. These transactions may include SHORT sales, stabilizing transactions and purchases to
cover positions created by SHORT sales. SHORT sales involve the sale by the underwriters of a greater
number of shares than they are required to purchase in the offering. ‘‘Covered’’ SHORT sales are sales
made in an amount not greater than the underwriters’ option to purchase additional shares from us in
the offering. The underwriters may close out any covered SHORT position by either exercising its option
to purchase additional shares or purchasing shares in the open market. In determining the source of
shares to close out the covered SHORT position, the underwriters will consider, among other things, the
price of shares available for purchase in the open market as compared to the price at which they may
purchase shares through the over-allotment option. ‘‘Naked’’ SHORT sales are any sales in excess of such
option. The underwriters must close out any naked SHORT position by purchasing shares in the open
market. A naked SHORT position is more likely to be created if the underwriters are concerned that
there may be downward pressure on the price of the common stock in the open market after pricing
that could adversely affect investors who purchase in the offering. Stabilizing transactions consist of
various bids for or purchases of common stock made by the underwriters in the open market prior to
the completion of the offering.
This is too funny. GE is the parent to CNBC. CNBC has been the mouthpiece for the short sellers for years. The common mantra from CNBC and their puppet masters has been; “Short Sellers can’t destroy good companies” and “CEO’s that complain about short sellers are diverting attention away from their real issues”
Today GE is added to the list of companies that can’t be shorted at the request (begging) of Jeff Immelt. CNBC is afraid to report much on this because it would point out the hypocricy. Is Immelt hiding something about the company that CNBC does not want to uncover or…can short sellers destroy good companies.
We will never fully know the answer but what we do know, predatory short sellers were about to drive our national economy into the abyss and some here are unwilling to understand that.
John: I wonder how hard Mr. Byrne had to gulp before signing that particular underwriting agreement?
Dave: I’m still comfortable asserting that in any large company, short selling’s effect on stock price follows fundamentals, and doesn’t lead them. Of course, that’s easily true in GE’s case.
For small-cap companies, the theory of large numbers can swamp business reality, and I understand those who offer sympathy when the small-caps complain of being shorted to oblivion.
However, in a past life, I was with a company subjected to just such an assault. And the shorts were right about the fundamentals. But if they’d been wrong, and we could have proved this by “operating our way” out of it, those shorts would have been squeezed hard, as small-caps’ prices can jump more violently than large, based on fundamentals.
Speculative short-selling is never risk free, and market based mechanisms exist to ensure that risk applies to shorts of large and small companies alike. As a result, I remain distinctly queasy about limitations on short-selling beyond the existing requirement that the stock be properly borrowed beforehand.
Michael, the issue of fundamentals is a double edged sword. Lets take pharmaceuticals. People speculate on these stocks based on the future outcome of their drug tests. But since these tests take years to complete, and longer to get FDA approval, the ability to fund such programs is highly dependant on the companies ability to raise capital. Short sellers can destroy that ability and thus destroy the company.
Consider the Op-Ed in the WSJ by James Chanos today “The vast majority of equity short sales are market neutral; the short seller has no fundamental view of a company’s outlook”
If a short seller has no fundamental view of teh company they short, and they are using this trade as a hedge for another, what does that say of the trade that destroys market value? To me this speaks of manipulation as the short seller would not have necessarily considered these small illiquid companies overvalued yet they drove the market down anyway.
As to your comment about “borrowed beforehand” I agree. I believe that the recent movement by the SEC was wrong because it threw out the baby with the bath water. The legitimate investors was harmed alongside the nefarious. Unfortunately this had to come because individuals like Mr. Chanos lobbied very hard that a pre-borrow not exist in our marketplace. Mr. Chanos would rather risk a settlement failure and expect the system to cleanse itself of that failure later than to become a more efficient marketplace by insuring the failure won’t exist initially.
Since 2005 the level of failures in the system have near tripled in aggregate dollar value. The biggest short sellers do not think this is a problem - can you guess why not? Short sellers have failed to police themselves and so we now have “martial law”.
Dave:
“what does that say of the trade that destroys market value?”
That presupposes that a short sale destroys market value, which is something I don’t agree with in any blanket fashion. I actively disagree in the case of large-cap equities (such as pharma) - it’s hideously expensive to short meaningful amounts of such stock, and is therefore quite risky. It’s never done on a whim, but instead because of a conviction. George Soros, for instance, would never had bet against the pound had he not been convinced he was right. He wasn’t trying to drive the pound down; he knew where it belonged, and placed his bets accordingly.
As to the naked short issue, I’m pleased to agree with you on that. Chanos’ reputation today isn’t as toxic as it has been in the past, but his asserting (explicitly or de facto) that naked short rules don’t apply or don’t matter is self-serving in the extreme.