Today, the UK experienced a small quake that the BBC reports merely rattled the crockery on kitchen sideboards, nothing compared to the quakes and after-shocks rattling stock market investors. I feel flabbergasted at the insouciance (blithe unconcern or faith in honest doubt) with which exchanges and regulators view the short-selling tremors in stock markets without serious challenge that politicians are stridently (anxiously and angrily) calling for? We have had not very effective bans on 'naked short-selling' but it now seems that SEC and FSA believe it is enough to insist on short-sellers reporting only when their short positions exceed 3% of a stock? This is fantastical. From the data just this year we can see that all the thousands of short-sellers added together borrow in total less than 10%, usually less than 5%, of a stock. And we can see this is easily sufficient to pull down the share price for narrow speculative reasons i.e. greed (unless you ideologically believe short-selling is merely derivative style self-protection and healthy competition transferring money from failing firms to superior more successful ones; our dog eat dog banks shorting of each other in a Darwinian race to see who falls furthest - a giant game of chicken?)
Are we expected to believe three quarters to one third of the shares loaned out could all have been borrowed by only one short-seller with 3% or more of the target's stock? The answer is no and therefore the FSA's short-selling reporting proposal will result in zero reporting of short positions. And since this should be obvious to any professionals, it makes a complete farce of the welcome given to this 3% idea by financial industry bodies representing institutional investors!
The media is also happily reporting that hedge funds (who are not the only short-sellers, but undoubtedly the dominant players) had a 9.9% loss in the year to end September, and are now experiencing 10% withdrawals, plus Nouriel Roubini's claim (widely reported) that 500 hedge funds will fold in the next few weeks. I take the view that these news items will serve Hedge Funds very nicely by helping in efforts to dissuade regulators from restoring or extending short-selling bans or making new laws to gain more transparency and make hedge funds subject to stricter regulation on a par with the regulation of mutual funds or even that of banks. The reported average losses of hedge funds is a good performance. It is only the aggregate; many funds have made strong gains. That 500 funds (out of over 40,000 hedge funds) will close is an easy prediction and probably a conservative one. More than 1,000 hedge funds closed in 2004/5, though 1,500 new ones opened at the same time; birth rate may be more interesting therefore than death rate of hedge funds. That investors in hedge funds are withdrawing 10% of funds (an estimate by Credit Suisse/Tremont) is also an easy call, neither surprising nor unprecedented (in fact the least one can expect in a currently cash-strapped world). The sum involved is $170-300bn. Reuters continue to refer to “the $1.7 trillion hedge fund industry.” That may be the US share. Others believe the global figure is $3 trillions. Institutional Investor News estimated total industry assets at $2.68tn by Q3 2007. The fact is that we do not know. We need to know. Many investors will withdraw to shift out of some hedge funds now (it takes time) only to invest in other hedge funds later or build their own hedge funds for the rich fees (1-2% management fee plus up to 20% of gains). There is no official public guidance to choke off stock lending on which much short-selling depends! Of course, supposedly, it is up to the good sense of stock-holders to be sensible and not lend stock they know will only get dumped to drag down market prices. But owners of shares do not always know when their shares have been lent. Some stock owners may themselves be derivative-shorting the market anyway via puts, and are happy to earn a small additional 200-500bp margin by renting shares they have already hedged. Many holders of stock cannot sell if they manage index-tracking funds (traditionally over half of mutual, insurance and pension funds' equity holdings). Furthermore, stock exchanges like the LSE are doing their best to attract short-sellers (CFD – contracts for difference) simply because these drive a large % of transaction volumes and transaction volumes are factored into stock exchanges' own share price valuations. Exchanges are happiest to have stocks churned and seem indifferent to price quality issues. Exchanges appear blithely indifferent to the growing imbalance between extreme speculators and long term investors.
Some long term investors like Berkshire Hathaway's Warren Buffet are happy about short-selling for now. He is now shifting massively into US equities and will buy somewhere around the floor of current prices (Dow at 7,500, FTSE at 3,000?). Warren Buffet 's personal investment account until recently comprised only US government bonds. According to this weekend's FT, his 'net worth' will soon be 100% invested in US equities! Motto: “Be fearful when others are greedy and greedy when others are fearful.” Buffet is little-invested outside the US and actually he will be investing in US equities just as globally everyone is piling into a rising US $, and where better than US equities just as they may be about to bounce off both a short term and a long term bottom? In this respect he is anticipating where greed risk-takers are going next. Motto: “follow the high net worth money.”
The FSA (FSA) said on Wednesday it does not see the need for new regulation of hedge funds because they are performing relatively better than others. The latter point is true but does not directly relate to whether or not hedge funds should be subject to new laws, an issue that concerns the so-called 'shadow-banking' sector. Hector sants, FSA CEO said at Hedge 2008 "I ... recognise there is pressure for more regulation in a rather general way... I don't particularly think more regulation is needed, but I do think more effective regulation is needed... Hedge fund managers in general are weathering the market turmoil pretty well in the circumstances, certainly versus other components of the financial services industry", adding that he expects more funds to fail.
Recently it has been claimed that a third of hedge funds are in money market funds and another third is committed to short-selling. The final third may be pledged as collateral or in various vulture fund plays. A big percentage must be in macro-strategies. Who knows? The leverage (excluding derivative market leverage) of hedge funds could be anywhere in the $10-20 trillion range, which could therefore represent anywhere from 8% to 16% of world financial assets ($118tn at end 2006) or more likely 10-30% of world financial assets today. We don't know. But this rough estimate alone suggests that 'shadow banking' is enormous. When we consider leverage via derivatives the scale becomes hard to compute. The FSA, following the SEC's similar stance, said on Thursday it plans to make (short-selling) investors disclose holdings of more than 3% in companies through CFDs (contracts for difference). This would seems absurd even if the reporting must cover positions held to that threshold or above at any moment in time however brief, except when we appreciate the scale on which hedge funds can operate. The rationale is unclear, however, since prices can be moved very effectively by the frequency of the net direction of buy/sell signals more than by the volumes involved. Price movements do not correlate with volume. That is stock market 1.01 (US expression).
The FSA said a final draft of long overdue rules on CFDs (said to be one third of trading in UK equities) - under which one party agrees to pay another the difference between the current and future price of a share - will be published in February 2009 and come into force by September 1 2009. Do we hear stable doors closing? This delay reflects the fact that the FSA does not regulate by simple fiat, or very rarely and reluctantly. It is really still part of a self-regulation culture like a membership club that relies on consulting with the industry first, seeking the agreement of the members who, after all, pay the FSA's fees, like membership subscriptions even if they have no choice and no power to determine those fees. Lord Turner has said that the FSA will from now on stop regulating on the cheap. But, until and unless government pays for its own agency, it would seem unlikely that the membership club regulatory culture will change. "Our goal is to provide an effective and proportionate disclosure regime that works for all involved, and sustains market confidence and efficiency," said FSA Director of Markets Alexander Justham. Clearing services publish stock lending and we can see the effect on bank shares.
Reuters explains that “CFD holders, who effectively have the benefits and risks of a stock without owning it, are currently not obliged to make their positions public, allowing some hedge funds to use them to anonymously build sizable stakes in companies they wish to influence.” This also sounds insouciant, when we know that the “benefits and risks” referred to are the inverse of long term investors' interests, especially with respect to bank stocks that have a systemic importance in banks' capital and why naked short-selling of bank stocks was temporarily banned! The ABI Director of Investment Affairs Peter Montagnon (Association of British Insurers, the UK's biggest institutional investors), referring to the FSA's proposed new rules on CFDs, said “the measure would improve transparency...This is a welcome step forward. Companies should know who has built up a stake and investors too should be aware of what would otherwise be happening behind their backs." If they are lending out their shares to CFD speculators, how is this happening behind their backs? The UK's Association of Investment Companies, the investment trust industry, also welcomed the move, saying, "These disclosures should let shareholders understand who might try and exert influence over the affairs of companies they own and then allow them to act accordingly to protect their own long-term interests." Again, why do they not take action themselves on stock lending? It is not that hard to know what is going on already.
Hedge Funds are said to devote 30% of funds to short-selling (renting borrowed shares to sell into the market then buying them back cheaper later to return the lender). The markets and shares that are the targets of short-selling are those expected to fall, or already falling and expected to fall more or known to be vulnerable to being dragged down by short-sellers. They are will be 'shorted.' This is not hard to know by traders with access to derivatives markets who can detect overnight 'puts' that will trigger price falls in the cash market as soon as stock exchanges open next trading day. For prime brokerages and their hedge fund clients this is not rocket science.
Intra-day short-sellers using borrowed stock will seek to sell at times and in exchanges for maximum negative impact, say on opening to mid-morning and then buy them back at mid-day before the afternoon mini- “dead cat” bounce – or at whatever time fits with the period over which the shares are borrowed. For maximum impact short-sellers try to signal as loudly as they can to the whole market. detecting these signals is easy for market insiders and leaks out to all others. How this is done is exactly the opposite way to how big buyers or sellers normally seek to minimise market impact by disguising signals when trying to buy cheap or sell dear. Maximum market impact is obtained not by size and direction (a big sell-order) but by the frequency of sell orders in the cash market i.e. a lot of smaller sell-orders. I know this from my own models and from work done by and for stock exchanges in the past.
When stock markets in US and Europe fell by over 40% in the year to date, what profit gains were possible for short sellers sector by sector for June and July? How when falling sectors devastate the portfolios of most investors can this multiply the wealth of those who use CFDs and inverse ETFs (Exchange Traded Funds). Again this is not hard to know. below is a list of short-selling CFD gains that were possible in the US this year. Hedge Funds may wish to check whether they performed this well. Between June 5 and July 15 the technology sector share falls delivered 30.9% gains to short-sellers, and the real estate sector 46.1%. Between June 5 and July 11 in the semiconductor sector the gain was 37,2%. May 15 to July 15 the consumer services sector delivered 37.7% and the financial sector a whopping 106.7%.
What about September and October, great days for shorting? 49.6% gain in 14 days in semiconductor (October 1 – 15), 61.0% in technology (September 25 - October 10), 89.13% in real estate (September 26 - October 15), 89.6% in consumer services (September 26 - October 15), and 89.9% gain in financial stocks (October 1 - October 9)! If Hedge funds deliver loss performances given these gains, offering gains to concerted equity plays of 300-500% in 4 months, then that does suggest that they really do need some risk regulatory oversight or cash-flow forensic audits. The other side of this coin of course is what has happened to mutual funds, insurance and pension funds who funds have lost massive value? This is surely a massive shift of several $trillions, a Mount Everest of Funds, from funds that serve the general public interest to hedge funds serving the super-rich. That would be one view. Of course, mutual funds, insurance and pension funds may be complicit with hedge funds (some of biggest of which are owned by banks) insofar as possibly up to 10% of the funds of the former may be vested in the latter? US Mutual funds 5 years ago used to be ten times the size of hedge funds. They may now be less than three times or even only twice the size of hedge funds! Banks as we know are desperate to bank profits and restore their capital reserves. They also have hedge funds who may be aggressively doing their bit to book profits by short-selling, which can be ironic when the banks have for short period been protected from naked short-selling. But also the banks' corporate clients would be somewhat aggrieved to learn when the FSA's disclosure rule results in publishable data to learn that hedge funds owned by banks were dumping their stock. It may also be a dysfunctional fact of life that banks happily extend credit facilities to hedge funds that are shorting bank shares and the credit-worthiness of the banks' corporate finance clients. Short selling is an easy choice when bank managements lost credibility in how they cope with the changed macro-economic situation. It does not help when banks and their underwriters, not just hedge funds, are short selling each others' stocks to make money as their own share prices fall. Banks short-selling each other cannot be conducive to restoring interbank credit markets. As one US newsletter defines seeking to mitigate the rapidity with which markets can collapse in our dog eat dog world is merely “protecting assets like a junk-yard dog!”