An Interesting Take on Short Selling & CDSs

Just an interesting fact

• "The SEC is really flapping its gums here -- it's really not doing anything different," says Robert Ellis, senior vice president of wealth management at Celent. "They missed another opportunity to bring back the uptick rule. I guess lobbyists and hedge funds don't want them to bring it back." (I've said the same - hedge fund political contributions have shot through the roof - and in America those who pay, get to play)
  
• Nearly 30 billion shares were sold short in the market in late August, a sixfold increase over the last decade, according to ShortSqueeze.com. (wow - especially considering the S&P 500 is essentially at the same spot as it was a decade ago i.e. the market has not gotten "bigger")
• Ellis says that trend has effectively transferred wealth from retirement accounts, which are unable to short stocks, into hedge funds. He notes that brokerages can profit on both ends, because the collect fees on both the long and short positions, and don't necessarily have to tell clients that they are lending out the stock. (ah the great transfer of wealth - one of my favorite topics)
  
• Since the restrictions on short selling on 19 financial firms were lifted... four of the firms in question have essentially gone under. (another wow)
  

I wrote a piece about a year ago that at some point the unregulated pools of capital would get so big they would create havoc is some parts of the system. (can't find the entry now!) That was at oil in the $70s - so we can see the havoc being brought on (both to upside and downside) - again they don't have the "most" money but as the marginal customer with the most velocity of money, they move markets. They manage 1% of the world's assets (maybe 3% with leverage) but account for anywhere from 25-60% of all trading. This is why I focus on their footprint constantly.

John Mack, CEO of Morgan Stanley is getting peeved. Both he and the CEO of Goldman are now in close contact with Mr. Cox from the SEC (and lo and behold - the rules get changed now)

• Morgan Stanley Chief Executive John Mack lashed out at short sellers Wednesday after watching his firm's shares plunge as much as 42 percent and seeing prices for its debt-default insurance soar into distressed territory.
• A day after Morgan Stanley announced better-than-expected third-quarter earnings and delivered greater profit and revenue than its larger rival Goldman Sachs Group, investors pushed its stock to a 10-year low and traded some of its bonds as if the No. 2 investment bank were near default.
• In a memo, Mack told employees there was no "rational" reason for the movement in its stock or credit default swaps, which serve as insurance policies for debt. "What's happening out there? It's very clear to me -- we're in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down," Mack said in a memo obtained by Reuters.
• Mack also said he spoke with federal officials to enlist their help and spoke with clients and counterparties to assure them Morgan's financial health was sound. "We have talked to (U.S. Treasury) Secretary Paulson and the Treasury. We have talked to Chairman (Christopher) Cox and the Securities and Exchange Commission.
• Like Morgan, Goldman contends that a 14 percent drop in its share price and widening CDS spreads were driven by speculation. He also confirmed that Goldman CEO Lloyd Blankfein received a call from Cox. The two discussed the market moves and concerns about potentially improper short selling activity.

I honestly think the credit default swaps issue is the main thing here. People are taking illiquid instruments and treating them as gospel. I've come to that conclusion myself after realizing how much of this oil move from $70 to $150 was levered hedge funds able to "affect" a market in pack mentality.... but saw it on some CNBC articles yesterday.

• Are credit markets accurately reflecting conditions? That's the heart of an angry debate going on on the NYSE floor and on trading desks all over.
• Bears say the are accurately reflecting conditions, and in fact they have been accurately reflecting conditions all year. This is the main argument for bears: the most bearish positions--as reflected in the credit markets--have been the most correct positions this year.
• Bulls are just as adamant, saying the credit default swaps market are thinly traded and may be subject to manipulation
• Morgan Stanley is the battleground here: supporters insist that the conference call went well, that Morgan has strong capital and liquidity positions, have reduced bad asset exposures, and have prefunded their issuing needs for the next 6 months. Stay tuned!

And another where an analyst has come to the same conclusion I have

• UBS's Glenn Schorr is the first one I have seen to directly address the cause of the selloff, the increasing cost of credit default swaps to guarantee the company's debt: "we find it disconcerting that the illiquid CDS market (or the rating agencies) can have so much influence on the fate of these companies and alter the landscape of the brokerage industry."
• He notes both Morgan and Goldman have strong capital and liquidity positions, have reduced bad asset exposures, and have prefunded their issuing needs for the next 6 months

So it's sort of a smoke screen - people who traditionally use such measures of insurance to measure "danger" are being manipulated into thinking something is far worse than it is (on indiviudal stocks) - as hedgies can create the illusion of "danger" by buying these instruments in packs, driving up their price - which sends the signal to the markets that "something is wrong". So rational longs are using their normal thinking and selling these stocks due to the swaps.... which feeds right into the hands of the hedgies with the heavy short positions.

Again, due to the political contributions I don't know if this will ever be investigated but maybe if they take down the entire financial system someone will say "hey maybe we need to investigate it - lobbyist or not".

• (2007) American hedge funds have increased their political donations by more than two thirds in the past four years and the figure is set to rise considerably in the run-up to the 2008 presidential election.
• James Lacier, a senior Washington research analyst at Prudential Securities, said: “Hedge funds are becoming more active, in large part because there are regulatory issues hanging over their heads. “It was the same with tobacco and casino companies in the mid1990s when the Democrats started going after the tobacco industry and the debate on gambling on Indian reservations was in full force.”
• Matthew Bernstein, of the lobbying firm DLA Piper, estimated that hedge funds had quadrupled their lobbying expenditure — which is separate from political donations and has not been quantified — in the past three years. At the same time, key players in the hedge fund industry are taking important roles helping to raise money for candidates.

This is just my theory but I think it's quite reasonable - these companies business models are not degrading this fast. When you see it done to companies that just reported positive earnings, it really begins to stink of something amiss. When bad companies go bankrupt that is one thing, but forcing others into bankruptcies, or marriages they don't want, or causing them not to be able to raise money - those are distortions of the market. All so some guys can buy another yacht.

I wonder who lobbied to get rid of the uptick rule - something that was in place for eons? Was it that urgent to get rid of it? I've yet to see one explanation other than "it's an old fashioned rule". Huh? Again the loss of this item was not a "cause" of current issues - there are true fundamental causes for the drops we see - but it is like dead wood around a fire... easy tinder. It's all tied together - there are no coincidences. Granted the market has gotten so whacky it's even causing great harm to SOME hedge funds - but great wealth to others.