Tuesday, January 27, 2009

Short-selling: the ideology & the Paulsonian reality

It is one of the wonders of rivers how salmon manage to swim upstream to spawn against everything pouring fiercely down-river. It demands great fortitude and courage. But, don't think of hedge funds and short-selling like that, not this year or last, or the year before. The picture above is not liquid but marble. Sensible short-sellers have seen their opportunities etched in marble. It's a wonder that far more hedge funds have not profited as well as for example Paulson & co. (more later).
In the UK, short selling of designated financial sector stocks was restricted with effect from 19 September 2008 until January 19. The restrictions prohibited the creation of, or increase in, a net short position giving rise to an economic exposure to shares in 34 banks. The US introduced a prohibition of naked and covered short selling for 306 financial stocks on 22 Sept.'08.7 After 8 Oct. the ban only applied to naked short positions. The FSA was expected by The Guardian to bow to political pressure and media outrage to renew its short-selling ban. It didn't and didn't tell Chancellor Darling until too late. He was furious. The FSA's excuse? They claimed that hedge funds (AIMA etc.) could sue the FSA if it didn't drop the ban. Why? Because AIMA, ISLA and LIBA had commissioned academic research from Professor Ian Marsh (pictured below) and Norman Niemer of Cass Business School, London, that found no strong evidence that the emergency short selling restrictions imposed in various markets around the world changed the behaviour of stock returns. When shares are about to be diluted by new issues, it is a glorious time for short-sellers - traders who prodit on price falls. Stock markets have fallen all year, misery for investors, but for short-sellers it has been Christmas all year long!
Stock lending may in normal times of orderly markets be useful for reasons other than short selling. But, in a long falling market, stock lending is overwhelmingly for short selling. This is when stock is borrowed by one trader for a few days and sells into the automated markets where FTSE index funds and last week’s short-sellers are buying. When the price falls enough that day or next day, the trader who borrowed can buy it back for less than he sold it, keeping the profitable difference. Short selling depends on the ease and low cost of stock borrowing for short periods of a week or a month. Borrowers require lenders. Stock lending is a practice with 200 years of history. It is over-the-counter dealing, which means it is not transacted via exchanges. It used to be an honourable business of a bilateral agreement between two parties. In recent years it has increasingly become a marketplace brokered by intermediaries. The public need to understand how when equity markets fall value is not merely wiped out; the losses of investors can be turned into short-sellers' cash profits. As it were, what you see rising and falling about the water has its counterpart below the water. Institutional investors lend out their inventory to gain small % incomes that may or may not accrue to the ultimate owners of the shares. The Institutional Investors ideologically morally comfort themselves with the idea that they are not contributing to the fall of shares by lending our shares. They take comfort in the self-serving ideological view that short-selling does not move share prices and is good for the efficiency of the equity markets. These ideas are entirely bogus.
Shareholdings of 3% or more have to be published as regulatory news. The FSA required short positions of 0.25% in bank stocks to be reported to it, but did not renew this on the 19th January. Such restraints on short-selling are a joke to all involved! More serious embarassment awaits the stock lenders if the FSA publishes its so far unpublished report about them. This may not happen, since the unit trust funds and others are busy remontrating with the FSA to drop the publication idea for fear of exposiing their (and that of the custodians and collateral holders) stock lending 'strategies' - surely another egregious joke at shareholders' expense, who now massively include the Government!
We do not know how much of trillions wiped off share prices are short-sellers’ profits, mainly gained by hedge funds. All we know about stock-lending is part guesswork. We know it can account for more than half of trading on the LSE and other exchanges. We also know that lots of small sell orders can move a share price far more than one big sell order. The FSA’s code and ban on ‘naked short-selling’ is a sick joke. In Europe and the USA there may be nearly $20 trillion of securities owned by investment funds that are available for lending for a short time, a week say or a month, for a small percentage fee. As we saw on Friday, it takes only 1% of shares to be sold for the share price to fall twenty times this!
I have just read the CASS Business School report and find it is completely unreliable and worthless as evidence of anything. Also note that the report was finished on 30 Nov. but not released until 29 Dec., presumably so that its pro-short-selling sponsors could check it first!?
The report attempts to find correlations based on intuitive assumptions that all also being equal the group of 'protected' stocks should perform better than expected during the ban? This approach had at least 4 fatal weaknesses:
1. proving the ban did not change returns is also evidence that the ban was ineffective or too weak, not least because short-selling could shift to derivative puts, but also because it was based on a high reporting threshold of net positions by end of day of 0.25% of a company's stock, per investment trading firm. There was no attempt to first determine what short-selling of UK banks continued despite the so-called 'ban'.
2. the study failed entirely to look at stock lending data; what % of each bank's stock was out on loan and what % level indicates short-selling and not trade settlement efficiency needs. Not all 'protected' stocks as a group were shorted on the same days or to the same extent. Short-selling does not operate against other factors operating on the same day to pull down a share price. The key test therefore is to look at how short-selling can 'move the price' not just profitably ride the fall. The study did not examine this despite being part-funded by the International Stock Lending Association? It looked at the whole matter at a distance, abstractly statistically far removed from detailed realities, including trying to absurdly isolate theory proof against a background of "all other things equal", when they most patently were not and could not be!
3. how prices change ('price discovery') and can be 'moved' in equity (cash and derivatives) markets is essential to know. The FSA ban by setting a reporting threshold of 0.25% clearly believes prices can be moved by short sellers. But, of course it is not a matter of individual short-sellers moving the prices, but also how they collectively do so.
4. Research of many years standing including some I pioneered (when advising Reuters) showed that prices are a quarter of the time moved by 3rd party news and as much again by peer-group or sector moves, and most of the rest by company announcements and results. In 2008 banks during capital issues became especially vulnerable. Prices are also moved by the 'frequency of direction' of orders far more than by order size. Hence a 100 sell orders are far more effective than 1 big sell order. This is how very small share borrowings used to sell short can have major price movements. The truth is that short-selling is so easy and safe in the past 2 years it's a wonder far more are not doing it? Hence the FSA's 0.25% threshold was far too high to be effective. And the only true effectiveness would have been to severely restrict or ban stock lending! Even on days of relatively positive news we can find cases of 1% or less of a company's stock traded and the price falling same day by 20%. My conclusion is that the FSA was never seriously committed to banning short-selling! Even the LSE was not interested in protecting a very important part of its total market capitalistaion; it was more interested in encouraging CFDs (contracts for difference - the small short-seller's favourite trade) that were 40-50% of transactions i.e. the LSE is more interested in order flow (for commercial reasons) than it is concerned about market quality!
Stock lending data is sample-driven and reported 2 months late. That, plus the high 0.25% hurdle setting of the FSA's rule, means that too little data shows up. One exception has been the Paulson hedge fund. In January, it had 0.97% of HBOS shares shorted just before the merger with Lloyds. What else do we know about Paulson & Co?
Only a handful of hedge funds disclosed their positions, notably one run by John Paulson Ipictured) in the US, who took out a near-£1bn bet that share prices in British banks would fall heavily. Short sellers borrow shares they do not own and sell them in the hope of making a profit by buying them back more cheaply when the time comes to return them to their rightful owners.
The FT reported (27 Jan.) that Paulson & Co, made a profit of at least £270m betting on a fall in the share price of RBS over the past four months. Investors say Paulson held a short position for 4 months in RBS, suggesting profits could be far higher. The decision to cover the short on 23 Jan. maximised its profit, when RBS shares jumped almost 20% on Jan 26. HoC MPs will on Jan 27 interrogate hedge fund managers, including from TCI, Marshall Wace and Blackrock, called before the Treasury Select Committee, following a letter from the committee's chairman, John McFall MP, to the FSA questioning its lifting of the ban. The US Congress quizzed hedge funds similarly last November.
RNS filings reported in December showed Paulson & Co. firm had taken huge short positions on four of the five biggest UK banks. It borrowed and then sold Barclays shares worth 1.2% of the bank’s value, approx. $55m. His positions also included similar bets on Lloyds TSB - approx. $412m, and RBS - approx. $464m, with the combined stake totaling about $1.6bn. Judging by the RBS data the profit could be anything from 50% to 150%. The stake in HBOS reported in mid-January at 0.97% coincided with a 30% share drop. HBOS had been shorted all year long by hedge funds, including infamously Morgan Stanley in mid-summer at the same time as it was acting as c0-underwriter for HBOS's £4bn share issue. Morgan Stanley borrowed and sold short about £140m of the bank's stock. Shadow-banking, Hedge funds and short-selling especially are like a great nuclear submarine in freely rampaing around under a fishing fleet. The 52-year-old Mr. Paulson's New York firm gained a superstar reputation by betting against the housing market netting over $3bn. This year, according to Wall Street Journal, that will reap another $500m. The firm's 3 main funds are up between 15% and 25%. Paulson Advantage Plus fund netted a return of 20% for the year to the end of August against 158.75% for '07 (growing with new investors coming in as well as market gains from $100m at start fiscal ‘07 to almost $9bn today). Paulson’s Advantage fund gained over 100% in 2008. Paulson's Credit Opportunities fund by Oct.1'08 was up 12.95%, having made 351.72% in '07. These numbers are impressive considering the average hedge fund is down more than 17%. For all of 2007, Mr. Paulson’s $35bn raked in more than $15 billion in gains. It is quite possible the firm has gained over $1bn of the fall in UK banks' shares. And this hedge fund may be only one of several to have done so? But, very interestingly and honest, George Soros does not seek to minimalise the impact of short-selling. I might only question his support for recapitalisation where this involves rights issues, which are clearly just more food for short-sellers. His expolanation about short-selling is important and fascinating (see next post above). See also this link:
http://allaboutalpha.com/blog/2008/12/02/securities-lending-starting-to-dry-up-a-little/ gives some insight into the scale of stock lending and that it changed importantly after 2000 when a much wider range of securities were involved. Shorting goes on in every market. It seems about 5% of all equities are on loan at any time? That is easily enough to move markets dramatically. In fact the number of $trillions on loan is probably an indicator as good as any for guessing how much hedge funds have to play with e.g. say $600bn in money amrket funds then use certificates of deposits from the MM funds as collateral for borrowing $2-3 trillions in cash equities and derivatives. Stock available for borrowing is in the many $trillions and stock loans can be for days, a week, a month i.e. short periods were the leverage involved in getting the stock is far greater than other leverage ratios that are declared for financial reporting periods.
What do the institutional investors think they are playing act by lending our customer's shares? Should customers sue the unit trust, investment funds, pension and life assurers for risking their shares at the hands of short-sellers? Are the lenders not acting like turkeys voting for thanksgiving when they lend out shares:
It was short selling the currency that hit the pound in 92 and is doing so again now - and short selling by small German as well as foreign banks that were main reasons for the massive depreciation of the Rmark in 1923!
Then what happens when benchmarks are discounted?
This can be especially important at the time of shareholder meetings or when mergers are afoot such as between Lloyds TSB and HBOS. In September, over 7% of Lloyds TSB shares were loaned out, down from 11.48% in August. In September, at least 5% of HBOS market cap was on loan - but this was three times higher at 16% in July (higher figures have also been estimated including above 20%) and 11% in June. The fact is that we need far better oversight to know the truth of all this!

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