Investing – The Attack of Short Sellers

November 30, 2008 njaiyo 0 Comments

Friday, November 28, 2008

Odd. This month, the market seemed… well, calmer. Things weren’t as crazy as last month, but we still had pretty big stuff going on. Perhaps we’re used to crazy.

This month, Paulson reversed his position on the TARP (the Troubled Asset Relief Program, aka the rescue plan), saying that the government wasn’t going to buy troubled assets from banks. That sent the Dow Jones skidding to 7552.29, the lowest close in six years. Things got so bad that the government had to step in and save Citibank with a $20 billion bailout. And the day after that, Paulson announced a new $800 billion rescue package.

So what does all this mean? We’ll get to that, but if you’ve been reading this column, you know that I’m a big believer in first understanding how we got here. Usually, that can tell us a lot about where we are going. So next, a detour into the events of the last few months.

Stocks CAN Go To Zero

After the fall of Bear Stearns and Lehman Brothers, the market learned something very important: that stocks, and especially financial stocks, can go to zero. Equity holders can be wiped out. That may seem obvious as a statement, but if you look at the last year, it’s been a back-and-forth between buyers and sellers. Stocks go down and buyers step in; or the government does something to support the market (like cutting interest rates); or a big buyer (like a sovereign wealth fund) steps in, buys, and instills confidence in the market, causing a rally.

When more bad news hits, the cycle repeats. The market sells off, and someone steps in and creates the bottom (or a temporary bottom). That was true until Bear collapsed in March 2008. The week before, Bear traded as high as $50-60. The evening of Sunday, March 16, the government announced that Bear would be sold for $2. Were people surprised? Yes, to say the least.

So the market learned that equity could be wiped out. Many thought that this was a one-off, rare occurrence. That is, until Fannie, Freddie and AIG in September 2008. Those cases showed again that while the bondholders might recover something, the equity would almost certainly be destroyed.

Lehman was the nail in the coffin for the bulls, because Lehman’s bankruptcy demonstrated that there was a situation where no one would emerge unscathed. And Lehman demonstrated how disastrous systemic risk could be. Because not only would those with direct stakes in Lehman get hurt (the bond and equity holders), but anyone who had parked money at Lehman (for example, hedge funds that had accounts at Lehman); who had traded with or was a counterparty in a transaction with Lehman; and who had invested in securities backed by Lehman, would also take a hit. When Lehman went under, it wasn’t just Wall Street crying; it was governments, pension funds, municipalities and university endowments.

That set the stage for the rampant fear of late September and October. Now it was clear to the market that stocks could easily go to zero. And in fact, the government, traditionally the agent of last resort, would let it happen. If buyers were hesitant before, now they were running for the hills. There was no one left to create a floor in the market. Just the government. And as the TARP showed, Washington was still reluctant to pull the trigger on a rescue plan.

The Deadly Downward Spiral

So we know what the endgame can look like. Just before the collapse, the financial institution’s stock nosedives. The current crisis has shown that this could happen in a matter of weeks and even days. In the midst of the nosedive, we often wonder whether the steep drop-off in stock price is justified. “Will the bank go under? Or is it a buying opportunity?” we ask. And in each case over the last year – “ Bear, Lehman, Merrill, Morgan Stanley and Citibank – “ the banks themselves insisted (and perhaps believed) that they could whether the storm.

With the investment banks, their high leverage and lack of deposit base (a source of funds) made their potential collapse believable. But with Citibank this last week, some were shaking their heads and wondering why. Many were saying that Citibank’s balance sheet wasn’t all that different from JP Morgan’s, and Morgan’s stock was not hitting the single digits. Others were saying, “The stock must be a bargain, it’s not as if all of the bank’s deposits and assets vanished overnight, right?” Citibank, which was as high as $55 or so last year, went from about $15 to less than $4 in a matter of weeks.

Why is this downward spiral so deadly? Recent months have shown that it’s not just a matter of having deposits or access to government funds (Citibank had both). Even with access to money, a nose-diving stock price creates its own reality. The drop in stock price can set off a chain of events that by themselves can destroy a financial institution:

A low stock price makes it very hard to raise any more money.
People become afraid to deal with the bank:

Depositors start pulling their money out
Counterparties stop trading with the bank, and
Lenders are afraid to extend credit.

The cost of doing business rises dramatically:

Credit default swaps (CDS’s), which are insurance on a bank’s securities in the case of default, become much more expensive
Lenders may increase their collateral requirements, and
Ratings agencies may downgrade the company’s debt.

This last one, the ratings agency downgrade, is the biggie. Once a downgrade occurs, the cost of financing jumps (keep in mind that banks are borrowing on a regular basis to fund their normal operations).

In addition, regulators require banks to maintain certain capital ratios. The sum of these pressures can drain cash from a bank, making it very difficult to maintain the capital ratios required by regulators.

At this point, the bank is trapped and on the verge of failure. The bank can’t get additional cash from the market because its stock price is so low. It can’t get cash from lenders because the lenders are afraid that the bank will go under, and any financing they could get would be at very expensive interest rates. And finally, the government won’t let the bank operate unless it can maintain its capital ratios. Unless someone steps in and bails out the bank, or buys it, it’s end of story for the bank.

The Spark That Sets off the Fire

So we know what the end looks like, and we know what the stock slide before the collapse looks like. Now the question is, what sets off the downward spiral? Did the whole market suddenly decide the stock was too risky? Was there an event that set it off? Or did someone yell fire?

Here’s my take on what happens. It starts with general concerns about a sector or a sector problem. For example, the general belief that banks are in trouble, that all the bad news is not out yet. Then events occur that highlight the existing weakness. This month, it was Paulson’s announcement that the TARP would not be used to buy troubled assets from banks. The market then re-examines its assumptions about the sector, and zeroes in a company that might be particularly vulnerable.

This month’s choice was Citi. Already weak from the failure to acquire Wachovia, Citi’s huge balance sheet now became the focus of worry. The bigger the balance sheet critics reasoned, the more junk that would be on it, the bigger the writedowns to come. And the market knew that further writedowns in auto loans, credit cards and commercial real estate were coming. So Paulson’s change in strategy amplified existing market concerns. Add that Citi’s CEO, Vikram Pandit, is new in his job and doesn’t really have the respect of Wall Street or the media.

So now we have all the right ingredients for a stock to go over a cliff. Confidence in Citibank was weak (or weaker than for other banks, such as JP Morgan, Wells or Bank of America), and it wouldn’t take much to push it over. So what started the spiral?

The Technical Indicators.

Traders follow a number of indicators when trading a stock. One of those is short volume, a measure of how strong bearish sentiment is. Basically, if the volume of shorts is high, a lot of people think the stock is going down. Put options are an equivalent indicator. If the market is buying a lot of put options (which yield profit if a stock goes down), then traders feel that the market is losing confidence in the underlying stock.

Another indicator is credit default swaps, or CDS’s.

These are basically insurance policies on securities issued by a company, and they pay if the company defaults on that security. So when a bank is in trouble, or even perceived to be in trouble, the price of the credit default swap soars. When the market sees this happening, bearish sentiment spreads like wildfire.

Market Behavior.

Traders do try to keep their ear to the ground about what’s happening. Any negative behavior by clients, lenders or counterparties can ignite bearish sentiment. For example, if someone hears that a hedge fund has pulled assets from a bank, that’s a bad sign for the bank. For those of you not familiar with how hedge funds work, these funds keep money at a bank for trading purposes, much as you or I would keep money at Schwab or TD Ameritrade. If you’re worried about Schwab’s viability, you would pull your money out of Schwab (and I’m not saying that Schwab has a problem, it’s just an example).

Other indicators are when a bank cuts back lending, or when a counterparty is reluctant to do business with a target bank. Word of any of these events can send a stock downward quickly.

All the Explanations.

Now take these indicators and add any of several explanations for the bearish sentiment and the stock starts spiraling downward. Over the last few weeks, look at all the things being said about Citi:

Citi’s expected losses were so big that the last $25 billion injection by the government was a drop in the bucket.
Citi was desperately trying to buy a bank with deposits to shore up its capital base. The fact that no such transaction occurred only fueled the fire – “ essentially, the market said that Citi couldn’t find a bank big enough to stem the expected losses.
Citi was considering selling itself, or breaking itself up. Pandit then came out and said that it wasn’t going to sell Smith Barney, its brokerage unit. This only made matters worse, because then the market feared that Citi wouldn’t do anything at all to stop the bleeding.
A faction of the board wanted to oust Vikram Pandit, and there was movement to find a replacement.

All these things, in addition to ballooning short volume and huge CDS spreads, fueled a sense of panic and helped drive the stock down to $4 a share. And keep in mind that rumors are enough to create a violent reaction in this market.

Now if you stepped back, there were counter-arguments for each of the concerns cited above: Citi’s balance sheet wasn’t significantly worse than JP Morgan’s, argued many, and JP Morgan stock wasn’t skidding downhill like Citi’s; Citi’s search for an acquisition is ongoing, so the fact that it was trying to buy a bank doesn’t mean much; selling assets is normal in this environment; and yes, Vikram Pandit is new and isn’t the best communicator, but that doesn’t mean he’s doing a bad job, and besides, he was dealt a bad hand.

Of course, the market didn’t, and doesn’t, care. Traders sell first and then ask questions later.

The Margin Calls.

Once the stock starts sliding, this forces others to sell. And I don’t mean motivates, I mean forces. Anyone who is leveraged will get a margin call, and they will be forced to sell. Anyone who is down on his portfolio and is afraid of another September or October will sell. And remember that all bank stocks got hit, and that the market as a whole dived. So gripped by fear, investors called funds and hedge funds and demanded their money back. Those redemptions forced even more stock sales. Basically, it’s just a big snowball going downhill.

Was There Manipulation?

Truth is, we’ll probably never be able to prove it if there was. But think about how easy it would have been to manipulate the situation. If you wanted to go after a stock, and you had the resources to do it, all you had to do was

Buy a lot of credit default swaps and drive up the price (or buy at a higher price than required);
Buy a lot of put options and drive up the volume and price;
If you’re a hedge fund, pull the money that you hold at a bank, tell everyone and then short the stock; and/or
Spread a lot of rumors about why a bank might go under.

Any major trader could have done one, or any of a combination of these things to create selling pressure on a stock. Now, they’d have to risk losing some money, but if they are successful, they’ll actually make lots of money with their short-side bets. And don’t forget to consider all the variations on these themes. For example, you could buy a bunch of credit default swaps, and also short the stock. So when the stock goes down, you get a double whammy of profit – “ you make money because the price of the CDS goes up, and because the short bet succeeds.

Being a cynic, I think there was, and is manipulation. Still, the truth is, it’s incredibly hard to prove. In the CDS market, there is no public quote system and trading is done by phone and email between dealers. There’s very little information about who’s trading and at what prices, and the SEC only recently began requiring hedge funds to log their trades. And besides, if you asked a trader, they could say they bought the CDS’s, were short, or bought put options because they were concerned about the stock’s fundamentals. Really, you couldn’t say they were wrong. Truth be told, I think some manipulated the stock, and others were truly concerned and were trying to protect themselves from further declines in the stock. Sorting it all out wouldn’t be easy.

The Fallible System That Won’t Change

If all this is true, then we live in a system that is subject to wild swings and to manipulation by a few powerful players. Will the system change? I think probably not. That’s because there’s no political will for it.

In order to change the system, I think that Washington would have to reform, regulate and open the CDS market so that quotes and trades are public. Hedge funds and short sellers would have to report their trades, and the profits from those trades. The uptick rule, which required a stock to go up before it could be shorted again, should be re-instated to slow down the downward spiral of stocks. And wouldn’t it be great if people could be held accountable for any rumors spread?

Many of these measures are doable (the last, holding people accountable for rumors, is pretty much impossible). Still, there doesn’t seem to be a lot of motivation for change. The current administration seems to be clutching the flag of laissez-faire capitalism. It’s rejected calls for regulating the CDS market, for regulating hedge funds and for restoring the uptick rule. Christopher Cox, head of the SEC, has said nothing, and despite all the fanfare of testimony in Washington, there’s really no momentum for change. The new administration claims to want change, but has offered very little in terms of detail.

There’s also a lot of resistance from a lot of powerful Wall Street players. You may remember that John Mack, head of Morgan Stanley, blamed the short sellers when his firm was under attack back in September. Last week, Vikram Pandit did the same. What we know now is that many hedge funds were so enraged by Mack’s accusation that they pulled their funds from Morgan in retaliation. Since then, Mack has said very little on the subject.

The SEC, prompted by all the craziness in September, did attempt a ban on short selling. Not surprisingly, there was outrage on Wall Street, and critics charged that the short selling ban didn’t really work. If you accept the discussion above, you can see why the short selling ban wasn’t enough: you can stop the short selling, but the CDS market can still ignite bearish sentiment in a stock. The short selling ban ended after a month, and now, no one is talking about it except the targets whose companies might collapse. It seems that the idea of restricting or slowing short selling has quietly faded into the night.

The Implications

All in all, there seems to be more talk about figuring out whom to blame than about what to change. If you’re an investor, all this has huge implications for how you handle your future investments.

As long as banks remain vulnerable to drastic downward spirals, we will have to accept that volatility will remain high and that we will be subject to continued crises and bailouts. With the Citi bailout, the government did learn one thing, and that was to not wipe out the equity. This reduces the fear that stocks will go to zero. So the fear is reduced but not eliminated.

Banks will remain vulnerable for a long time. The current $800 billion rescue plan includes $600 billion for purchasing debt from Fannie, Freddie and the Federal Home Loan Banks. The remaining $200 billion will finance investors buying securities tied to student loans, car loans, credit-card debt and small-business loans. Many fear that this will not be enough in the longer term to stem the tide. They could very well be right.

Also, we are still reeling from all the pain from the last couple months. Layoffs continue, stores are closing, capacity is being reduced. This may be one of the worst holiday seasons ever for retail. All this may very well spur another round of mortgage-related losses, as well as losses in securities related to student loans, car loans, credit cards and small businesses.

That means the market is likely to remain range-bound for some time (as discussed in last month’s article). We’ll have rallies, but bad news is likely to cause pullbacks. Trading wise, that means buy lows and sell the rallies within the range. Alternatively, if you are a long-term investor, you can buy and hold, but you really have to be willing to hold for the long-term.

The Next Shoe: Commercial Real Estate

We are now getting reports of problems in the commercial real estate market – “ malls and strip malls are closing, retail sales are anemic. Weakness in the market for office and industrial space should manifest as well.

It does make sense if you think about it. All these problems have forced the consumer to pull back in a big way. And companies like Mervyn’s, Linens “n Things, and Circuit City (all closed or in bankruptcy) are part of the result. Retail will take a major hit this year, and the real estate that houses the retail is not far away from showing its wounds. As shops close or suffer from the consumer pullback, retail real estate will have less money for paying down its debt. The banks, insurance companies and investors that hold commercial mortgage-backed securities will soon have to write-down the assets on their balance sheets.

The same is true for office and industrial space. When Citi lays off more than 50,000 people, or when the auto makers shut down capacity, or the makers of “stuff” (meaning tangible items) pull back, they shut offices and cancel leases. Office buildings collect less rent, some will default and the banks, insurance companies and investors who bought related securities will take a hit.

The Outlook

While the crisis is far from over, we do have cause for optimism. A couple weeks ago, I thought we were in a very dangerous place. We had a lame duck administration that wasn’t providing leadership, and it would be a couple months before a new administration could do anything. Last week showed that Bernanke and Paulson were still kicking, and that President-Elect Obama was laying the ground work for a new administration (and hopefully, new non-laissez-faire initiatives).

As for the fundamentals, they are tough, but they are improving, slowly. Despite the recent run on Citibank, we’re not on the precipice the way we were in September and October.

One other thing. I do think that we understand better what is happening in the markets, and that makes it easier to handle. A couple months ago, we could only watch, stunned and so surprised we hardly knew what to do. Now I think – “ and I hope – “ we understand better the problems, the pitfalls and the long path to recovery.

Until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.

All material presented herein is believed to be accurate but we cannot attest to its accuracy. The writings above represent the opinions of the author, and all readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed may change without prior notice. The author may or may not have investments in the stocks or sectors mentioned.