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The SEC Panics

by: Felix Salmon July 15, 2008 | about stocks: FNM / FRE / RBS    
Felix Salmon

Felix Salmon

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I think it was about the time that the SEC started trying to curtail short selling that I finally decided that we're in panic mode. The market's actually flat, as I write this, although Fannie (FNM) and Freddie (FRE) are down 20%, maybe because the Ackman plan (.pdf) actually makes quite a lot of sense.

Ackman's idea is to wipe out the current shareholders, and then create new equity by taking each dollar of senior unsecured debt, and replacing it with 90 cents of new debt and 10 cents of new equity -- a much more sensible leverage ratio than what we've got right now. The government would put a floor under the value of the equity, so the debt holders would retain at least face value, even if they lose some coupon income on the 10% of their debt which becomes equity. If I were the US government I'd go a little bit further and guarantee the next three years' coupons too, maybe give existing shareholders a small stake as well, but that's really a niggle.

In any event, the SEC response was to ban naked shorting of Fannie and Freddie. You can still buy puts, load up on protection, borrow stock and sell it, all that kind of thing; you just can't sell stock you haven't borrowed.

The most charitable view of this is that the move is political, designed to make it seem like the SEC is Doing Something in the face of all the chaos. But it doesn't look like that: it looks like the SEC is happily signing on to the belief that stocks wouldn't be falling if it weren't for short-sellers. In other words, the Powers That Be don't trust the market, and the SEC has gone from facilitating price discovery to making it harder.

Meanwhile, check out the Royal Bank of Scotland (RBS) share price: down another 10% today, to seriously distressed territory: 

The stock is now yielding close to 12 per cent and sits on a discount of 40 per cent to forecast book value. 

You think that's all the fault of short-sellers too? I don't. I think that financials in general are toxic right now, and that the market has to get its revulsion for them out of its system. I think people who bought at 2x an overstated book value should finally give up and sell at 0.5x the new, lower, book value, and I think they should be proved smart as a couple more big retail banks get taken over by the FDIC and their equity goes all the way to zero. And then I think people should realize that the sun is still rising in the mornings, that good borrowers like InBev (INBVF.PK) can still line up $45 billion in financing, that people can still buy houses if they're able to put 10% down, and generally that the financial system still works fine. It might not be hugely profitable for shareholders, but it's still capable of driving the economy.

So let the short-sellers do their worst. It'll just hasten the necessary and inevitable, and that's probably a good thing.

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This article has 34 comments:

  •  
    Jul 15 03:11 PM
    Ackman's plan makes no sense for anyone but himself. FNM and FRE are not insolvent, don't need a bailout, and certainly don't have to have their short term debt wiped out.

    This is just another attempt by Ackman to create a crisis in a company that he has shorted. I'm astonished by the gall of someone who goes on CNBC, states that he is short a stock, and then politely suggests a restructuring plan that sends that stock to zero in order to "benefit America". Give me a break. I hope he loses his shirt.
    Reply
  •  
    Jul 15 03:20 PM
    I thought that naked shorting was illegal anyway?
    Reply
  •  
    Jul 15 03:22 PM
    naked short selling was illegal even before above comment
    Reply
  •  
    Jul 15 03:42 PM
    The short sellers cut down every rise eminent in the financials .

    Most obvious is what had happened in the morning of July 14 .

    FNM / FRE traded over $ 11 before the bell in response to the Sunday's backing announcement .

    After the bell , the two were short sell down to about $ 7 in about a 10 minutes time .

    Not just the said two , all bank stock were short sell down drastically .

    The short sellers are well fed in the expense of the banks' equity .

    The concerted power released in such a short time can only be done by some conspired group of short sellers .

    I do think that the Administration is doing the right thing in curbing short sellings , at least on a temporary basis .

    USA is facing a financial war and not just a simply market of supply and demand .

    Short sellers can take a vacation leave to spend their money easy earn in expense of the economy .

    Give the banks a chance to survive , please .

    Let the investors get back to their old habits of viewing that a significant rise would mean a sign of recovery from the rock bottom price rather than being a signal to a further major drop .

    Reply
  •  
    Jul 15 03:57 PM
    Its possible that with oil dropping and everthing looks bad this might be a great time to buy financials. I just loaded up on WM today..looking for 20 bucks.
    Reply
  •  
    Jul 15 04:11 PM
    Listen genius, perhaps you're panicking with your own naked shorts. This is a ridiculous practice manipulated by hedge funds that are literally destroying some companies.

    Naked shorting should be banned in all companies, end of story.
    Reply
  •  
    Jul 15 04:19 PM
    The SEC is doing what it should be doing, keeping the markets honest and fair. What they are trying to regulate is "naked" short selling. It's where people are selling shares that they DON'T have. This shouldn't be going on anywhere, in any stock. It's especially bad in these stock though because of the recent news.

    I remember a day last week where there were 300+ million shares of FRE traded. There are only about 650 million shares in the company available and institutional ownership is about 95%. What is basically going on is that people are just rapid fire short selling the stocks dozens of times in a day, covering, and then shorting again. All the while they don't have any of the shares they are selling.

    And the Ackman plan, give me a friggin break. The guy is short the stock! His plan for the companies will make him a fortune, if I were a news editor I would be embarrassed to publish the plan. It's ridiculous. I hope Ackman gets taken out to the woodshed on his short positions. These companies have problems (and they should given this is the worst housing bust EVER) but they aren't insolvent.
    Reply
  •  
    Jul 15 04:35 PM
    This is ridiculous - naked shorting should be illegal on every stock not just FNM, etc.

    I hope this is just the beginning....bring back the uptick rule too

    Lame story Felix
    Reply
  •  
    Jul 15 04:45 PM
    Have all free-market conservatives totally lost their minds here? Wipe out all the shareholders in a semi-public entity--and then what, you expect anyone in their right minds to ever invest in stock again knowing that constipated pure-market types are eager to bankrupt them? You need to go have a little chat with your ideological cheerleader Larry Kudlow before you guys go killing the golden goose you worship when good times are making you rich.

    Oh, and by the way, these two entities are not even in any real financial distress, their writedowns are small compared to the rest of the sector; the powers that be are taking action in the fear of a panic against them in the market. Do you think threatening to wipe out their current shareholders is going to instill confidence in the new shareholders?
    Reply
  •  
    Jul 15 05:08 PM
    Salmon, its all the chic these days to hollered from a high horse that regulators are panicking. Shouldn't they? The markets have all lost its integrity. What they are doing has been long overdue. They are all trying to claim back the integrity of the public markets before the likes of Ackman gets elevated to 'saviour' status.

    I've always questioned the value of short selling - naked or not. They don't add any value to the overall scheme of things. Someone suggested it makes the market more efficient by identifying bad stocks - what a load of rubbish. A company which is badly run will not survive in the long run anyway - its shareholders will want accounting from its management and shareholders who cannot take the risk will sell the stock anyway. What do non-shareholders or short sellers positively add to the situation in this instance other than to act like a vulture circulating round what could potentially be a dying victim. Short sellers' intent is to hasten the death, not prevent the death, and that to me, is the most non-value adding activity of all time. Over time, this will serve only to crim free enterprise and prevent healthy risk taking.

    Some elevate short selling to taking risk. What noble risk do you take when you borrow someone else gun only to shoot the guy you borrowed from? What is wrong with this current generation? Well, its no wonder the market is losing its integrity - just ask heads of listed companies - who gives them bigger headaches: their major shareholders or short sellers? I'm sure its the latter and I wonder, as a minority shareholder, why anyone would waste time with someone who has a short position on the company.

    The SEC should ideally not just ban naked shorts but all shorts. In addition, they should also have disclosure rules that make sure everyone knows who holds beneficial ownerships to short positions, just like everyone knows who holds beneficial ownerships to long positions. All shareholders should be specifically educated and told that their shares will be used for scrip lending business by the custodians and brokers and be given an option to opt out as well as to determine their price and tenor of lending.
    Reply
  •  
    Jul 15 05:09 PM
    Oh come on, please!
    There they go, talking free market rules and regulation about an entity that is one of the worst examples of socialist subsidized fiat money mirages the so called capitalist world has ever seen.
    Back to the US..., back to the US..., back to the USSR (copyright Beatles)
    The Funny Freddies should go the way of rotten meat – to the trash.

    Have a good day
    Reply
  •  
    Jul 15 05:38 PM
    This may be a dumb question, but when I short a stock with my broker (Interactive Brokers), how do I know if it's naked or not? I assume it has to be borrowed if it's through my broker -- right? They shouldn't allow me short it if they didn't have it available to borrow.
    Reply
  •  
    Jul 15 06:13 PM
    The bloomberg link in the first paragraph is bad. Can you post the correct one?
    Reply
  •  
    Jul 15 06:25 PM
    Felix is right on here. So is Ackman. Fannie and Freddie are certainly insolvent. The reason it doesn't appear so is that their write downs bear little rational relationship to what they are actually holding. Fannie and Freddie did wade into the toxic subprime and Alt-A pools and they are an abomination because their executives get paid like hedge fund managers and their shareholders (till recently) made out very well and this is all with some vague implicit taxpayer backing, but without the taxpayer getting anything in return for it.

    Fannie and Freddie ARE the US mortgage market and the US mortgage market is secured by real estate that peak to trough is going to fall 30% or more. I'd say that will put Fannie and Freddie ultimately underwater by $1 trillion or so. It won't look like that now, but how about when nobody can buy a house without 20% down (or even 30% down) and everyone suddenly learns that only 15% of Americans can afford to do that? That realization will send prices down another leg for sure.

    I think that if Fannie and Freddie's shareholders want to speak up about their right as investors in a capitalist system to not be jerked around, then that right should be respected and Congress should pass a resolution very clearly stating that there is no federal backing for either entity other than the paltry $2.25 billion credit line each has with the US Treasury. That's it. Period.

    The problem is that implicit promise (to socialize losses by backing them with taxpayer money) combined with ridiculously weak regulation and huge potential gains for investors and managers creates a perverse incentive for management to take big risks right now - HUGE risks. If they win, everybody makes out great. If they lose, the Feds come in and make sure bond holders don't lose anything. I wish the US Treasury would back me in my business decisions like that with taxpayer money.

    Fannie and Freddie have hurt the US housing market for 30 years by pushing up prices. They've not made housing more affordable. They've made it far less affordable by working with a coterie of corrupt banks, real estate agents and appraisers to push up prices as high as possible to expand their lending as widely as possible because it's how they make money. If it weren't for Fannie and Freddie, home prices would probably be 30% lower than they are right now and that means that 90% of Americans would need mortgages 30% smaller than they need right now.

    The key is less lending not more. Lower prices make houses more affordable. Bigger loans do not make houses more affordable. Bigger loans make houses more expensive and hence less affordable. Banks will always claim lending makes things more affordable and the sellers who work with banks (whether the real estate industrial complex, universities in student lending, or any seller) will claim that loans make the product more affordable. But the racket is that sellers and lenders work together to push up prices because they both benefit from higher prices.
    Reply
  •  
    Jul 15 06:43 PM
    Hey Maw,

    I think if you're trading with a mainstream broker you're fine. If not I would just give them a call. I think it's impossible to know where exactly the shares come from.

    And selling short has IMMENSE value to it. If you can't sell short, the only position you could take in equities (excluding options, etc. I'm just talking purely equities) is that they will appreciate. Equities are mispriced all the time, and causing people to only be able to make one-sided bets will cause them to be even more mispriced. It would really screw up the pricing and cause even worse bubbles than what we see now. It's naked shorting that is ridiculous and should have been banned a long time ago.
    Reply
  •  
    Jul 15 08:40 PM
    My guess is that we would not be in the mess we are if it had been possible to "short" houses in the first place. Funny thing about the SEC is that they only understand ever increasing prices. Like the rumors thing. People are acting on rumors because the rest of the "official" news are mostly lies so what's left but rumors? The SEC would do much better by going after the pumpers
    Reply
  •  
    Jul 15 08:53 PM
    Sean makes a lot of sense to me. It is one of the clearer things I have read on all this.

    The notion that short selling should be "banned" or such statements are insane. Are you people real? It must come from people on Wall Street who want securities to go only one way...up....and that sounds a lot like what people were thinking about ah...housing
    Reply
  •  
    Jul 15 09:35 PM
    Ops did it again, houses are for people to stay in - they affect real lives and real families. Its high time the high brow, finance type get off their condescending attitude to attitude real issues and stop making a casino of every asset they can get their hands on.


    On Jul 15 08:40 PM Ops did it again wrote:

    > My guess is that we would not be in the mess we are if it had been
    > possible to "short" houses in the first place. Funny thing about
    > the SEC is that they only understand ever increasing prices. Like
    > the rumors thing. People are acting on rumors because the rest of
    > the "official" news are mostly lies so what's left but rumors? The
    > SEC would do much better by going after the pumpers
    Reply
  •  
    Jul 15 09:37 PM

    Like I said, stock prices can come off too when shareholders sell - we don't need the short sellers to do it for them. Its the crazy notion that many shortists have that they have a 'right' to short sell. Come on, you are borrowing stocks from shareholders - please get it right.

    On Jul 15 08:53 PM OregonRain wrote:

    > Sean makes a lot of sense to me. It is one of the clearer things
    > I have read on all this.
    >
    > The notion that short selling should be "banned" or such statements
    > are insane. Are you people real? It must come from people on Wall
    > Street who want securities to go only one way...up....and that sounds
    > a lot like what people were thinking about ah...housing
    Reply
  •  
    Jul 15 09:58 PM
    Wipe out the shareholders indeed - esp with the treasury and the OFHEO saying loudly that F&F remain "adequately capitalized". Do you think anyone will invest in the USA again! Once foreign money starts being pulled out - the market will not recover for 5 years.
    Reply
  •  
    Jul 15 10:10 PM
    fellow seekers: Did anyone watch the hearing today? When asked about shorting's kissing cousin, the uptick rule, Cox said it was perhaps the most studied issue in his tenure as Chairman. Cox defended the uptick rule; interesting...All that work on the uptick rule yet naked shorting, which has been controversial since the dot.com era, is just now hitting the radar screeen? Where were these great thinkers when Fannie and Freddie were trading at 50, 40, 30, 20 and 10? Don't get me wrong, I think its a silly move and should not have been announced. (There have also been reports it will be postponed till at least monday as well.) But if you're going to do it, why wait? Maybe the SEC follows the brokerage house rule of waiting for huge drops in value before removing buy ratings...

    As for the wisdom of the shorts. Consider that Fannie and Freddie never had to maintain the same cap levels of their competition, but heck that provision was in their congressional mandate.

    Once the overall real estate market started dropping how could Fannie and Freddie escape the same harsh realities faced by other lenders?

    I can't take credit for this, but Joe Batapaglia, who was once one of the worst shills on the Street, has recently become far more objective. I still don't agree with everything he says, but he characterized Fannie and Freddie as an example of federal government SIV's. I thought that was pretty shrewd. How many SIV's are in similar shape?

    Unless and until housing values stop dropping the entire financial services sector will remain problematic, and will hold the economy and market in check. Rather than a micro discussion of Fannie and Freddie, we need a macro discussion of what monetary and fiscal policies are needed to first stop the home value bleeding and slowly repair equity.
    Reply
  •  
    Jul 15 10:29 PM
    The SIV analogy is a good one. Both bond and stock holders bought in based on the "implicit" treasury backing. Both investors should be protected now that the backing has become explicit. I don't see any reason why the shareholder needs to be wiped out as the company is only following the rules set by congress on leverage.
    Reply
  •  
    Jul 15 11:31 PM
    For all you people who think that naked shorting should not be allowed, I will give you a sound argument why it should be allowed. If you are an individual investor, you will not be allowed to sell naked, as the standard brokers will follow those rules about obtaining stocks to borrow. I have personally been caught on the wrongside of a trade and wanted to so desperately short moore shares to dollar cost average down only to be unable to borrow those shares. Sometimes the stock falls back to my entry point but sometimes it doesn't and you can lose big also. There is more risk in going short and I have only traded stocks short for the last 2 years and have made more money than with all my long positions. Granted we are in a bear market, but whyt shouldn't the markets be free and completely lucid. The way they are set up now, it is not protecting the active investor because you are being limited in how you can trade. Why should I be allowed to only go one way in a trade, especially if you know it's a dog. We should be allowed to make money on these pump jobs freely and as much as we can stomach the risk.

    Most "good" companies cannot be affected by the short sellers unless the short interest is allowed to be equal to the shares outstanding, which is hard to reach 50%, without naked shorts. If you are an investor, you should not fear shorts as the are doing exactly what you are trying to do and that is make money. Do not make this a closed and back room market. Let the markets be free.
    Reply
  •  
    Jul 15 11:41 PM
    Sorry for the long winded post. What I mean to say is that get rid of naked shorting but allow 100% of the shares to be shorted or bought long. That would solve this issue and make for better pricing of stocks. Naked shorting is found because the big guys want to dollar cost average their positions after all the "shortable" shares are already held short.
    Reply
  •  
    Jul 16 12:12 AM
    More protection for the Wall Street elite from Washington. So the brokers will only lend to their cronies. Did they forget that brokers get interest on the lent shares? This will backfire BIGTIME when investors see that the regulators put in rules which specifically help certain private interests. This may in fact be unconstitutional as a "bill of attainder" or violative of equal protection. Sad, and will not help these institutions from inevitable bankruptcy.
    Reply
  •  
    Jul 16 01:26 AM
    Glassbox, to the extent that you are saying that you need to actually borrow the shares to short...I agree. No issue. Seems to me that "naked shorting" is or should be stopped (illegal) for all companies not just the ones like Goldman who have friends in high places...like ah Paulson to start with.

    To the extent that you are saying that shorting should not be allowed...like I said...that is nutty. I realize that this is not the best of times for those in the "financial community" but from out here in tree land it looks like it should have occurred long ago. Good companies do ah good.. Companies that are poorly run by imperial CEO's like the guy at Bear for one (he was out playing bridge when the company was burning I seem to recall) deserve what they get and actually deserve a good deal more...and I am not talking about a larger severance deal.

    People are starting to pay attention to this as it has finally come to affect their lives. It has gone on way too long. We shall see if we have a melt down or not...we are way too close. But, judging from the comments here and in tree land the "rabble" will not be pleased until those responsible are held accountable. When the Democrats sweep in they will be more than happy to provide the political circus for the people.
    Reply
  •  
    Jul 16 01:31 AM
    OregonRain, I have my views on the value short sellers add to companies. Assuming the short seller stays, then the current disclosure and pricing framework in short selling and scrip lending is again so skewed towards 'those in the know' that the general investing public has no sense what is happening. And when that happens, you will inevitably get crooks who will exploit information asymmetry - all in the name of making the market more efficient.


    On Jul 16 01:26 AM OregonRain wrote:

    > Glassbox, to the extent that you are saying that you need to actually
    > borrow the shares to short...I agree. No issue. Seems to me that
    > "naked shorting" is or should be stopped (illegal) for all companies
    > not just the ones like Goldman who have friends in high places...like
    > ah Paulson to start with.
    >
    > To the extent that you are saying that shorting should not be allowed...like
    > I said...that is nutty. I realize that this is not the best of times
    > for those in the "financial community" but from out here in tree
    > land it looks like it should have occurred long ago. Good companies
    > do ah good.. Companies that are poorly run by imperial CEO's like
    > the guy at Bear for one (he was out playing bridge when the company
    > was burning I seem to recall) deserve what they get and actually
    > deserve a good deal more...and I am not talking about a larger severance
    > deal.
    >
    > People are starting to pay attention to this as it has finally come
    > to affect their lives. It has gone on way too long. We shall see
    > if we have a melt down or not...we are way too close. But, judging
    > from the comments here and in tree land the "rabble" will not be
    > pleased until those responsible are held accountable. When the Democrats
    > sweep in they will be more than happy to provide the political circus
    > for the people.
    Reply
  •  
    Jul 16 01:57 AM
    Prohibiting short sellers may distort the market, in favor of the bulls, helping them to push up market prices artificially. Shorts provide a balanced and free market. Without shorts, is to allow markets to be manipulated.
    Reply
  •  
    Jul 16 02:02 AM
    Imagine if you were in Ackmans shoes, short 5% of Fnm and you learn abet a little to late, that Treasury has received a blank check from Congess to spank his FANNIE. 2 minutes into the open and Treasury is buying up 100000 blocks of shares. Tick: 6.25, Tick 7.00 Tick 8.25 tick 10.00.. The king of shorts is getting his lemons squeezed. That stock pops 50% by Noon and Paulson is eating Ackman for lunch. Treasury sells into this Ackman squeeze and by the end of the day the Tax payers are up 3%.

    Not a bad day..
    Reply
  •  
    Jul 16 03:34 AM
    The world starting with no short selling. Its the figment of imagination created by investment and custodian banks. The world can continue with out them. If its extraneous and superflous, there is a high chance that it is also unnatural.


    On Jul 16 01:57 AM Takayama wrote:

    > Prohibiting short sellers may distort the market, in favor of the
    > bulls, helping them to push up market prices artificially. Shorts
    > provide a balanced and free market. Without shorts, is to allow markets
    > to be manipulated.
    Reply
  •  
    Jul 16 05:54 AM
    hi felix, this is certainly one of your weaker stories. subtile shift from "naked shorting" to gneral shorting at the end - otherwise you had no story at all.
    the sec bans an already illegal practice, but just temporary and just for a few selected darling stocks. THAT IS THE REAL BIG STORY - and nobody picks it up? It#s like allowing a killer to kill whomever he wants but , please, not bankers from wallstreet for the next 30 days.
    and of course, the sec may decide tro extend that banning of illegal stuff beyond bankers from wallstreet. but before, we allow the killers to kill some more - as long as it is not the beloved bankers. heck, some of the killers might be bankers, uhm?
    Reply
  •  
    Jul 16 08:35 AM
    Here is the link to the actual SEC order:

    www.sec.gov/news/press...
    Reply
  •  
    Jul 16 08:37 AM
    Interesting list of companies:

    BNP Paribas Securities Corp. BNPQF or BNPQY
    Bank of America Corporation BAC
    Barclays PLC BCS
    Citigroup Inc. C
    Credit Suisse Group CS
    Daiwa Securities Group Inc. DSECY
    Deutsche Bank Group AG DB
    Allianz SE AZ
    Goldman, Sachs Group Inc GS
    Royal Bank ADS RBS
    HSBC Holdings PLC ADS HBC and HSI
    J. P. Morgan Chase & Co. JPM
    Lehman Brothers Holdings Inc. LEH
    Merrill Lynch & Co., Inc. MER
    Mizuho Financial Group, Inc. MFG
    Morgan Stanley MS
    UBS AG UBS
    Freddie Mac FRE
    Fannie Mae FNM
    Reply
  •  
    Jul 16 01:19 PM
    Confusion reigns.

    Naked short selling has been illegal forever.

    It is also difficult to do as no prime broker will allow it. There is very little of it going on. The author obviously doesn't know what he is talking about.

    Blaming shorts for what is happening to financial stocks is nonsense.

    Blame the managements who made risky loans. Blame the regulators who were asleep at the switch. Blame Congress for enacting legislation which put pressure on lenders to act imprudently.

    This country has bankers who do not know how to make loans, an auto industry that cannot make an auto anybody wants or needs, an airline industry that cannot price their service adequately and a homebuilder industry that doesn't know how to stop building in the face of sharply reduced demand and much larger supply.

    That's why we are in trouble.
    Reply
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