SEC fills a hole in the rulebook

WSJ News item: SEC to stop “naked” short selling of financial stocks:

Under current rules, a short seller must first locate shares to borrow, but does not have to enter into a contract with the share lender. Often, more than one trader is able to borrow the same shares, creating a multiplier effect in the size of the total short position.

Under the emergency order, a short seller would be required to have an actual agreement to borrow the shares. The new move would effectively take shares out of the market for borrowing, which could reduce the amount of stock available for selling short.

You might have thought these rules already existed, but it turns out that the U.S. stock market deserves the “Wild West” moniker that was once reserved solely for the Vancouver Stock Exchange. Until now, a U.S. short-seller didn’t need to formally borrow the shares that were being shorted – they just had to have a dealer “locate” them. That meant, I guess, that the same 10 hedge funds could all locate the same share position to short against, but since none of them actually set up the borrow, and paid the borrow cost, everyone got to play with the same stock position.

For free.

In Canada, I’m unaware of any investment dealer that will set up a large short position without arranging a formal borrow for the same amount of stock. The formal borrow isn’t generally a contract between the actual holder of the long position and the short seller (the dealer plays the role on behalf of the long owner); but the long position will only be rented out once at any given time. There are fees for such things, and the larger the retail network of the dealer, the higher the likelihood that you’ll be able to find enough shares to borrow as many smaller positions can get strung together to satisfy a larger borrow need.

It’s good business, as well. Some investment dealers charge as much as 1% a month of the value of the long position for the right to be perfectly offset on the short position. Then there’s the risk of “buy-in”, which happens if the ultimate owner of the long position wants to sell the stock – then the borrow evaporates and the fellow who is short needs to find a new position to borrow against. This can all happen quite quickly – a three day settlement period isn’t very long if you are looking for 500,000 shares of a small cap. stock.

It is telling that the SEC is just now plugging such an obvious hole — a hole that shouldn’t even exist. Why should the same block of shares be “available” to every hedge fund in the U.S. to swing a short? And without any formal arrangements required, how methodical will the paper trail be if the SEC tries to check later to ensure that Investment Dealer X actually located the stock in the first place?

If timing is tight, and a large hedge fund client wants to short a million shares of Washington Mutual (WM:NYSE), that’s a trade you want to make happen. There’s a reason why hedge funds make up 40% of the commission paid to trading desks in North America. Although they are not popular with the media or company CEOs, short sellers serve a purpose on many a ticker: it’s called built-in buying.

When Research In Motion (RIM:TSX) raised US$944 million in a marketed equity offering in January 2004, there was a substantial short position on the name. Back then, RIM was just about to break through the one million handset install base figure, and many U.S. hedge funds thought the company was a flash in the pan (RIM now sells more than that in a month).

As the roadshow went along, demand for the offering grew and grew. The European accounts loved the story in particular, and Fidelity wanted to maintain their standing as the company’s largest institutional investor. So what happened? The shorts got squeezed. Rather than see RIM’s shares weaken during the roadshow – in anticipation of a dilutive price on the financing – the shares actually got stronger. Even as the book increased in size.

The shorts were forced to make a decision: continue to lean against the stock of a Company with almost US$1 billion of new cash on hand, or cover on the equity deal and move on to greener pastures. Many scrambled to cover, which helped boost the share price and added more names to the Lehman/Merrill institutional book.

In the world of financial institutions, it isn’t so simple. The share price of Bank XYZ is taken to be a proxy for its solvency by many clients and counterparties around the world. Lean on that share price, and a hedge fund would expect that counterparty banks around the world will tighten up the overnight funding lines of Bank XYZ. Once word gets out that funding is tight, the share price might go do even more.

And, if you have a real strategy in place, short the stocks of the firms that provide credit insurance to these banks, creating the appearance of weakness at the monoline insurers. If rumours persist that the monoline insurer can’t make good on the credit default insurance they sold to Bank XYZ, the the research analysts who cover Bank XYZ will soon put out a report on the impact that a failure at the monoline insurer will have on Bank XYZ’s income statement and balance sheet.

But let’s not discount the losses that are being taken on the various subprime loans, ABS assets and flakey conduits that these financial institutions created/acquired. Hundreds of billions of dollars have been written off the world over: and that’s got little to do with hedge fund trading.

Just look at the hell that Washington Mutual’s new investor Texas Pacific Group is experiencing (from Bloomberg):

“Three months ago, with Washington Mutual’s shares at $13.15, a group of investors led by Forth Worth, Texas-based TPG agreed to buy $7 billion of stock at $8.75, a 33 percent discount. The stock slumped 35 percent Monday to $3.23, leaving TPG’s investment down 63 percent. TPG also has warrants to buy 57.1 million shares at $10.06 each.

The company said in a statement late Monday that it’s “well capitalized” with more than $40 billion in liquidity and $150 billion in retail deposits. It has about 2,500 branches throughout the nation.

WaMu incurred $3 billion in losses in the past two quarters as customers fell behind on their mortgages. The company cut its dividend twice this year and stripped CEO Kerry Killinger of his role as chairman.

The lender probably will report a second-quarter loss next week of $1.2 billion, according to a survey of analysts by Bloomberg. Analysts at Lehman Brothers Holdings Inc. said Monday that WaMu may post cumulative losses of $26 billion. The stock tumbled 92 percent in the past year.

As losses mount, a clause in the TPG agreement makes it more costly for WaMu to raise capital or be acquired. If WaMu is sold for less than $8.75 a share or is forced to raise more than $500 million in equity, it must compensate TPG for the difference, according to filings with the Securities and Exchange Commission.

“We don’t know how their investment plays out, but we also don’t know how this affects WaMu to the extent they need to raise more capital,” said Steven Davidoff, law professor at Wayne State University Law School in Detroit. “They really can’t raise equity.”

TPG spokesman Owen Blicksilver declined to comment. WaMu spokesman Brad Russell confirmed details of the TPG deal.

The world’s biggest banks and lenders have raised $325.2 billion and recorded $415 billion in write-downs and credit losses in the worst housing crisis since the Great Depression. More than 100 lenders have been forced to halt operations, close or sell themselves. Pasadena, Calif.-based IndyMac opened Monday under the control of the Federal Deposit Insurance Corp.”

For all of the handwringing about the impact of hedge funds and shorting, the original loans that caused all of this mayhem weren’t written by guys in red suspenders on Wall Street. The SEC needs to tighten their rules, this is true. But let’s not make hedgies the fall guy for US$400 billion of writedowns.

Leaders in the banking industry fortold “blood in the streets” last summer (see prior post “Maybe there is a credit bubble after all” June 1-07):

‘We are close to a time when we’ll look back and say we did some stupid things,’ Lewis said… ‘We need a little more sanity in a period in which everyone feels invincible and thinks this is different.”

Bank of America Corp. (BAC:NYSE) Chief Executive Officer Ken Lewis

“I am not a forecaster of the future; I’m a historian. And history says this will blow up. It always has. And there will be some blood on the street.”

Wells Fargo & Co. (WFC:NYSE) CEO Richard Kovacevich

Why wasn’t the Fed, the Treasury Department, and the SEC listening to these executives at the time? It’s not like anyone can be surprised by what has come to pass. Filling rule loopholes is always a good idea.

But the horse is not just out of the barn, it’s in the glue factory.

MRM