Monday, September 22, 2008

The mother of all short squeezes (1)

Last Friday, September 19, was triple witch, the day index futures, index options, and stock options all expire. Friday morning's round of market manipulation from the federal government was cleverly timed to hit at a moment of maximum volatility: the idea being, presumably, to create the mother of all short squeezes.

The SEC temporarily banned the short selling of 799 financial stocks and eased conditions on the repurchase of shares by issuers. Additionally, large market participants will now have to report their short positions as well as their long positions.

Aside from the obvious question why we didn't ban the buying of tech stocks in 1999-2000, there is good reason to think this action will have paradoxical and unintended results. The move (along with the nontrivial interventions announced by the Fed) will set an artificial floor under the prices of financial stocks. Now, among the effects of a successful intervention to save the American financial system will be to set an eventual floor to the valuation of financials. We say artificial because the ban on short-selling will restrict the ability of the market to signal its perception of downside to the current valuation -- denying the government its best signal as to the adequacy of its interventions.

In the short term, we saw a rush of money into financials (all up astonishingly on the day – XLF, the ETF which tracks the financial stocks in the S&P 500, was up almost 21% at Friday's open) driven by forced buying and exacerbated by triple witch. But when the dust settles and everyone is long, the restriction on short-selling will no longer provide active support for valuations.

Worse, as long as it is in place, the ban on short-selling serves as a signal of the weakness of the financial sector: anything you aren't allowed to say bad things about must be bad. Dealbreaker posts a picture of the Pakistani stock market post the introduction of restrictions on short-selling to demonstrate the worst-case scenario for a short squeeze.

Those with negative views on financials will find other ways to operationalize their views: they will try to buy puts (artificially inflating the implied volatility of financial stocks, which removes another important source of information from the market and plays havoc with risk management), or they will short other instruments like the XLF (forcing the index issuers to sell their long positions in financial stocks, adding to the post-short squeeze long selling pressure), or they will short stocks not on the list.

Ultimately, while stocks will have to recover if there is a wider economic recovery, their very visibility –- and the ease with which moves like this are 'understood' and picked up by the media –- argues against support for stock prices as a first measure. Credit markets, and the underlying performance of the real economy, are far more important; and they are easily lost in the fray.

For what it's worth, research done on July's temporary rules, which banned naked shorting of the primary dealers, shows that it contributed an extra $22bn of aggregate borrow demand for those stocks, as prime brokers scrambled to make sure they had inventory of the stocks should their hedge fund clients wish to short them. Now that naked short selling of all stocks has been banned, should we expect a proportional rise in the aggregate quantity of all equities on loan?

Naked Capitalism point out that the cash reserves the broker-dealers receive when they loan out stock – and unavailable to them if there is no short-selling – are unlikely to be replaced by short-term funding.

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