Regular readers will know that I enjoy at times highlighting information that I feel offers value to investors on stocks in the news, potential investments and market insight. As a regular reader and contributor at the Financial Webring Forum I had the opportunity to read a very interesting post today by Norbert Schlenker.
I would encourage readers to view the post and seek what independent insights they can into the current financial/credit crisis being covered extensively in the media.
From: A Rant
By: Norbert Schlenker
Please excuse me. This is going to be a long winded ramble about what’s happened over the last week. Rather than sprinkle comments in a bunch of threads, I figured I would just collect it all in one place. I made a couple of acid comments Friday re a rigged game and my mood as a result being apoplectic. I have been asked for an explanation and feel obligated to reply.
To start, let me say that I am a very prosaic investor in real life. I am long only and have a very diversified portfolio. I don’t short anything outright to make a profit, although I will occasionally employ a short sale on a very short term basis in order to accomplish something else, e.g. converting currency to avoid being jacked around by a bank.
I believe (broadly) in market efficiency. I acknowledge that there are pricing anomalies, but I have little faith in my ability to identify or exploit them, particularly when it comes to equities. I accept market prices as a good faith and unbiased estimate of “true value”. I am unwilling to stake my long term financial goals on the assumption that I am somehow smarter or more visionary than anyone else with intelligence and capital. In the end, I know that I must rely on the market to turn an investment into spendable cash. I have no power to force liquidation at my own estimate of true value. At the far end of my investment horizon, a very simple truth holds. Realizable value turns entirely on what others think. Not true value. Not my beliefs. Consequently, I am also willing to accept that, if I’m buying today, today’s market value is someone else’s realizable value, unlikely to be true value, perhaps too high, perhaps too low. Someone is making a mistake, either me as buyer or someone else as seller. A hundred years from now, we’ll know who. But I don’t know today and, quite honestly, I’ve got better things to do than worry about it.
Why the short selling restrictions enrage me
A market is, first and foremost, a price discovery mechanism. I rely on markets – we all rely on markets – to set reasonable prices on goods. Reasonable. Not perfect. Just reasonable.
(There are other ways of setting prices in economies. We’ve seen them tried. Our luck is that we’ve seen them tried mostly in other countries because then someone else somewhere else bore the burden of a mechanism that generally slows economic growth, fails perhaps gently and sometimes catastrophically, and enriches the politically connected. I’m one of the lucky beneficiaries of not having been subjected to such ridiculous experiments. Believe me, I count my blessings.)
Part of the price setting mechanism in a free market is people selling something that they believe is overvalued. The market isn’t going to produce an unbiased estimate of the true value of any good, whether it’s avocadoes or shares, if sellers are prevented from offering goods that are priced above true value. If we decree* that no seller be allowed to act on her own judgment that an avocado or share is trading above true value and thus offer it for sale, with the seller bearing the financial consequences of his judgment, the market price is no longer an unbiased estimate of true value. The market price of avocadoes becomes a joke, something to be gamed by those in the know.
Two objections often get raised at this point, first that avocadoes are qualitatively different from shares, second that sales are not the same as short sales. I deny the first absolutely.** I deny the second as well but that requires an argument. The objection usually turns on the abstract nature of a short sale, offering to sell something you don’t own. There is something viscerally wrong with a short sale. People go to prison for selling things they don’t own. If you see a car for sale in the want ads, call the advertiser, go visit, hand over your money, drive away in the car only to find that you can’t register it because it wasn’t the advertiser’s to sell, you expect to see someone go to jail. If your son Tommy hands a dollar to Joey in the schoolyard expecting to get a couple of chocolate bars and Joey stiffs him, then you expect unpleasant consequences for Joey.
But that’s not what a short sale is about. Short sellers have to deliver the goods.*** Forget avocadoes and shares for a minute. Take something simpler, say a sofa. You can walk into a furniture store and buy a sofa off the floor, a display model. Hand over your cash or credit card and you can have the sofa delivered the next day. More likely though, you walk in, see a style you like, but the fabric is wrong. You want this style but the fabric on the one over there. Or the fabric in some book of swatches the store hangs on a rack in the back. The probability is near zero that you will have a sofa tomorrow. You pick your style and your fabric. The store will have your sofa built. You will wait two months. You will also put down a deposit today, probably for at least half the value of the sofa.
Did the store sell you a sofa today? I don’t think so. The store has just made a short sale. They have taken your money for a product they don’t own. It’s even more egregious than a short sale of shares. When someone sells shares short, they’ll borrow them to deliver. It’s not as if the shares don’t exist. This sofa you just “bought” can’t be borrowed. It doesn’t even exist.
Should the furniture store be legally barred from selling you a sofa that doesn’t exist? I don’t think so. I’ll bet you don’t think so either. Vast swaths of the economy operate on the basis that sales of items that don’t even exist at the time of sale can be sold. Sofas. Airplanes. Ships. New houses. They’re all short sales. Think about the effect of banning short sales of new houses by home builders. The effect on you. The effect on the economy. How many houses would get built if every house was required to be a spec house?
So what’s so special about the shares of financial institutions that it’s reasonable to decree that they can’t be sold short? I submit that there is no good reason for this. Don’t get me wrong: I think there’s a reason it’s been done. I just don’t agree that it’s a good reason. It’s an attempt, which will ultimately fail IMO, to paper over the rot on bank balance sheets. In the end, there’s a simple fact that can’t be papered over. The banks have crappy assets. They did it to themselves. They must bear the consequences themselves. Creating a temporary (?) rule to prevent people who believe that the banks have crappy assets from selling the bank’s shares is somewhere on a continuum from folly through delusion to criminal.
No one should believe the share prices at Friday’s close on those 799 institutions that the SEC protected. I’m not saying that the mid-day Thursday crash low prices are correct, either. But if I were a betting man, I would bet that Thursday mid-day is a better estimate of true value than Friday’s close. Thursday afternoon and all of Friday were a government induced ramp job, one of the greatest pump-and-dump operations ever seen.
And everybody’s going to pay for it except the people who should.
The Paulson rescue plan
The US government, either as Treasury or the Federal Reserve, has already spent**** close to a trillion dollars keeping the financial system running this year. Thursday, the Secretary of the Treasury and the chairman of the Federal Reserve went to Congress to ask them for another trillion dollars. (Hundreds of billions have been mentioned in public. Trust me, it will be a trillion at least.) The legislators are said to have exited the meeting white as sheets. They probably had reason to be shaken.
There are real liquidity problems, which the Fed has been trying to handle over the past year. Bernanke made his bones on the causes of the Great Depression, much of which was due to undue contraction of liquidity in the US economy. The Fed has been beavering away trying to keep that from happening again. In the process, they’ve ballooned their balance sheet. The Fed is now levered about twice as far as Bear Stearns and Lehman when they collapsed. In theory, there is no limit to the Fed’s balance sheet. However, this is not a theoretical world. Put enough pressure on the Fed and something has to give.*****
Liquidity problems are breaking out all over. Short T-bills traded through zero last week. LIBOR and the TED spread spiked because no one was willing to lend to anyone other than the Treasury itself. Money market funds collapsed, generally not because their assets were actually bum, but because they had promised absolute liquidity on their liabilities and liquidity disappeared for their assets. I’m of two minds about the measures Paulson announced re MMF guarantees. It’s a misuse of the $50b slush fund****** he has sitting around but the system was sufficiently seized up that something had to be done. Maintaining liquidity happens to be the Fed’s job but, as noted above, they are overstretched already. I can live with it. Paulson had legal authority (not that he should have such authority in the first place IMO, but that’s another story) and, with sand in the gears and no more oil at the Fed, he did what he had to do. In the end, it will be a complete ballsup, because only the MMFs with crap on their books will pay the insurance premium, i.e. if your MMF is in the program, you know it’s larded with crap. Investors will flee and the Treasury******* will get the bill.
However, the problems don’t end with lack of liquidity. Lack of liquidity is a symptom, not a disease. The problem is solvency. Large parts of the US financial system are not just illiquid. They are insolvent. Their liabilities exceed the fair value of their assets under any fair mark. The problem is not that they can’t sell their paper because the market is illiquid. The problem is that they hold paper on their books at a dollar or 75 cents when it is actually worth a nickel. Not bid a nickel. Worth a nickel. Banks in the hot real estate markets of two years ago are stuffed to the gills with mortgages that are not paying and will not pay. When you wrote second mortgages or extended lines of credit at the top and the collateral is worth half what you lent, your dollar asset is worth a nickel.
People were paid big money to put those “assets” onto the books of US banks (and through securitization, investment banks and pension funds and mutual funds worldwide). Those assets are impaired. They were impaired from the word go but the chickens have finally come home to roost. The people who got paid the big money? They’re gone, pockets full. There aren’t enough jails to hold them all or prosecutors to send them to jail. They got off scot-free, top to bottom. From the high school dropouts who made hundreds of thousands a year telling people that real estate could only go up or that this teaser loan was way better than a fixed rate, to the CEOs who made hundreds of millions shopping asset backed paper that was really toilet paper, they lived large. Lucky them. There were no losers.
Oh, there were whiners, the people who complained about being priced out of houses, the skeptics about house prices, the people who just couldn’t keep up with the Joneses down the street with the Hummer and the BMW and the ATVs and the big screen and and and. Screw them. Nothing ever got done with a negative attitude like that. Screw them. Look at the GDPeeeeee!
And here we are today. Everybody is whining now. So what happens? Paulson is going to produce a plan over the weekend and Congress is going to ram it through.******** It’s designed to help the whiners. I urge you to follow the money, both where it comes from and where it goes. It’s going to come from everybody. US taxpayers and lenders to the US, many of whom are outside the US these days, are going to pony up the money. If they can’t find the money there, they’ll print it, i.e. it will come out of US hides in the form of inflation.
Where’s the money going? There is no plan yet so it’s hard to be certain but it’s a fair guess that it will be used to buy the crap assets out of US financials. There can be no winner here. If Treasury pays too little for those assets or even fair value for those assets – which the talking heads will insist is going to happen – then banks are going to fail. Lots of banks. Big banks. Banks today have liquidity problems because they’ve got nickels that they’re calling dollars and no third party will fund that fairy tale. If Treasury takes the asset worth a nickel off their hands for a nickel, their liquidity problems are over but the bank is finished. So it seems to me exceedingly unlikely that nickels will be swapped for nickels. The Treasury will get a nickel worth of paper and the bank will get fifty cents of cash. And the bank, while weakened, will survive.
Note who gets the pony: the same people who already got paid for making those nickels look like a dollar get paid again to sell their nickels for ten times what they’re worth.********* And who gets the shovel to walk around and clean up after the pony? That would be you and me.
What I’m going to do
In normal circumstances, I take market price as a fair estimate. If I want to buy bank shares, I would generally buy them at market. What does the short selling ban mean to me? It means that any observed market price is almost certainly an overestimate of true value. In these circumstances, I will lower my bid. I am but one investor among many and I’m not stupid or vain enough to think that what I believe here will change things, but I will lower my bid anyway. If it is decreed that certain people cannot sell, then the game is rigged. I will lower my bid. I will be a willing participant in blowing out the spreads. There are consequences to what the SEC has done. Up 1000 points Thursday and Friday is one consequence. But it’s not the only consequence. I don’t play rigged games. And in the long run, I doubt I will be alone. That +1000 will disappear. Short sellers had nothing to do with it. The jump at the end of the week is a short run thing and what they’ve done is unsustainable. (Think Dow +1000 means happy days? You haven’t looked at the bond part of your portfolio, have you?)
In the long run, the real danger comes from the rescue plan. There’s real trouble hiding in the banks. There’s been a big party. Quite a few people enjoyed themselves immensely, but not everybody. Party’s over. Time to clean up. We’re not going to enjoy this nearly as much. And just about everybody gets to help, either through higher taxes or higher interest rates or inflation. Probably some of each.
I’m not happy. I was always at the fringes of the party, as were most investors. Buy and hold has been kind to us all. Sandwiches and punch made it out to the periphery and I was happy with what I got. But what a mess now. I’ll do everything I can to minimize how much I have to shovel. I’m outside the US physically and I’ll get what I can out of the US financially. To be honest, I don’t know at this point where I’ll go.
I am a generally happy investor, understanding that there’s always a house rake on everything I invest in, content to live on what’s left after management and the government have had their share. I understand those rules. I will play that game. I will live with the ups and downs of Mr. Market, because he’s randomly insane either way and in the long run it will all work out. I will not play a crooked game, one where the rules get changed in the middle. I like symmetry. Everybody gets a turn on the pony and everybody gets a turn on the shovel. When the rules change so that some just get to keep riding on the pony, based on who you know, not what you know, i.e. politics, I’m a lot less interested.
I still have a bid. It’s just gotten lower. A lot lower.
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* I use “we decree” because the securities commissions act under authority we grant.
** I’m prepared to argue the point, but (a) I’m right, (b) you’re wrong, and (c) this is too long already.
*** There’s another objection in here regarding naked short selling, which is selling short with neither intention nor means of delivering. That’s something different and I agree it should be penalized.
**** The press releases all say “loaned” or “invested”, not “spent”. We’ll see.
***** Force me to guess and what has to give is the value of the dollar. Inflation is coming.
****** He used something called the Exchange Stabilization Fund.
******* Treasury (noun): A siphon into the wallets of the taxpayers.
******** I have little faith in legislation crafted in 72 hours. How about you?
********* I was watching CNBC for a short time Friday when they happened to have Bill Gross on. When asked if he’d be interested in helping out Treasury with the management of all this crap they’re going to buy, there was no disguising the grin.
Norbert Schlenker is President and founder of Libra Investment Management.
See Norbert’s Profile
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