Mother of All Short-Covering Rallies

Today the SEC followed the lead of their British counterparts and banned short-selling in almost 800 Financial sector stocks.  In addition, it looks like we will have something that is being described as a second Resolution Trust Company (RTC2) to buy up all the toxic sludge that is floating around Wall Street. 

In the short term this is fantastic news for the embattled Financial Services sector stocks.  In the medium to long term, it is very bad news.  If your trading horizon is a month or so, load up on the investment bankers, very weak banks, etc. For example, even the walking dead like Washington Mutual (WM), National City (NCC) should do very well today and probably for the next week or so.  The greater the current short interest in the name, the bigger the pop you will see. 

However, keep a very close eye on them.  This should only be a short-term trade, although it could be an extremely profitable one.  Longer term, look to firms who will still have customers regardless of the economic conditions and which have very strong balance sheets. Names like Proctor & Gamble (PG - Analyst Report) and Coca Cola (KO - Analyst Report) spring to mind.

By and large, the short-sellers have been right about the underlying fundamentals of the sector.  The sector made a ton of loans to people without checking to see if they had the ability to repay those loans, and then leveraged themselves up to extremely imprudent levels.  As long as real estate prices were going up, there were very few defaults or foreclosures.  If someone couldn't repay the mortgage, he could just sell the house. 

As soon as housing prices started to fall, however, the whole thing was bound to unravel.  Thus as the cycle was still going up, these bankers could book massive, but largely illusory profits, and pay themselves massive bonuses.  As things started to fall apart, everything possible was done to hide the true condition of their balance sheets from the investing public.  Most notably by reporting a large part of the paper as level-three assets. 

Short sellers play a very important role in price discovery, making the capital markets much more efficient.  They also provide a lot of liquidity, since they are guaranteed buyers at some point as they cover their positions; that usually happens when nobody else wants to step in and buy.  Are there abuses by short sellers?  Of course, just as there are abuses on the long side.  Enforcement of the ban on naked short-selling makes sense.  In other words, you do actually have to find shares to borrow before you can borrow them and sell them short.  Bringing back the uptick rule, which was implemented after the crash of 1929 and only eliminated last year, would make a lot of sense.  That would be sensible regulation. 

Banning short selling in 799 stocks until October 2, which is extendable for 30 days thereafter (anybody look at the calendar to see what occurs 33 days after Oct 2) and doing it on the day when all the options and futures expire, smacks of market manipulation on a scale that would make Jessie Livermore blush.  One effect of this will be to effectively shut down the Options market.  People who write (i.e. sell) puts hedge their positions by shorting the underlying stock.  Now, with short selling eliminated, people wanting to bet against these companies will migrate to the options market. 

However, the other side of the trade will be severely compromised.  Write a put and you have nearly unlimited losses (there are infinite potential losses on writing calls, but with puts a stock can not go below zero, so that caps it) yet only a set premium.  If you can short the stock then you can hedge the position.  Unless the premium you get for writing the put is extremely high, it is just plain a stupid bet.  You could then see a situation where the at-the-money call (the strike price equal to the current market price of the underlying stock) is trading for $2 and the at-the-money put is selling for $10.

There are very real differences between the original RTC, which disposed of assets the government already had by virtue of paying off depositors and shutting down insolvent S&L's and the current proposal.  In the first one, the shareholders, both common and preferred, we already wiped out, and many of the unsecured creditors (not depositors under $100,000) took a hair cut.  The assets were by and large real assets -- say an empty strip mall in Texas. 

In this situation, we are talking about buying up lots and lots of toxic paper at a substantial discount. Well, the question is: substantial discount to what? Par? What it is currently trading for?  If this toxic paper is currently trading for $0.25 and the government buys it up at $0.25, then it has solved nothing other than it has forced price discovery of the assets and made the holders recognize their losses, and thus take a hit to their capital. 

If instead the government (a.k.a. taxpayers) buys it at, say, $0.75 on the dollar, then this is nothing but a massive bailout and transfer of wealth to Wall Street.  How big a transfer of wealth is hard to say at this point; it depends on what price is paid and how that price is arrived at.  And no, mathematical models of the value of this paper will not due. Those models have been proved to be extraordinarily wrong.  Mark-to-myth, and all that.  But in all probability, the transfer of wealth from the taxpayer to Wall Street will be measured in the hundreds of billions.  Welfare for the rich indeed.

Read the full analyst report on WM

Read the full analyst report on NCC

Read the full analyst report on PG

Read the full analyst report on KO