Printer Friendly

eMail Article

July 22, 2008

A Short Covering Rally
by John Mauldin

How do you spell short-selling rally, gentle reader? In this week's Outside the Box we look at several short items (pardon the pun) from various sources, which paint a not pretty picture. The first hit my inbox this morning from Art Cashin (of CNBC fame and also Head Floor Trader for UBS).

"Deconstructing The Rally - The sharp rally that sprang from the new short sale restrictions has been spiky and, in several ways, very powerful. The impact of the short rule change was evident. As Barron's notes, the 150 stocks with the heaviest short interest rallied a stunning 15%. The stocks with the smallest short positions rose only 2%. That may be a function of existing shorts scrambling to cover to pass the new, belated, scrutiny. That thesis got added weight from a couple of areas. The Merrill Lynch results got mostly panned by several analysts and TV pundits. Nonetheless, the stock closed 24% above its lows for the week. Also, the financial sector ETF rose nearly 25% from the lows.

"All of the above suggests that the rally is based on the two pronged government move. First, put a safety net under the financials, especially Fannie and Freddie. Second, restrict opportunities to sell the financials short. We'll wait to see if those efforts have further legs this week."

Then let's look at this column written today about, among other things, past attempts at messing with the short rules. In short, it just doesn't work for very long. This is a Taking Stock column by Spencer Jakab for the Dow Jones Newswire.

The Mother Of All Short Squeezes May End Badly
By Spencer Jakab

In the words of the notorious 19th century speculator Daniel Drew: "He who sells what isn't his'n must buy it back or go to pris'n."

The rules governing short selling -- borrowing shares to bet on price declines -- are vastly more stringent than they were in the era of robber barons like Drew, Jay Gould and Jim Fisk, but one thing hasn't changed much: When markets decline, those who profit are seen as un-American, even evil, and the weight of the authorities is brought down against them with devastating, but usually temporary, results.

That pattern may be playing out now after Securities and Exchange Commission Chairman Christopher Cox shocked the market by announcing at a Banking Committee hearing Tuesday vague new emergency restrictions against "naked short selling" to begin four trading days later. Though almost none of the 19 financial firms targeted were on Reg SHO lists in place since 2005 that highlight firms with failures to deliver borrowed shares, his comments had explosive results after many of them had hit multiyear lows.

Fannie Mae (FNM) and Freddie Mac (FRE), which also received additional credit lines, each rallied by over 96% from Tuesday's intraday low through Friday's close while major firms with no government safety net like Bank of America Corp. (BAC) and Lehman Brothers Holdings Inc. (LEH) surged 49% and 59%, respectively, with some troubled regional lenders like Huntington Bancshares Inc. (HBAN) doing even better.

What does it all mean? Asked just hours after Cox's testimony, one dedicated short hedge fund manager had a sarcastic reply: "This means the financial crisis is over," he said, going on to clarify that nothing at all had changed fundamentally in his opinion. Of course many shorts like him suffered stinging losses and reduced capital, but the other side of the coin is that there are now far more shares to borrow at much higher prices than a few days ago. Financial stocks may well retrace at least part of their recent gains as the shock of Cox's step wears off.

Past Examples Not Encouraging

The fact that the initial results were spectacular, particularly for financial stocks, shouldn't be too encouraging. Consider what happened in April 1932, at the depth of the worst-ever bear market. Upon the announcement of a cumbersome new rule that required written permission from each shareholder before a broker lent out his stock, the Dow Jones Industrials rallied 3.51%. By the time the rules were instituted weeks later, the short covering was over and the slump had resumed.

More recently, attempts by authorities in the U.K. to force disclosure of short positions in financial firms undergoing capital raising have had mixed results as mortgage lenders Bradford & Bingley PLC (BB.LN) and HBOS PLC (HBOS.LN) traded near the prices of deeply discounted rights offerings. Nudgem Richyal, a fund manager at JO Hambro in London, said some secretive hedge funds pulled back in order not to leave themselves open to a short squeeze or bad publicity.

"The last thing you want is your name splashed all over the FT," he said.

An extreme example comes from Pakistan where the local SEC responded to a stock slump last month by banning short selling and limiting daily price declines to 1% while allowing them to rise by 10%. The initial reaction was a massive 8.6% one day rally followed by 15 straight days of slumping prices amid extremely low turnover, the worst such period for that market in several years. As rioting investors stormed the Karachi Stock Exchange last week, the rules were rescinded.

Shorts Help In Price Discovery

Aside from such extreme examples, a lack of price discovery because shorting is banned can sometimes hurt the most vulnerable investors. For example, when Palm Inc. (PALM) had its initial public offering in early March 2000, the initial pricing range was $14-$16 a share, reflecting bubble era valuation sensibilities, but the deal was so hot that it was issued at $38 and traded as high as $165 the first day as retail investors bought and those well-connected enough to get IPO stock sold. Since most of the equity was still owned by 3Com Corp. (COMS), the subsidiary was worth $54 billion and the parent at $28 billion. As a result, 3Com's other businesses were briefly worth negative $60.78 a share according to Spinoff Advisors LLC, making a short sale or put buying of Palm a no-brainer but prohibitively expensive with such a small float.

Needless to say, many saw only the price and were sucked in at or near the top, losing over 99% on a split-adjusted basis if they still held it today. There is no record of the SEC warning these retail investors of their folly. Intervention is popular only in bear markets.

And what about the view that short sellers target and destroy otherwise healthy companies? Ignoring the possibility that banks could be hurt by illegal false rumors, it is hard to understand how the operations of most businesses can be affected by the simple act of selling their stock while legitimately borrowing it. Legendary hedge fund manager Michael Steinhardt weighed in on this subject last week.

"If one looks back and finds those stocks that have been picked upon by shorts, that have been the subject of all this sort of talk, and find out what ultimately occurs to the price of those shares, overwhelmingly, one will find that the shorts were right," he said in comments to CNBC.

Is it possible though that Cox's actions, however unnecessary, marked the ultimate bottom for banks? They do seem cheap by historical measures, but the widespread euphoria last week looks more like a bear market rally than classic capitulation.

Investment strategist Barry Ritholtz wrote in his blog that one reason to doubt that the bottom is in for bank stocks is that The New York Times, The Wall Street Journal and Barron's (the latter two sharing an owner with this newswire) all produced prominent articles on Saturday suggesting the worst was over for financial stocks.

"Can you recall the last time three major media players all picked the bottom in a market or sector on the exact same day -- and were all proven correct?" he asked.

And now let's look at a few paragraphs from Bill King's daily epistle which is really The WSJ: SEC Short-Sale Rule Gets Negative Reviews In a letter to Mr. Cox, the American Bankers Association, a trade group that represents the interests of 8,500 banks, said it fears short sellers will now focus on banks not covered by the new rules, many of which are already big targets of short sellers... [Sorry guys, you're not covered under the Crony Capitalism Act!]

On Friday, the SEC said market makers wouldn't have to pre-borrow the stock, but they would still need to deliver it within three days. [This is the heart of last week's rally. 'Fails to deliver' have been endemic for years.] http://online.wsj.com/

And this rather pointed editorial from the Economist (also courtesy of Bill King):

The Economist: Bear markets often involve bare-knuckle fights, but it is still a shock when the referee starts punching below the belt. The Securities and Exchange Commission (SEC) has intervened in the epic struggle between financial companies and the hedge funds that are short-selling their shares...The SEC's moves deserve scrutiny. Investment banks must have a dizzying influence over the regulator to win special protection from short-selling, particularly as they act as prime brokers for almost all short-sellers...

The SEC's initiatives are asymmetric. It has not investigated whether bullish investors and executives talked bank share prices up in the good times. Application is also inconsistent. The S&P500 companies with the biggest rises in short positions relative to their free floats in recent weeks include Sears, a retailer, and General Motors, a carmaker. Like the Treasury and the Federal Reserve, the SEC is improvising in order to try to protect banks. But when the dust settles, the incoherence of taking a wild swing may become clear for all to see. http://www.economist.com/finance/displaystory.cfm?story_id=11751227

John Mauldin thought: Deciding to actually enforce a rule already on the book is not going to make the profit picture at banks and other companies any better. They are still going to be shorted as soon as the dust clears. This just gives them (mostly banks) more room to fall. As noted two weeks ago, there may be as much as $1 trillion still to be written off by banks, brokers, insurance companies, pension funds and sovereign wealth funds. This is going to be ugly for at least a year. Those hoping for a bottom should look for it when the quarterly bleeding stops. Bill Gross said today that for Fannie and Freddie to raise capital it will need the help of the government. My side bet is that this will not be good for equity holders of Fannie and Freddie.

And finally, let's look at one last piece from Cumberland Advisors about the debacle at IndyMac. This may cost the FDIC as much as $8 billion. How many other problems are lurking like this? Remember, Indy Mac was not even on the watch list for their regulator a few months ago.David Kotok and his team at Cumberland Advisors are a great source of this type of detailed analysis. This piece was written by Bob Eisenbeis, who is Cumberland's Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at www.cumber.com.

IndyMac: Who is to Blame for What?

Last Monday witnessed the reopening of IndyMac under the management and receivership authority of the Federal Deposit Insurance Corporation (FDIC). Photos of lines formed by anxious depositors appeared in numerous news accounts and triggered widespread concern about the safety of depositor funds.

IndyMac's regulator, the Office of Thrift Supervision (OTS), closed the institution on Friday, July 11 and turned it over, as the law requires, to the FDIC to act as receiver and insurer of deposits. The FDIC's preliminary estimates are that the failure will cost it somewhere between $4 and $8 billion. This is despite the requirements in the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) that regulators intervene and attempt to minimize losses to the insurance fund. In fact, the theory behind FDICIA intends that an intuition should be closed before its net worth goes to zero, so that creditors can be repaid without loss to the FDIC or taxpayers.

The statement that the OTS released announcing the failure indicated that it had been concerned about IndyMac's "precarious financial condition" as early as November of 2007. The institution had modified its business plan and sought to raise additional capital. Furthermore, additional steps had been taken following OTS examination of the institution in January of 2008, to return it to financial health.

The press release intimates that these plans and efforts were frustrated by the leaking of a letter from Senator Schumer to the OTS, questioning IndyMac's financial viability, which triggered a deposit run and caused the demise of the institution. Clearly, Senator Schumer's actions seem reckless. Had his remarks been uttered by a private citizen and not protected by the legal immunity accorded to our federal legislators, that person might have been subject to prosecution, if the claims proved to be false. That said, it seems the OTS's responses were equally reprehensible and self-serving.

As in most highly charged events, the facts have mostly gotten left behind, so it would pay to restate them and to delve into why the losses are likely to be so large.

IndyMac was a hybrid savings institution spun off from the now defunct Countrywide, that specialized in the origination, servicing, and securitization of Alt-A (low-documentation) mortgage loans. It grew very rapidly, doubling in size between March 2005 and December 2007 from $16.8 billion to $32.5 billion. Its funding in rough order of importance consisted primarily of Federal Home Loan Bank (FHLB) advances and insured and uninsured deposits. The advances were a particularly important source of funding, accounting for between 32% to 45% of its total liabilities.

IndyMac's reported capital declined over the period from its peak of $2.7 billion in June of 2007 to $1.8 billion at the end of March 2008. Uninsured deposits began to run off in mid-2007, long before Senator Schumer's letter. In fact, the bank actively replaced slight declines in FHLB advances and a drop in uninsured deposits with insured deposits, and particularly with fully insured brokered deposits under $100K. At about the same time, the bank's stock price began to plummet, dropping from a high of about $35 per share in June to about $3 just prior to the Schumer letter. Additionally, earnings also turned negative in the fall of 2007. These factors all pointed to a very troubled institution whose situation was continuing to worsen.

Despite the OTS examination in January and subsequent actions by the institution to change its strategy, its capital position continued to decline and earnings deteriorated. In the face of this, OTS director John M. Reich maintained that IndyMac was adequately capitalized and the institution touted that fact in its SEC filing. In fact, in the bank's March 31, 2008 10Q it stated that tangible and Tier 1 core capital stood at 5.74%, well above the regulatory requirements for the bank to be classified as well-capitalized. Risk-Based Tier 1 capital was 9% and Total Risk-Based capital was at 10.26%. Given that it was supposedly adequately capitalized and was done in by a liquidity problem as some $1.3 billion of deposits ran off, it stretches credibility that the bank's failure would lead the FDIC to estimate that it could stand to lose between $4 and $8 billion.

How could losses of this magnitude accumulate in just a matter of a few days due to a supposed run of $1.3 billion? The answer, of course, is that they didn't.

The bank was likely to have been deeply economically insolvent, which was masked by faulty accounting according to current rules and regulatory standards. Clearly, the bank's active bidding for brokered deposits and reliance upon funding from the FHLB amounted to a big gamble - financed by other government entities - that it might weather the storm. Keep in mind that IndyMac had, at closing, about $10.1 billion in FHLB advances and perhaps even Federal Reserve discount window borrowings as well. Any such borrowings would be over-collateralized with high-quality assets - in this case the collateral was largely mortgage-backed securities. Such claims stand ahead of insured deposits or the FDIC in the liquidation. This means that much of the best collateral that could have been used to backstop the FDIC or shared to reduce losses to uninsured claimants was instead siphoned off by other agencies. Indeed, the FDIC initial estimates are that uninsured depositors may receive fifty cents on the dollar of uninsured deposits.

What emerges from even a partially informed and quick analysis of the available evidence and data is the suggestion that (a) the institution was in deep trouble long before it was closed; (b) the OTS appeared to be late to the party, despite market signals; (c) OTS actions were ineffective when measured against the intent of FDICIA; and (d) the institution engaged in moral hazard behavior by pumping up its brokered deposits that were 100% insured and borrowing from the FHLB, and possibly the Federal Reserve. The bottom line is that the FDIC is left to clean up the mess and the costs associated with regulatory ineptitude, and the moral hazard behavior will be paid for collectively by the banking system through higher FDIC premiums on the surviving banks.

All the King's Horses and All the King's Men. It all just makes you shake your head and sigh.

Your wondering what they will do next analyst,

John Mauldin
Frontlinethoughts.com

Note: John Mauldin is president of Millennium Wave Advisors, LLC, (MWA) a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273. MWA is also a Commodity Pool Operator (CPO) and a Commodity Trading Advisor (CTA) registered with the CFTC, as well as an Introducing Broker (IB). John Mauldin is a registered representative of Millennium Wave Securities, LLC, (MWS) an NASD registered broker-dealer. Millennium Wave Investments is a dba of MWA LLC and MWS LLC. Funds recommended by Mauldin may pay a portion of their fees to Altegris Investments who will share 1/3 of those fees with MWS and thus to Mauldin. For more information please see "How does it work" at www.accreditedinvestor.ws. This website and any views expressed herein are provided for information purposes only and should not be construed in any way as an offer, an endorsement or inducement to invest with any CTA, fund or program mentioned. Before seeking any advisors services or making an investment in a fund, investors must read and examine thoroughly the respective disclosure document or offering memorandum. Please read the information under the tab "Hedge Funds: Risks" for further risks associated with hedge funds.

If you would like to reproduce any of John Mauldin's E-Letters you must include the source of your quote and an email address (John@FrontlineThoughts.com) Please write to info@FrontlineThoughts.com and inform us of any reproductions. Please include where and when the copy will be reproduced.

John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions.

Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staffs at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above.

PAST RESULTS ARE NOT INDICATIVE OF FUTURE RESULTS. THERE IS RISK OF LOSS AS WELL AS THE OPPORTUNITY FOR GAIN WHEN INVESTING IN MANAGED FUNDS. WHEN CONSIDERING ALTERNATIVE INVESTMENTS, INCLUDING HEDGE FUNDS, YOU SHOULD CONSIDER VARIOUS RISKS INCLUDING THE FACT THAT SOME PRODUCTS: OFTEN ENGAGE IN LEVERAGING AND OTHER SPECULATIVE INVESTMENT PRACTICES THAT MAY INCREASE THE RISK OF INVESTMENT LOSS, CAN BE ILLIQUID, ARE NOT REQUIRED TO PROVIDE PERIODIC PRICING OR VALUATION INFORMATION TO INVESTORS, MAY INVOLVE COMPLEX TAX STRUCTURES AND DELAYS IN DISTRIBUTING IMPORTANT TAX INFORMATION, ARE NOT SUBJECT TO THE SAME REGULATORY REQUIREMENTS AS MUTUAL FUNDS, OFTEN CHARGE HIGH FEES, AND IN MANY CASES THE UNDERLYING INVESTMENTS ARE NOT TRANSPARENT AND ARE KNOWN ONLY TO THE INVESTMENT MANAGER.

Copyright © 2003-2009 John Mauldin. All Rights Reserved

Image rendition and html coding Copyright © 2000-2009 SafeHaven.com

« Opinions expressed at SafeHaven are those of the individual authors and do not necessarily represent the opinion of SafeHaven or its management. Articles are available via RSS/XML. Please visit RSSHelp for instructions. »