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Sunday, 26 October 2008

Protecting assets like a junk-yard dog?

Today, the UK experienced a small quake that the BBC reports merely rattled the crockery on kitchen sideboards, nothing compared to the quakes and after-shocks rattling stock market investors. I feel flabbergasted at the insouciance (blithe unconcern or faith in honest doubt) with which exchanges and regulators view the short-selling tremors in stock markets without serious challenge that politicians are stridently (anxiously and angrily) calling for? We have had not very effective bans on 'naked short-selling' but it now seems that SEC and FSA believe it is enough to insist on short-sellers reporting only when their short positions exceed 3% of a stock? This is fantastical. From the data just this year we can see that all the thousands of short-sellers added together borrow in total less than 10%, usually less than 5%, of a stock. And we can see this is easily sufficient to pull down the share price for narrow speculative reasons i.e. greed (unless you ideologically believe short-selling is merely derivative style self-protection and healthy competition transferring money from failing firms to superior more successful ones; our dog eat dog banks shorting of each other in a Darwinian race to see who falls furthest - a giant game of chicken?)
Are we expected to believe three quarters to one third of the shares loaned out could all have been borrowed by only one short-seller with 3% or more of the target's stock? The answer is no and therefore the FSA's short-selling reporting proposal will result in zero reporting of short positions. And since this should be obvious to any professionals, it makes a complete farce of the welcome given to this 3% idea by financial industry bodies representing institutional investors!
The media is also happily reporting that hedge funds (who are not the only short-sellers, but undoubtedly the dominant players) had a 9.9% loss in the year to end September, and are now experiencing 10% withdrawals, plus Nouriel Roubini's claim (widely reported) that 500 hedge funds will fold in the next few weeks. I take the view that these news items will serve Hedge Funds very nicely by helping in efforts to dissuade regulators from restoring or extending short-selling bans or making new laws to gain more transparency and make hedge funds subject to stricter regulation on a par with the regulation of mutual funds or even that of banks. The reported average losses of hedge funds is a good performance. It is only the aggregate; many funds have made strong gains. That 500 funds (out of over 40,000 hedge funds) will close is an easy prediction and probably a conservative one. More than 1,000 hedge funds closed in 2004/5, though 1,500 new ones opened at the same time; birth rate may be more interesting therefore than death rate of hedge funds. That investors in hedge funds are withdrawing 10% of funds (an estimate by Credit Suisse/Tremont) is also an easy call, neither surprising nor unprecedented (in fact the least one can expect in a currently cash-strapped world). The sum involved is $170-300bn. Reuters continue to refer to “the $1.7 trillion hedge fund industry.” That may be the US share. Others believe the global figure is $3 trillions. Institutional Investor News estimated total industry assets at $2.68tn by Q3 2007. The fact is that we do not know. We need to know. Many investors will withdraw to shift out of some hedge funds now (it takes time) only to invest in other hedge funds later or build their own hedge funds for the rich fees (1-2% management fee plus up to 20% of gains). There is no official public guidance to choke off stock lending on which much short-selling depends! Of course, supposedly, it is up to the good sense of stock-holders to be sensible and not lend stock they know will only get dumped to drag down market prices. But owners of shares do not always know when their shares have been lent. Some stock owners may themselves be derivative-shorting the market anyway via puts, and are happy to earn a small additional 200-500bp margin by renting shares they have already hedged. Many holders of stock cannot sell if they manage index-tracking funds (traditionally over half of mutual, insurance and pension funds' equity holdings). Furthermore, stock exchanges like the LSE are doing their best to attract short-sellers (CFD – contracts for difference) simply because these drive a large % of transaction volumes and transaction volumes are factored into stock exchanges' own share price valuations. Exchanges are happiest to have stocks churned and seem indifferent to price quality issues. Exchanges appear blithely indifferent to the growing imbalance between extreme speculators and long term investors.
Some long term investors like Berkshire Hathaway's Warren Buffet are happy about short-selling for now. He is now shifting massively into US equities and will buy somewhere around the floor of current prices (Dow at 7,500, FTSE at 3,000?). Warren Buffet 's personal investment account until recently comprised only US government bonds. According to this weekend's FT, his 'net worth' will soon be 100% invested in US equities! Motto: “Be fearful when others are greedy and greedy when others are fearful.” Buffet is little-invested outside the US and actually he will be investing in US equities just as globally everyone is piling into a rising US $, and where better than US equities just as they may be about to bounce off both a short term and a long term bottom? In this respect he is anticipating where greed risk-takers are going next. Motto: “follow the high net worth money.”
The FSA (FSA) said on Wednesday it does not see the need for new regulation of hedge funds because they are performing relatively better than others. The latter point is true but does not directly relate to whether or not hedge funds should be subject to new laws, an issue that concerns the so-called 'shadow-banking' sector. Hector sants, FSA CEO said at Hedge 2008 "I ... recognise there is pressure for more regulation in a rather general way... I don't particularly think more regulation is needed, but I do think more effective regulation is needed... Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry", adding that he expects more funds to fail.
Recently it has been claimed that a third of hedge funds are in money market funds and another third is committed to short-selling. The final third may be pledged as collateral or in various vulture fund plays. A big percentage must be in macro-strategies. Who knows? The leverage (excluding derivative market leverage) of hedge funds could be anywhere in the $10-20 trillion range, which could therefore represent anywhere from 8% to 16% of world financial assets ($118tn at end 2006) or more likely 10-30% of world financial assets today. We don't know. But this rough estimate alone suggests that 'shadow banking' is enormous. When we consider leverage via derivatives the scale becomes hard to compute. The FSA, following the SEC's similar stance, said on Thursday it plans to make (short-selling) investors disclose holdings of more than 3% in companies through CFDs (contracts for difference). This would seems absurd even if the reporting must cover positions held to that threshold or above at any moment in time however brief, except when we appreciate the scale on which hedge funds can operate. The rationale is unclear, however, since prices can be moved very effectively by the frequency of the net direction of buy/sell signals more than by the volumes involved. Price movements do not correlate with volume. That is stock market 1.01 (US expression).
The FSA said a final draft of long overdue rules on CFDs (said to be one third of trading in UK equities) - under which one party agrees to pay another the difference between the current and future price of a share - will be published in February 2009 and come into force by September 1 2009. Do we hear stable doors closing? This delay reflects the fact that the FSA does not regulate by simple fiat, or very rarely and reluctantly. It is really still part of a self-regulation culture like a membership club that relies on consulting with the industry first, seeking the agreement of the members who, after all, pay the FSA's fees, like membership subscriptions even if they have no choice and no power to determine those fees. Lord Turner has said that the FSA will from now on stop regulating on the cheap. But, until and unless government pays for its own agency, it would seem unlikely that the membership club regulatory culture will change. "Our goal is to provide an effective and proportionate disclosure regime that works for all involved, and sustains market confidence and efficiency," said FSA Director of Markets Alexander Justham. Clearing services publish stock lending and we can see the effect on bank shares.
Reuters explains that “CFD holders, who effectively have the benefits and risks of a stock without owning it, are currently not obliged to make their positions public, allowing some hedge funds to use them to anonymously build sizable stakes in companies they wish to influence.” This also sounds insouciant, when we know that the “benefits and risks” referred to are the inverse of long term investors' interests, especially with respect to bank stocks that have a systemic importance in banks' capital and why naked short-selling of bank stocks was temporarily banned! The ABI Director of Investment Affairs Peter Montagnon (Association of British Insurers, the UK's biggest institutional investors), referring to the FSA's proposed new rules on CFDs, said “the measure would improve transparency...This is a welcome step forward. Companies should know who has built up a stake and investors too should be aware of what would otherwise be happening behind their backs." If they are lending out their shares to CFD speculators, how is this happening behind their backs? The UK's Association of Investment Companies, the investment trust industry, also welcomed the move, saying, "These disclosures should let shareholders understand who might try and exert influence over the affairs of companies they own and then allow them to act accordingly to protect their own long-term interests." Again, why do they not take action themselves on stock lending? It is not that hard to know what is going on already.
Hedge Funds are said to devote 30% of funds to short-selling (renting borrowed shares to sell into the market then buying them back cheaper later to return the lender). The markets and shares that are the targets of short-selling are those expected to fall, or already falling and expected to fall more or known to be vulnerable to being dragged down by short-sellers. They are will be 'shorted.' This is not hard to know by traders with access to derivatives markets who can detect overnight 'puts' that will trigger price falls in the cash market as soon as stock exchanges open next trading day. For prime brokerages and their hedge fund clients this is not rocket science.
Intra-day short-sellers using borrowed stock will seek to sell at times and in exchanges for maximum negative impact, say on opening to mid-morning and then buy them back at mid-day before the afternoon mini- “dead cat” bounce – or at whatever time fits with the period over which the shares are borrowed. For maximum impact short-sellers try to signal as loudly as they can to the whole market. detecting these signals is easy for market insiders and leaks out to all others. How this is done is exactly the opposite way to how big buyers or sellers normally seek to minimise market impact by disguising signals when trying to buy cheap or sell dear. Maximum market impact is obtained not by size and direction (a big sell-order) but by the frequency of sell orders in the cash market i.e. a lot of smaller sell-orders. I know this from my own models and from work done by and for stock exchanges in the past.
When stock markets in US and Europe fell by over 40% in the year to date, what profit gains were possible for short sellers sector by sector for June and July? How when falling sectors devastate the portfolios of most investors can this multiply the wealth of those who use CFDs and inverse ETFs (Exchange Traded Funds). Again this is not hard to know. below is a list of short-selling CFD gains that were possible in the US this year. Hedge Funds may wish to check whether they performed this well. Between June 5 and July 15 the technology sector share falls delivered 30.9% gains to short-sellers, and the real estate sector 46.1%. Between June 5 and July 11 in the semiconductor sector the gain was 37,2%. May 15 to July 15 the consumer services sector delivered 37.7% and the financial sector a whopping 106.7%.
What about September and October, great days for shorting? 49.6% gain in 14 days in semiconductor (October 1 – 15), 61.0% in technology (September 25 - October 10), 89.13% in real estate (September 26 - October 15), 89.6% in consumer services (September 26 - October 15), and 89.9% gain in financial stocks (October 1 - October 9)! If Hedge funds deliver loss performances given these gains, offering gains to concerted equity plays of 300-500% in 4 months, then that does suggest that they really do need some risk regulatory oversight or cash-flow forensic audits. The other side of this coin of course is what has happened to mutual funds, insurance and pension funds who funds have lost massive value? This is surely a massive shift of several $trillions, a Mount Everest of Funds, from funds that serve the general public interest to hedge funds serving the super-rich. That would be one view. Of course, mutual funds, insurance and pension funds may be complicit with hedge funds (some of biggest of which are owned by banks) insofar as possibly up to 10% of the funds of the former may be vested in the latter? US Mutual funds 5 years ago used to be ten times the size of hedge funds. They may now be less than three times or even only twice the size of hedge funds! Banks as we know are desperate to bank profits and restore their capital reserves. They also have hedge funds who may be aggressively doing their bit to book profits by short-selling, which can be ironic when the banks have for short period been protected from naked short-selling. But also the banks' corporate clients would be somewhat aggrieved to learn when the FSA's disclosure rule results in publishable data to learn that hedge funds owned by banks were dumping their stock. It may also be a dysfunctional fact of life that banks happily extend credit facilities to hedge funds that are shorting bank shares and the credit-worthiness of the banks' corporate finance clients. Short selling is an easy choice when bank managements lost credibility in how they cope with the changed macro-economic situation. It does not help when banks and their underwriters, not just hedge funds, are short selling each others' stocks to make money as their own share prices fall. Banks short-selling each other cannot be conducive to restoring interbank credit markets. As one US newsletter defines seeking to mitigate the rapidity with which markets can collapse in our dog eat dog world is merely “protecting assets like a junk-yard dog!”



It is only fair to consider the counter-argument of why asset management arms of banks should continue to lend bank shares? I'm grateful to David Rule Chief Executive International Securities Lending Association whose views I reproduce below.

Robert Peston of the BBC and Jeremy Warner of the Independent recently asked why the asset management arms of banks continue to lend bank shares. It is perverse to lend shares at small fees to hedge funds so that they can sell those shares short on a massive scale and drive prices downwards, frustrating the plans of those banks to maintain or restore their capital and to raise new capital through rights issues. It looks a no-brainer. But the argument is nonetheless flawed according to david Rule. His answer is in three parts:

1. ‘Lending shares facilitates short selling by hedge funds that want bank share prices to fall’

• That is true but very far from the whole truth. In fact,Rule says, only a fraction of securities borrowing is to cover short sales by investors with a simple directional view that a share price will fall. (My view is that may be so in most orderly markets, but not in disorderly bear markets.)

• Rule says, much more commonly, securities are borrowed to cover short positions taken to hedge long positions in a share or a related instrument. For example, dealers will enter into short positions to hedge long positions taken when they buy shares from a client. Their ability to provide liquidity to clients as market makers in this way relies on a well-functioning share borrowing market. (My view is that clearly buying long is not happening in an over-sold strong bear market and anyone with a long position knows this short hedging of long merely adds to the short-selling pressure - obviously self-defeating to someone with a long position unless they are really taking a bear view in which case they can short the lot).

• Similarly, Rule says, short positions are taken to hedge positions in equity derivatives related to share indices. Without a liquid securities borrowing market, traders would be unable to keep the value of the FTSE 100 futures contract in line with the prices of the component shares by arbitraging between them. Liquidity in the futures contract would deteriorate.(this is quite funny - where cash market positions are being employed to hedge the derivatives market, which is supposed to be hedging the underlying cash market!?)

• Shares are also borrowed for settlement reasons. Without share borrowing, says Rule, chains of failed trades would be common as market participants were unable to deliver shares themselves because other counterparties had failed to them.(My view: Failed trades are normally a significant % part of Operational Risk. In current circumstances failed trades should be allowed to fail and not be shored up in ways that simply support short-sell gaming. "I had to borrow shares because I sold shares I couldn't buy cheap enough or.. what? In fact this share lending helps short-sellers avoid their natural losses, which they postpone and roll-over until the next price fall they can exploit.)

2 ‘Hedge funds can drive share prices downwards by selling shares short’

• Rule says,Short sellers have no more influence over share prices than any other traders. If selling pressure caused a share price to fall below what other investors judged to be its fair value, they would buy and the share price would correct. Those who argue that short sellers can drive a share price below its fair value need to explain why other investors do not take that buying opportunity. After all, the universe of potential buyers of shares is much larger than that of potential short sellers. Most institutional investors are still constrained to be long only. (My view: Obviously short-sellers do not have to sell at prices below what others are willing to buy at - why should they? They merely have to maintain a stream of sell-orders and that influences buyers' view of market value. Who buys at 'fair value' when P/E ratios can range from 30 to 5? Fair value is a long term concept, not an intra-day or inter-day concept. Short term speculators exploit market prices not fair value. Whatever one's view it is merely theological or ideological to assume that markets always instantly adjust and close gaps between market and fair values. Has 'arbitrage' no future? Rule is just being defensively fundamentalist.)

• Rule continues by taking up my point, More fundamentally, they need to explain why they do not believe the market is efficient and how a share price can move away from fair value for a sustained period of time. Academic theory and common sense suggests that the best way to get a fair price for a share is to allow all market participants, with their varying views, to trade in the shares1. Putting obstacles in the way of those that believe share prices are over-valued will only make prices less efficient. In effect, it removes a class of traders from the market who believe shares are overvalued but do not currently own them. In the long run, all investors will then be worse off because they are more likely to trade at prices that are too high in relation to underlying fundamentals. (I'm unaware of anyone suggesting a permanent end to security lending - where would that leave central banks - but also we are not talking about long term Short-sellers do not take up long term positions, only very short term ones. Underlying fundamentals are not individually fundamental; they are relative and systemically created, and if prices can be too high they can also be too low, and currently unconstrained stock lending is biased strongly toward driving prices below fundamentals, which can be judged by P/E ratios of banks scarcely exceeding book value!)

• Rule next says, Short selling is certainly not a one-way bet. Buyers of shares can only lose the amount of money they invest and they benefit from the long-run bias for share prices to rise as economies grow. By contrast, short sellers face potentially unlimited losses and that bias is against them. Nor is it obvious how the rights issue process creates a one-way opportunity for short sellers. They may benefit if the share price falls below the rights price. But they have no magical powers to keep it there. The rights process does not prevent buying by investors who believe the share price is too low.(My view: the bear market bias is with short-sellers. That much is obvious.The question then is shouldn't we constrain short-sellers to allow long term investors more time to make considered judgments and win more time, in the case of banks, for them to restore their capital reserves?)

3 Rule says about the idea that ‘Short selling on a massive scale has driven bank share prices lower in order to frustrate rights issues’

• The UK settlement system Euroclear UK and Ireland publishes data on outstanding securities lending positions in UK equities. As explained above, far from all securities lending is to facilitate directional short positions. But a massive wave of short selling would be expected to lead to an increase in securities lending. It is interesting therefore to look at the data for lending of shares in the UK banks involved in rights issues (see charts in the my blog).

- Lending of HBoS shares has been more or less constant at around 6.5-7.0% of market capitalisation since its rights issue was announced on 29 April. That equates to around 5 times average daily turnover in HBoS shares, which is well below the average level for FTSE 100 shares of around fourteen times.

- Lending of RBS shares actually fell sharply after the announcement of its rights issue on 22 April. It did then rise from around 2% of market capitalisation to 6.5% between mid-May and early June. But, even on the extreme (and almost certainly wrong) assumption that this increase was entirely to facilitate directional short positions, it represents only about 15% of market turnover over the period in which the rise occurred.

• In sum, nothing in the data supports suggestions that falls in bank share prices have been caused by a wave of short selling so large that it has temporarily swamped all other trading and distorted the market.

(The problem here with Rule's argument is that when share values fell steepest stock out on loan was highest. But, in any case, context, quality of market and frequency of direction of orders is more influential on prices than volume. To argue whether the loaned stock was all for direct short selling is lost by the need to consider what was happening in derivatives trading.)

Rule then asks, so what would be the effect of the asset management arm of a bank ceasing to lend bank shares? (I assume he also means institutional investors as well a banks' AM arms?)

• On bank share prices: if the supply of shares to the securities lending market was reduced significantly, the immediate effect might be a short squeeze as those traders that had sold the shares short were obliged to close out those positions and buy shares in order to return them to the lenders. But the spike would probably be short-lived as share prices re-adjusted. Over a period of time, the effect on share prices would be, in all likelihood, zero. (Well, it is also true that over time anything short-sellers do could be zero, but in the meantime banks go bust, get taken over and short-sellers bank profits and asset managements see their funds shrink and failing to meet obligations on insurance claims,pensions etc. and banks who are systemically interdependent have damaged each other and thereby the interbank liquidity on which they all depend.)

• Rule finishes with, on the liquidity of the market for bank shares: if liquidity in the market to borrow shares fell permanently, dealers would be less able to hedge trading positions in those shares or related derivatives. Settlement would also be more risky. Cash and derivatives market liquidity would fall, raising the cost of trading in the shares. (Again, no-one is suggesting a permanent ban on stock lending! But, while a temporary ban might seriously help in 1/100 or 1/25 market shocks, there could also be safeguard limits worth considering at other normal times.)

(Rule's last point below is clearly perverse!)
• On the earnings of the asset management arm of the bank on behalf of its customers: Those customers are likely to be long-term investors in pensions and savings products. Any short-term spike in bank share prices would be of no value to them. But they would miss out on the revenue from lending the shares. The intrinsic value to lending a share is part of the overall return on that share, along with dividends and capital appreciation. Giving up that revenue would be failing in their fiduciary obligation to their customers.
(If one begins with the fundamentalist presumption that short-sellers can have no effect on driving down shares below fundamental fair value, ok. But if this is wrong as I and most others believe to be the case in a severe market crash, then for savers it is glaringly perverse to lend shares at small fees to hedge funds so that they can sell those shares short on a massive scale and drive prices downwards so they can return the shares much devalued.Rule's defence of stock lending is like hearing a bank robber's defence from the dock going something like this, "I was acting for the greater economic good to increase the velocity of capital, necessary to the efficiency of the transmission mechanism, as Hayek said and quoted by Friedman when referring to Keynes on the question of counter-cyclical redistribution of income in the economy as a fundamentally good thing!")



Selling short
If a trader thinks a stock is bear food, he can borrow the shares from a broker and sell them. Eventually, the trader must buy the same quantity of shares back. Trader borrows 10,000 shares of TBTF Bank on Sept 1 and sell it for $10 per share. Then, on Oct 1, trader buys 10,000 shares of TBTF at $6 per share to return the borrowed stock and makes $40,000 (less commission & rental fee of say $2,000).(Note: If shares can only be borrowed if the value, not number, of shares had to be returned, short-selling cannot happen.)

Short interest
This is the total number of shares of a security that traders have sold short -- borrowed, then sold in expectation the security will fall in price. The traders then buy back the same number of shares and pockets the difference as profit.

Short position
When trader sells stocks he or she does not yet own, shares must be borrowed, before the sale is settled, to make "good delivery" to the buyer. Eventually, the short position must be 'closed out' by buying shares to complete the transaction.

Short sale
Selling a security that the seller does not own but is committed to repurchasing later. It is used to exploiut an expected fall in the security's price.