21 07 08 The Scourge of Short Sellers
Citibank 15, AIG 20, Merrill Lynch 22, B of A 19, LNC 42, Freddie Mac 4, Lehman 13 ... the list of financial companies whose stock has been battered the past few months is seemingly endless. Most are down at least 50%, many over 70% from their 52 week highs. By now we all know the story behind the plummet - sub-prime CDOs, CDO2, CPDOs, CDS and the resulting very large write downs. Certainly, some degree of punishment was appropriate for these companies given the poor risk controls and for some, reduced earnings potential over the next few years due to de-leveraging. Some have also taken realized losses on their bad investments or non-performing loans. Yet many, especially the insurance companies, have only taken paper losses and will quite likely see write-ups over the next two to three years. This is because they are valuing many of their holdings at extremely low levels because of a lack of liquidity in the markets for these specialized assets. Simply, if nobody wishes to buy anymore of these assets the only bids (if any) will be below fair/intrinsic value. Anybody who has sold a home or auto in a stagnant market understands this - bids will be few and usually well below what anyone would consider 'fair' value yet unless you absolutely needed to sell you would wait for the market to improve. The same applies to many of the CDOs and CDS on the books today but unlike a house which remains yours until sold, these assets are continuously receiving income streams which shortens their expected life. So while nobody may want to buy your CDO or CDS, you may in fact be paid back all you were due (or not pay in the case of a swap).So why have their stock prices gone so low? Is it simply panic selling? We will concede a portion of the move to 'panic' selling by investors who have suffered margin calls, wish no more pain or no longer understand what they own and are willing to take their lumps immediately. But panic selling happens over a short period of time, not over weeks and months. The plummet from late last week through this past Tuesday smelled of panic selling but that explains only the last few points. What of the rest that could be deemed 'excessive?' To begin, one should probably look at the daily volume traded.
Since June 17, Citibank has traded 49% of its 5.2 billion share float. AIG about 46% of its free float. Freddie Mac 274% of its float. A typical trading day a year ago would see each of those companies trade 0.5% of its float, or 11% over a 22 day period. So without question, turnover is way up. As are the number of shares being sold short. Short sales are the sale of borrowed stock - perhaps you think company A will report bad earnings and you would like to profit on an expected move lower. You can ask your broker to 'borrow' shares from another account which you can then sell. When you close your short position by buying the stock back, those shares are returned to the original holder. Most times there is no asking involved, brokers as part of their normal operations will borrow shares of common names and typically provide traders with a 'short-list' detailing which stocks can be shorted and how many shares are available. If the name you want is not on the list, they can usually call around to find some shares to short but probably will not bother unless the amount is worth the trouble. Not surprisingly, brokers get a small fee for lending the shares (you didn't think the actual owner would, did you?) which may rise as demand for shortable shares grows.
Short selling has always been viewed negatively by many investors who rush to blame 'evil short sellers' every time their stock declines in price. This is, of course, a naive view. In the normal course of things, short sellers provide additional liquidity to a market thus enabling those seeking to buy to obtain shares at a better price. In thinner issues, a short seller could also be the difference between buying your amount at one price instead of paying increasingly higher offers for smaller pieces until your order is complete. And those investors who regularly blame short sellers for all their ills rarely, if ever, thank them for pushing prices higher when they cover en masse creating a 'short rally'.
There are also non-speculative, legitimate reasons for short selling used daily by hedge funds and portfolio managers. As an example, a fund might hold a long position in Chevron feeling it is well run and has good reserves. However, they may not have good feel for the direction of crude prices in the near to medium term. In addition, when deciding on the purchase of Chevron they reviewed Exxon Mobil but felt it was not replenishing reserves fast enough and that management was not proactive. This presents the fund manager a way to stay long Chevron while minimizing his exposure to uncertainty in the crude market - to sell short an equal value of Exxon Mobil. As long as he holds this position his return will be based on the relative performance of these two companies. There are also a large number of hedge funds which use a 'long-short' strategy as the underlying basis for the fund, seeking to be market neutral. Gains (or losses) are achieved through fund manager 'alpha' - the ability to add (subtract) return in excess of the market. But again, we are speaking of relative stock/sector performances. A long/short strategy can be successful even if those stocks sold short increase in value.
Recently there have been suggestions that short selling has caused the plummet in financial stocks. We think that is not the correct question to ask. Rather, there are two distinct questions which must be answered: 1) was short selling the original cause for the decline in financial stocks? 2) has short selling during the decline been excessive and caused negative consequences which would not otherwise have occurred?
To the first question - there is no prima facie case to be made that shorts ignited the sell off in financial stocks. While early short sellers were the first indication of problems with these stocks, the root cause of the decline was the revelation of significant bad loans and bad investments, many highly leveraged, which left investors guessing at the extent of future losses at these institutions, both real and temporary.
The second question is more difficult to answer but we feel on the whole short selling has pushed many of these stocks far lower than they would otherwise have gone and has created severe knock-on problems. Bear Stearns is the most recent example of a liquidity 'death spiral'. The combination of rumors, relentless short selling and bad positions reached a tipping point when lenders would no longer accept any Bear Stearns assets as collateral. Once this happens, the end is quick. Bear had insufficient capital to fund their asset book without borrowing daily in the market place, a consequence of the use of leverage. Normally, this is standard practice for financial firms as rarely does the underlying value of their book change substantially over a short period of time. And even if they hold many illiquid assets, in normal markets reasonably fair bids can always be found - though not at a moments notice. It may take days or weeks to unload complex assets or those which are tailored for very specific or uncommon needs. Bear did not have that luxury as many of the assets they owned fell into the nobody wants at any price category. Without a backstop such as the Fed discount window, the forced sale to JP Morgan was the only way to preserve any value at all for the stockholders.
Interestingly enough, the Fed seemingly decided to make an example out of Bear Stearns but then put in new, 'temporary' liquidity facilities which not just traditional banks could draw upon but also the big brokerage houses which are primary dealers in government securities (Bear Stearns had been one). The result was to take immediate pressure off of Lehman Brothers who was also a 'target' of rumor and short sellers. And unlike in the examples previously mentioned, these short sellers intended to see the share price go to zero. Relative value was not then, nor now, part of the equation. But so long as the Fed facility remains in place, Lehman will have a life line to use as the sharks continue to circle it.
The past three weeks have seen the attention of shorts focus instead on the two quasi government entities - Fannie Mae and Freddie Mac. These two firms provide the bulk of liquidity to the mortgage marketplace by buying new originations and repackaging them as pools of securitized debt. This debt is bought by all types of investors - individuals, pension funds, sovereign wealth funds, central banks to name just a few. They make a profit by being able to issue this debt (agency paper) at a lower rate than they are receiving on the mortgages they buy and a significant reason for their lower cost of funds is the U.S. government provides an 'implicit' guaranty - or so the market has always believed. Like other lending institutions, they are holding a large number of sub-prime and alt-A mortgages which are either in default or foreclosure and have had to raise more capital to make up for the shortfall in income. But once again, aggressive short selling has created another untenable situation. Earlier in the year, sales of new equity to raise the needed capital went off reasonably well. This past week though, Freddie Mac found itself in a position where it was unlikely to be able to sell more equity as its stock price had fallen to such a low level any new issue would be unacceptably dilutive to all. And while the companies and regulators maintained that their existing capital was adequate for current needs, the market continued to drive their stock prices into the low single digits. At this point, many started to wonder when debt investors would walk away and provide the final nail in the coffin of these firms. Once again, the Fed has been forced to come to the rescue by opening the discount window to both agencies - even though they have no plans to make use of it. By putting this backstop in place the government has provided a lifeline. At the same time, the share prices of most other financial institutions fell to lows not seen in decades.
This is the scourge of short sellers. Going well beyond reasonable economic justifications, short sellers - as a group - have not just shorted stocks which would likely under perform, they have caused the viability of these firms to be put at risk, a situation which otherwise would not likely occur. A former SEC Chairman, Arthur Levitt, tried to brush off the effect of short sellers saying to the effect that there were many other ways to profit from a decline in stock price 'such as derivatives.' This is naive hogwash, and frightening considering its source. Mr. Levitt seems to believe that if an investor enters into a derivative contract, say a put option on Citibank, that this will have no effect on the stock price. We ask - what does he think the other side of the trade does with the position? Hope that the stock price does not go down? Of course not - the other side will hedge the position by -gasp- selling short the number of shares necessary to hedge the position. The cumulative effect is the same as if the original investor had shorted the stock, only this trade was far easier and involves no risk of a call on the shares they are short..
The current crop of SEC officials seem no better able to understand the current environment, vis a vis short selling. Prior to June of 2007, short sellers were required to wait for an up tick in the stock price before selling borrowed shares, thereby giving the true owners of the stock first shot at the bid. This rule had been in effect for many decades and while at times inconvenient, was not a major obstacle to those wanting to short a stock. In addition, there were similar rules in regards 'narrow' baskets of stocks. This rule did not apply to large baskets such as the S&P 500 as the individual contribution of each company to the index was in general small compared to the overall size of the trade. With the lifting of the up-tick rule, short sellers are not only able to trade in front of longs but now are also able to overwhelm the bid which can't be replenished at the same speed as the shorts are selling (in part because of the different time horizons which most longs have compared to short sellers). This results in an accelerating cascade of lower prices.
In an effort to look like they are on top of things and 'protecting' the little guy, the SEC this past week passed a new regulation to prohibit 'naked' shorting of 19 select financial stocks - the primary dealers in government securities. Naked shorting is the sale of shares which have not even been borrowed. During the dot.bomb craze, naked shorting was a popular strategy used via Canadian brokerages where rules were lax. Actually borrowing and delivering the shares? How quaint an idea! Its almost comical to read some of the comments the past few days from those in the industry bemoaning the additional burden of having to make sure they actually borrow the shares they say they want to be able to short.
Gregory Hold, chairman and CEO of direct-access trading firm Hold Brothers On-line Investment Service, warns that SEC's rule change on short selling will add another layer of bureaucracy to Wall Street's back offices and could create an artificial bubble in the value of financial stocks.Makes you shed tears for those poor back office operations and traders who may not be able to 'share' the same shortable shares, doesn't it?
"The (old) rules currently require that you locate the stock but don't actually borrow the stock. The rules on Monday will require you to take the formal delivery of the stock or begin the step of formal delivery," says Hold. "It adds a bureaucratic layer and it takes out the ability for multiple short sellers to claim the same shares," maintains Hold.
"Because the operations departments of brokerage houses may not be able to adapt to the new rule, many of those will eliminate short selling in financial stocks," Hold predicts. And due to the programming and software changes, that's another reason why financial firms may sit on the sidelines, says Hold. "This will eliminate a normal amount of downward pressure, creating an artificial bubble in those stocks," he says.
[...]
There are a couple of factors that could lead to a shortage in shares to borrow, according to Hold. One is that customers can't claim the right to borrow the same shares anymore. In the past, if a stock loan company gets calls from three hedge funds that want to borrow, the stock loan company is tempted to over promise the same shares to its customers because chances are some of the firms won't use the shares, especially those with short-term strategies.
Some hedge funds only want to borrow the stock for a few hours. "Now, because the actual mechanics of the delivery process make this impossible, and because there's no fudge factor " the stocks have to be delivered " the same stock doesn't stretch as far and that reduces the supply," says Hold. In addition, the Wall Street firms need the shares for their own trading and market making. There are plenty of legitimate reasons to sell short and they're trading the stocks of the financial sector, say Hold. Source: FinancialTech.com
And someone should really ask Mr. Hold if one can have a price 'bubble' when one starts from a price squashed artificially low by short selling? Wouldn't this be better described as a return to a more realistic fair market value?
Understand right now this move has nothing to do with a desire by the SEC to protect shareholders in those firms. No, this is all about making sure the U.S. government is able to maintain a smoothly functioning market for its own paper. With the estimates for the 'official' cash based budget deficit now pushing $500 billion again, the Treasury Dept. is planning on raising $119 billion of new money in Q3 2008 just to make ends meet. The recent chaos with FNM and FRE and its potential effect on agency paper set off alarms that under no circumstance could there be a run on any of the primary dealers such as Citibank and Lehman. Remember, the government will always looks out for itself before ever considering your well being!
If the SEC were truly concerned about the effects of short selling they should have gone a great deal further. To begin, this new regulation should apply to all shares sold short, not just the 19 primary dealers in government securities (already there have been complaints other financial firms whose stock prices are under duress were excluded, such as Wachovia and AIG.) Second, the SEC would have re-instated the up-tick rule and ended what can only be seen as a failed experiment in market self control. Third, the SEC would have addressed the issue of sector exchange traded funds (ETFs), in particular those which are leveraged and/or short only. One fund we find especially troubling is the ProShares UltraShort Financials (ticker: SKF).
From the ProShares product literature:
ObjectiveThis is an ETF set up with the express purpose of avoiding the need to find shares to short, the possibility of a short call and the ability to leverage at least 2x, more if margin is used. Quite amazing isn't it? One wonders what magic they use to accomplish this objective.
UltraShort Financials ProShares seeks daily investment results, before fees and expenses, that correspond to twice (200%) the inverse (opposite) of the daily performance of the Dow Jones U.S. Financials IndexSM ProShares make sophisticated sector strategies simple. To get short or leveraged exposure with stocks or ETFs, you used to need a margin account. ProShares makes it easier by building this exposure directly into an ETF. That means
with ProShares:
You can quickly get short or leveraged exposure as simply as buying a stock
You can track your investment throughout the day
You can avoid the hassles of a margin account:
You wont face margin calls or increased margin requirements
Your downside is limited to the cost of your investment; with margin its unlimited
You can use them in vehicles that do not permit margin accounts
Source: Proshares.com
Equity swaps. Equity swaps? Well you knew there had to be more swaps in there somewhere, didn't you? What was once limited to very sophisticated hedge funds and portfolio managers has gone mainstream at Proshares. From Finpipe.com comes this easy to understand definition: Equity swaps are exchanges of cash flows in which at least one of the indices is an equity index. An equity index is a measure of the performance of an individual stock or a basket of stocks. Common equity indices with which the general investor is probably familiar include the Standard & Poor's 500 Index, the Dow Jones Industrial Average or the Toronto Stock Exchange Index. Or in the case of the UltraShort Financials Proshare, twice the inverse return of the DJ US Financials index. So what we have here is a swap on a derivative (the return of an index). As in an interest rate swap, one side will pay floating (typically LIBOR + spread) while receiving 'fixed', or in this case, the return of the equity (or equity index) during the tenor of the swap. An example might be, pay LIBOR + 5bp and in return receive the return on the S&P 500 index over the next 6 months. The fixed rate payer will then turn around and buy the equity outright and will make their return by the spread over LIBOR they have charged you, the income from lending the shares they have bought and possibly a portion of any dividends paid on the stock. And of course, do not forget commissions! In the case of an index, they would likely buy a futures contract at very low margin and invest the balance in an income producing asset. Were the fix payer obligated for the inverse return of some asset, they would instead short the underlying asset.
But what is most important to note is that the underlying equity/index is bought or sold - the payer of the return on the equity side does not retain the opposite exposure - they have no interest in taking on a risky trade. Instead, they hedge it away. In the case of the financial index, the Financial Select Sector SPDR (ticker: XLF) would be the quickest and easiest way. The most recent three month average volume for XLF is about 145 million units per day (compared to about 15 or 20 million in early 2007). And in the past two weeks, all but one day saw volume over 200 million and July 17th saw 527 million units turn over! That means nearly 140% of the net asset value changed hands in one day. Where was all this interest in XLF before the past three months? It is certainly not the case that it is a new or unknown fund as it began trading in 1999.
We hope you now have a better understanding not just of the mechanics of ways people are shorting the financial stocks but also the serious ramifications of a system which is providing few, if any, checks against the destruction of shareholder value and corporations by downside speculators. This is not to say that we favor banning short selling as there are legitimate uses which we ourself have used. But we do feel that the SEC must re-examine what is to be considered acceptable on the short side of the ledger. We strongly favor the new regulation designed to prevent naked short selling but it must be expanded to included all stocks, not just those of most interest to the operation of the Federal government. Second, the SEC should restore the up-tick rule on individual equities and narrow baskets. This will be an inconvenience to some (as it was also in the past) but it is a small price to pay to maintain an orderly market. Third, the SEC needs to determine a way to combat the effects of increased use of non-exchange traded derivatives such as equity swaps designed to pay multiple times the inverse return on an index. We do not expect there is an easy answer and any solution is likely to be crude and inefficient, such as capping the maximum percentage of float which may be sold short.
Excessive shorting is a serious problem demanding serious attention. Unlike a speculative bubble on the long side, there is the real possibility of firms going under and shareholders losing their entire investment - not because of economics but because of a speculatively driven liquidity crisis. Hopefully some regulators or better yet the financial industry itself, will recognize these dangers and develop appropriate practices to prevent the scourge of short sellers from returning again another day.
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