Saturday, September 20, 2008

Paulson's Fundamental Flaws

The purpose of my Epiphany post was not to whine about the taxpayer being stuck with the bill. It was to point out a fundamental flaw in Paulson's frantic and breathtaking plan which is now before Congress.

That flaw is the inflation of the price of bad assets, out of the reach of the rest of the market. Whatever free market mechanism was left in the system for clearing out these bad assets is now gone. Only the taxpayer will buy them at these prices. And don't believe the part about a "reverse auction seeking the lowest price". Since when has anyone shopping with someone else's money haggled down to the lowest possible price? Especially when the purchase must be done in a hurry.

Well, I think I have identified a second fundamental flaw with potentially catastrophic consequences.

It lies in the banning of short selling. The SEC and Hank Paulson have placed the bet that the short sellers were driving down the financials, and that it was not just the shareholders liquidating out of fear. If they are wrong about the public's confidence in shares of the 799 financial institutions then the result could be catastrophic. Here's why:

A short seller is selling a stock he borrowed, but doesn't actually own, at current prices only to buy it back at a lower price. He causes two buys in the market. First is the person that buys the borrowed stock he sold, and the second buy is him buying it back at a lower price and then returning the borrowed stock to it's owner. In essence, he is betting on the price of the stock dropping and when it does he makes money. On the other hand, a long seller is an owner of the stock who just wants out. He is selling a stock he actually owns. He only causes one buy in the market because once he sells he is out. And as he sells, the stock is caught at the lower price by the short seller. So the short seller actually acts as a backstop against the panic selling of shareholders.

If you remove the short seller from the equation, then there will be no backstop if the actual shareholders get spooked by the market and decide to exit their positions.

Most short sellers place their bets because they actually believe a stock will go down based on fundamentals. In fact, most short sellers don't have the billions of dollars it would take to affect the market in a downward trajectory, so they must place their bets carefully. Some short sellers are doing it as a hedge against a long position they may have in the same company, perhaps in Preferred Shares with a fixed dividend. By shorting the common stock they can hedge their risk in the price of the preferreds.

The point is that legal short sellers provide a legitimate function in our current market setup. And by removing them wholesale from the marketplace creates a situation where the prices of stocks could theoretically freefall all the way to zero. That is where we are today.

This warning was issued by the editors at iTulip.com:

"Politicians forget that a short seller is a buyer albeit at a lower price. Take him away and in a market panic there are no buyers at all. A market can in theory then fall to zero. You've been warned."

Also, there were many short sellers that were completely wiped out on Friday. They will not be coming back to the trading floors because they are now bankrupt. I think the appropriate analogy is that all insects play an important role in nature. And if you completely eradicate one of them you will be overrun by the consequences. If you kill all the spiders, you will be overrun by the insects they once ate for lunch.

I'm going to post the entire message from the editors at iTulip because I think it contains a couple important messages:
Editor's addendum: On the short selling rules imposed today, two notes.
One, we extend our sympathy to Mike Morgan who we tried to warn against shorting financial stocks. This regime – we think it is fair to, at this point in time, to stop calling it an administration – knows no limits in the business of market controls.
Two, politicians forget that a short seller is a buyer albeit at a lower price. Take him away and in a market panic there are no buyers at all. A market can in theory then fall to zero. You've been warned.

FOFOA

8 comments:

Dave said...

Very good points, especially the analogy about the insects. Of course, banning short selling is a specific case of more general market manipulation, which is endemic today. In effect, all this market manipulation constitutes a form of price control, and that's never a good thing.

FOFOA said...

Dave,

You are absolutely right that price controls are always bad. If prices are not set by the marketplace based on supply and demand, then problems always arise. Shortages happen if the price is held too low and markets freeze up if the prices are too high as can be seen today in the housing market.

But I think it is more of a price distortion than a price control. The Fed is a very clumsy machine with really only one move it can make: injecting more money into the system. It's like a radio controlled car with only one button to control the car. You press the button and it sort of zig zags in one direction. Your only control is on or off. Not very controllable.

Money injections do one thing, they distort prices. When officials inject money into the economy, this distorts prices and causes business people, who use prices as guides for decision making, to make mistakes. These mistakes are called malinvestment.

As I type, Congress is considering giving Hank Paulson the mother of all money injections. And given a week or so, Hank, on behalf of the American public, will make the mother of all malinvestments. He will buy mortgage backed securities and derivatives.

Anyone who thinks this will solve all of our problems is either an idiot or is named Ben or Hank. That distinction was probably not necessary. But don't think for a second that Congress or any of them think this will solve our problems. They are simply in panic mode and they are going to do what they do best, spend money they don't actually have. They know that if they do nothing someone will blame them. So they have to do something. That's how deeply they look at it.

You think they are holding hearings with differing points of view this weekend? Not. I think Chris Dodd said it best when he said he wants a systemic (read: expensive) solution, not an ad hoc (read: cautious) solution. He said he's tired of getting phone calls in the middle of the night. And also they have to go on recess. (Don't want to miss the ol' tether ball game).

This is probably the biggest, most dangerous move, ever made with the least amount of thought given to the consequences, in the history of fiat money. This week will truly go down in history. And if the markets rally all week I will be extremely surprised. They can't ALL be that dumb.

Dave said...

One reason I call manipulation a form of price control is that it's producing the very consequences that arise when price controls are invoked: frozen markets, shortages, price disconnects, black markets. Frozen markets can be seen in lending and housing; shortages, price disconnects and emerging "black markets" (ex-COMEX, eBay) can be seen in precious metals.

And I totally agree with you about the insanely reckless manufacture of money to deal with these crises. It solves nothing and does so at an enormous, though hidden, cost known as inflation.

The real solution is for insolvent companies to declare bankruptcy and for overvalued assets to be marked to market (even if it entails a 95% loss), losses declared, and move on.

It won't be pretty or painless to have to acknowledge all that malinvestment that's been growing for decades, but at least those most culpable will bear most of the burden (as it should be) and we will emerge with a clean(er) slate.

As it is, we're simply transferring the losses from one place (the private sector) to another (the government). And worse, because the government pays interest on that money and will ultimately inflate the money supply to deal with these crises, our burden will continue to grow instead of being purged.

Dave

Martijn said...

I don't buy this reasoning.

A short seller sells a stock, expecting the price to go down. When it drops sufficiently, he will buy it back.

However, if it is dropping fast and no sight of a bottom is there, why buy it? Why buy a stock that will decline more (and as it declines improves your profits)?

Perhaps short selling does moderate markets a bit, but it limits both upward (by selling and hence creating additional stock) as downward (by buying and decreasing the stock supply), but I don't believe it is such an important backstop to panics. It might limit them a bit, but not that much, and besides it will also trigger them by curbing upward stock movements.

FOFOA said...

Why does a short seller "cover" when it turns out he was wrong and the price rises? Doesn't this limit his profits too? Actually, it kills them. But still, he must cover because he must deliver. This is the same in a downward move. He must deliver what he has sold short. So he must buy ON THE WAY DOWN. Time is a function in here. The time in which he is legally allowed not to deliver. But his buying slows the descent.

On upward moves, short sellers accelerate the trend because they are covering.

In a stagnant market, the short seller exerts downward pressure by BORROWING a stock to sell that the rightful owner did not want to sell at the stagnant prices.

But once the market becomes dynamic, the reverse is true. The short sellers exert UPWARD pressure because that is when they either lock in their profits or cut their losses. Both actions require buing - upward pressure.

Your theory is that the market goes into freefall and the shorts just sit back and watch. In reality, they don't respond this way. Most shorts set a price objective and take their profits. Some even hedge their bets ahead of time. But I do see your point!

For the record, I have never been an options trader so I may be wrong.

Martijn said...

Short sellers do indeed influence the market.

If they believe it too high, they initiate downward movement by shorting. And yes, they usually set goals, and apply the breaks once the train arrives at their set destination.
Also, if it turns out to be heading in the wrong direction they do indeed jump off, thereby accelerating it.
Shorting allows market participants to make or loose money by steering the market in both directions. So, indeed shorters can be a backstop in both directions.
So the short seller actually acts as a backstop against the panic selling of shareholders.
Yes, but it can also be the initiator. It is very difficult to say what the influence of a shorter is, that was my point.

"Politicians forget that a short seller is a buyer albeit at a lower price. Take him away and in a market panic there are no buyers at all. A market can in theory then fall to zero. You've been warned."
Way overdone. The short seller is not here to save us. Besides, if the market is really to go to zero, at the time shortseller A is covering, seller B will start shorting.

The SEC and Hank Paulson have placed the bet that the short sellers were driving down the financials, and that it was not just the shareholders liquidating out of fear.
Paulson's claim was indeed doubtful.

Generally I do agree that short selling can both moderate or amplify markets in both directions. It can also be abused to drive markets down (as seen in gold). The claim that short sellers will be our saviour is a bit over the top.

As far as naked short selling is concerned: we have seen that to be abused to rig the system, although that's a different discussion.

Btw: wonder what the shortselling ban ment to Goldman's program trading.

FOFOA said...

Martijn,

Armstrong seems to agree with me. This is from his latest.

FOFOA

Anonymous said...

Naked short sellers are the real problem. They never borrow an owned share. They create shares the same way the FED creates dollars. The real struggle is that they are not policed and they can crush companies with the aid of the brokerages.

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