Short of Wisdom, Common Sense and a Grasp of Reality

The hedge fund industry is feeling gloomy, and so is Mayfair.

Meanwhile our government is considering following London’s lead and making their lives even more difficult, by banning short selling for a while. Yep, Fannie would have been just fine with mismatched liabilities, toxic assets and corrupt accounting mixed in with 40-1 leverage if nobody had been selling their stock, which is really all a short sale is.

This is crazy, and likely to lead to a much worse environment for both investing and the smooth functioning of capital markets, which are supposed to over time allocate capital. They are not supposed to lead to higher returns regardless of the worth of a company.

Wealth is not created out of thin air, it is supposed to be connected to the actual income stream a company can produce over time.

Market corrections are what keep wealth from being a product of a mere price we would like for assets, which is awfully disappointing to those who want wealth to be a casino where the house always loses, the drinks are free and the girls (or young men) always accommodating.

This is an attempt at a bailout that will not work, an attempt to create a world where stocks only go up. Unfortunately, capital cannot be allocated away from poor returning investments and toward higher returning options without prices going down on individual companies, and at times in aggregate. It has no more hope of success than forcing people to only sell at higher prices. Once that occurs, there is no reason to have a market in the first place.

Short sellers do not cause markets to go down over time, they just profit from it when a companies stock declines . They do however serve an essential function in capital markets. This function is so essential that the Capital Asset Pricing Model (CAPM) assumes an unlimited ability to short stocks. That isn’t realistic, which is one reason the CAPM and its academic cousins such as the Efficient Market Hypothesis don;t work real well in the real world. It does underline the importance of short selling in keeping our markets as efficient as human nature and an unknowable future allow.

Barry Ritholtz vents:

We Are A Nation of Morons, led by complete Idiots, making us complicit in our own self destruction.

How can we argue? I think his list of consequences is a good start on what is wrong with this move:

1) We suffer a loss of Market Integrity; The US is now a Banana Republic

2) Blatant market manipulation: this is nothing more than an attempt to force markets higher;

3) 60 days prior to a presidential election? This is a none-too-subtle attempt to influence the elections — especially coming on top of the Fannie/Freddie bailout;

4) The coming pop will create a huge air pocket, ultimately leading to us crashing much lower;

5) Expect a huge increase in volatility — upwards first, then down;

I am not so sure about number three, but it certainly wouldn’t surprise me. The other four are dead on, and the last two should serve as a warning to all of us who are in the market. The government will change the rules at its whim, and like most government interventions, we will end up suffering for it.

Here is some recommended reading on short selling and its long colorful history.

As for Cox’s other ideas, lets look at this one:

Thursday, I am asking the Commission to consider on an emergency basis a new disclosure rule that will require hedge funds and other large investors to disclose their short positions. Prepared by the staffs of the Division of Investment Management and the Division of Corporation Finance, the new rule will be designed to ensure transparency in short selling. Managers with more than $100 million invested in securities would be required to promptly begin public reporting of their daily short positions. The managers currently report their long positions to the SEC.”

Does anyone see the problem with this rule? Cox and others are complaining about short sellers talking about the companies they are shorting and driving the price down. So the answer is to publicly reveal who is shorting what? Who needs rumors then?

Frankly, shorting is tough work, and the shorts generally are damn careful who they are shorting. When they do speak up they have essentially been right every time. They complain that the institutions are cooking the books, after huge amounts of due dilligence that seems beyond everyone else, and what do you know, turns out they have been cooking the books, or hiding the true state of their finances, etc. We don’t even have to pay for this market intelligence. If only the SEC were as concerned with the companies financial disclosure, transparency and honesty as they were with those pointing it out.

Still, generally we don’t know who is shorting who, and it certainly won’t help if we do:

It’s never easy making a lot of money shorting stocks, at least not over the long term. But there’s one strategy which always works: look for the people who are complaining in public about short-sellers, and short those stocks with glee and abandon.

Cox’s proposed rule would probably drive many hedge funds offshore. But before it did that, it would essentially place big red “short me” flags on any vulnerable leveraged stock. And he thinks that’s going to make things better? Someone get us a new SEC chairman, quick. This guy is not being helpful.

Meanwhile, it isn’t just brain dead Republicans trying to prop up the market with going after the evil short sellers and other dubious manifestations of denial:

New York Attorney General Andrew Cuomo said he has started a “wide-ranging investigation” into short selling, or bearish bets, in the financial sector. The UK Financial Services Authority imposed a temporary ban on short-selling financial stocks Thursday. And The California Public Employees’ Retirement System, the nation’s largest pension fund, said that starting Thursday it is no longer lending out shares of Goldman Sachs Group and Morgan Stanley, joining a growing list of public funds that are trying to limit short-selling of those two stocks.

Chuck Schumer ups the ante. From Naked Capitalism:

Bloomberg reports that Senator Charles Schumer proposed creating a new agency to provide equity to distressed financial firms. The stock market, and financials in particular, applauded.

But in this skeletal form, this seems like a world class bad idea. The only successful example of dealing with a financial crisis is Sweden, which did not try to prop up troubled banks, but instead nationalized them, wiping out equity, brought in new top executives, and recapitalized them. The cost of failure was high to the incumbents and the solution was comprehensive, not piecemeal.

Read the whole thing.

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