The forward P/E multiple on the broad stock market is not nearly as high as it was during the Internet bubble, but it’s at extreme highs if one accurately diagnoses the unsustainable stimuli currently driving global economic activity.

Just like low-quality earnings paint a misleading picture of a company’s value, this low-quality economic activity destroys wealth and promotes a dependence on sustained fiscal largesse.

Such a diagnosis would filter out how fiscal and monetary policies are distorting the efficient allocation of capital. Investors should interpret government spending as noise and interpret private sector behavior as the signal. In today’s state-sponsored economy, you cannot totally separate one from the other, but it’s still important to acknowledge the distorting influence that stimulus programs have on capital spending and hiring decisions.

What happens when the stimulus wears off? Why, we have even more excess capacity in sectors where stimulus was directed. Exhibit A: cash for clunkers. Exhibit B: the tax credit for homebuyers that will exacerbate the structural glut in housing supply. In the financial media, I’ve seen investor after investor defend these programs as valuable and necessary, which demonstrates their ignorance of sound economics.

We’re propping up zombie institutions, throwing good money after bad, and rewarding incompetence — all at the expense of prudent people’s savings and the capital that will be needed to fund the industries of the future. Top investors don’t tolerate low- or negative-return-on-capital decisions by the executives running their companies, so it’s puzzling to me why so many of these investors advocate the same type of economic malpractice on the part of government policymakers.

The latest sideshow for public consumption — a “paymaster” regulating pay at large banks — is another example of the government’s misdiagnosis of the problem.

Rather than regulate pay in the hopes that it discourages risky banking behavior, we should be phasing out the government guarantees of the banking system’s liabilities. That, I assure you, would discourage foolish risk-taking among bankers. Case in point: Goldman Sachs behaved in a much more responsible, sustainable manner when it was a privately owned partnership without government guarantees, rather than the high frequency trading, TLGP-hogging, heavily lobbying institution that it is today.

Like an addictive drug, today’s fiscal and monetary policies have made everyone feel better, but have further weakened the structural health and sustainability of the economy. If you doubt this, just look at the horror in most investors’ eyes when they are confronted with the prospect of a Fed Funds rate above, say, 2% — up from today’s range of zero percent. The addiction to E-Z credit and government support everywhere you look is one of the clearest reasons that this economic recovery is an elaborate illusion.

Yet we still see examples of extreme inefficiencies in the valuation of certain stocks. It feels eerily similar to the tech bubble, with investors behaving as if today is the last chance they’ll ever get to buy Amazon.com stock at less than 80 times earnings.

Whether it’s the sky-high multiple on Amazon’s maturing business, which seems to be discounting that every Chinese citizen will own a Kindle within 5 years, or the expectation that banks employing creative accounting have seen the worst of their credit losses, many investors are putting real money behind their belief in a super-bullish economic environment.

The reasons to be cautious and bearish are overwhelming. A market correction back to more normalized valuations may happen at any point.

Lastly, I attended the Value Investing Congress in New York last week, along with Addison Wiggin and Chris Mayer.

The most important takeaway for me was the audience’s apparent skepticism towards the two most bearish presenters: David Einhorn and Eric Sprott. Both hedge fund managers are bullish on gold and critical of Washington, D.C.’s wealth-diluting fiscal and monetary policies. The tone of the Q&A sessions after these presentations tells me that most investors are still very, very skeptical of investing in gold. That’s good news for gold bulls.

It’s also good news for stock market bears that so many believe in the Keynesian theories they read in their college economics textbooks. GDP growth driven by government spending is misleading, and damaging to capital formation. Much of today’s top line growth is coming at the expense of future profits — when mal-investments will be written off.

Regards,
Dan Amoss

October 28, 2009

Economic Misdiagnosis Due to Government Stimulus was originally featured on Whiskey and Gunpowder

But underneath the elation over Dow 10,000 lies the palpable feeling that this rally is to be “rented,” not “owned.”

As cool weather descended upon the Northeast U.S., risk appetites started to wane. At the beginning of October traders and investors finally sobered up. Were they second-guessing whether government spending could actually kick-start a sustainable recovery? Both stocks and corporate bonds sold off sharply.

Then today I woke up to these headlines:

“Stocks Climb as New Week Starts for Wall Street.”

“Hasbro 3Q profit rises 8.8 pct on cost-cutting”

“PetMed Express 2Q earnings rise 12 percent”

Here’s why you shouldn’t believe the hype…

Cost Cutting Does Not Equal Top Line Growth

Over the next several months, mainstream pundits and forecasters will start worrying about tepid hiring, even as the pace of job losses slows. As we “lap” the 2009 corporate cost cutting by early 2010, and top lines fail to rebound, earnings estimates will have to come back down. I’m amazed at how many sell-side analysts are modeling V-shaped recoveries in 2010 earnings. Most stock prices are simply disconnected from reality.

Sell-Off at the First Sign of Trouble

The bulls are now enjoying their victory lap after having bid the Dow Jones industrial average above 10,000 last Wednesday. It’s puzzling to see “investors” happy about buying into a market that’s clearly overvalued. A rational, disciplined investor would be fearful about buying today, after prices have been jacked up by an unprecedented seven-month rally.

Bulls see any cautious sentiment-that “rented rally” feeling-as a source of more untapped buying power, but I see it as a reflection of weak hands being the marginal buyers; at the first sign of disappointment, they’ll look to sell. My read of the sentiment surveys is that patient value investors are skeptical and bearish, while momentum investors are bullish simply because prices have been going up.

Fund Managers Won’t Ride to the Rescue

Despite the popular sentiment that “fund managers gotta keep buying into year-end to avoid underperforming,” which would keep this market in the stratosphere, the odds heavily favor lower stock prices in the coming weeks and months.

Data from reliable sources like TrimTabs show that not only is the labor market far weaker than advertised, but net inflows into stock mutual funds have slowed to a trickle, occasionally turning into outflows. This tends to give mutual fund managers itchier trigger fingers, since cash balances in equity mutual funds are already near record lows.

Pensions aren’t going to ride to the rescue either, since they were, with 20/20 hindsight, overinvested in stocks in 2007.

Buying Momentum Could Run Out

Momentum players face the prospect of having nobody-aside from another momentum investor-willing to buy their expensive stocks at today’s prices. Patient, disciplined investors are only willing to buy at much lower prices. This could lead to an air pocket where the market could correct dramatically and quickly, without an obvious catalyst — not that there is a shortage of bearish catalysts, ranging from bank failures to home foreclosures to a crisis in fiat money.

Some pundits point to corporate mergers and acquisitions as reasons to be bullish, ignoring that fact that most deals occur closer to the peak of markets, and most deals destroy shareholder value, because the buyer overpays.

Corporate CFOs and Treasurers are happy about the recent bull market in risk. They know much more about their prospects than outside investors, so their balance sheet management is telling. In a word, the approach toward capital structure is “defensive.” Heavily indebted companies are flooding the market with follow-on stock offerings to pay down debts. They’re also taking advantage of the Pollyannaish mood of the corporate bond market to issue risky bonds at attractive rates, as default risk seems to be a distant memory of bond buyers. Many corporate bond investors have taken the Fed’s bait to reach for yield, regardless of credit risk.

Most investors, however, have permanently dialed down their risk appetites, and therefore will not chase this expensive market. Those buying stocks at today’s valuations—especially U.S.-centric finance and retail stocks—will have a very hard time finding someone to pay an even higher price in the future.

Will Government Solve the Problem? No.

The big questions back at the beginning of the month: What kind of economic environment do we face? And more important, what’s already priced into the stock market? Here’s my view on these themes: As we see with “cash for clunkers,” government stimuli simply steal demand from the future.

Another big question is how will policymakers respond to a sluggish-to-nonexistent rebound in hiring?

The labor market is dealing with a structural imbalance fueled by government-sponsored housing and credit bubbles. Many will call for the government to “solve” this labor market problem, which will cause a new type of market dislocation. By early 2010, some will push for the federal government to start hiring the chronically unemployed in “New Deal” type of programs. [Count on this-Ed.]

But more importantly — because this is not yet a mainstream view — the real job creators in the U.S. economy, small businesses, will not expand hiring as expected. There are many reasons for subdued hiring plans; an emerging reason to avoid expansion and hiring will be heightened expectations that tax rates will soar in the future to pay for out-of-control government spending.

The economically illiterate, and those with preconceived “big government” agendas, will use any crisis as an excuse to expand government. You’ll be ahead of the game if you realize — as many in the media and academia clearly do not – that the government has no resources. It’ll take money out of one of your pockets, skim some off for its cronies, and expect you to be grateful when they put some of it-debased by the Fed’s inflation, of course-back into your other pocket.

Where you stand on this will determine your expectations for the future performance of most stocks (ignoring special situations). I certainly don’t enjoy having such a bearish outlook on the economy, but it’s the conclusion I reach after weighing all the evidence about the real economy; the credit markets; and policymakers’ damaging, distorting influence.

I’d recommend you adjust your portfolio accordingly.

Regards,
Dan Amoss

October 19, 2009

This Stock Market Rally Is Rented, Not Owned was originally featured on Whiskey and Gunpowder

Stock market bulls aren’t concerned about the inevitable acceleration in bank failures — at least for now. Even though deposits will be insured against loss, the loss of local banks will still have a depressing effect on hundreds of small communities. These communities are going to lose their only access to business credit when their local zombie banks — loaded with toxic construction or commercial real estate loans — are liquidated or merged into other weak banks.

Meanwhile, the latest monthly figures show that commercial bank balance sheets are shrinking at a fairly rapid rate, due to a combination of several factors: loan charge-offs, older loans are being paid back at a faster rate than new loans are being made, and regulators pressuring banks to build larger capital buffers.

So credit-fueled growth in consumption or investment is not occurring. Combine this with stagnant or declining wages and corporate profit margins and it becomes hard to imagine how GDP will rebound on a sustainable basis. GDP is the stat that every money manager fixates upon — despite the fact that GDP does not accurately measure true economic progress; it’s like evaluating a stock purely on sales growth, without thinking about what’s driving sales, and whether these sales are sustainable or accretive to wealth.

Nominal GDP is calculated as “consumption + investment + government spending + exports – imports.” Then, government statisticians subtract a highly doctored CPI figure from annualized changes in the above variables to get “real GDP growth.”

Note that all the variables in the GDP equation can be pumped up by excessive credit growth. As I mentioned in the Sept. 4 alert, if GDP is growing at the expense of degraded balance sheets, the end results are never happy. Japan’s GDP stayed higher than it otherwise would have been in the 1990s despite the incredibly wasteful spending on bridges to nowhere. Its policymakers reacted to a huge misallocation of capital into real estate in the 1980s by misallocating capital into government projects and subsidies to favored industries.

U.S. policymakers are following this playbook even faster, only without acknowledging one crucial difference: Japan had a high household savings rate to finance its government deficits, while the U.S. does not. Plus, the U.S. has already “dollarized” the rest of the world, and there are signs international demand for dollars has reached its saturation point.

The gold and commodities markets are reacting to this unpleasant reality. These markets are starting to discount the fact that the Fed will be the aggressive buyer of last resort for all types of debt securities. We’ve likely only seen the beginning of growth in the Federal Reserve’s balance sheet. As long as it can get away with it, the Fed will keep creating new money out of thin air to finance the U.S. federal deficit. Plus, via its liquidity facilities, the Fed and the megabanks will keep swapping Treasuries for legacy toxic securities marked at fantasy levels.

A few wild cards could disrupt this benign “reflationary” environment we’ve been in since the March stock market bottom, resulting in the stock market taking another nasty leg down:

1. If the “audit the Fed” bill were to pass and result in more handcuffs on the Fed, it would help to slow the reckless debasement of the U.S. dollar. But if it put an end to the Fed’s exotic lending facilities, which would force the owners of toxic securities to retain and mark them down sooner, then we could see a return to the January-early March 2009 stock market environment — only most of the damage would be contained to the financial sector as equity of insolvent institutions gets wiped out or diluted.
2. Contraction in the real economy and state governments could easily overwhelm expansion in the “federal government economy.”
3. International holders of trillions in paper U.S. assets could accelerate the rate at which they diversify into real assets. That’s how we could see a spike in “money velocity” that the deflationist camp says is a necessary condition for the CPI to rise. Most of the price pressure will be felt in oil prices, especially later in 2010 and 2011, when today’s underinvestment in new oil projects leads to tight international supplies.

I’d like to bring to your attention one more thing about today’s investing climate, because it’s being used so often lately in the media to justify today’s nosebleed stock valuations: the “money on the sidelines” fallacy. Growth or contraction in the current balance of $3.5 trillion in money market funds depends on how much companies look to borrow in the commercial paper market — not on the level of the stock market, as so many seem to believe.

Those who point to the $3.5 trillion in money market funds as if it’s a bucket that can be “poured” into the stock market bucket to keep the rally going do not understand that money does not go “into” or “out of” the market, but through the market. Trader A sells every share bought by Trader B. Once this transaction settles, cash goes one way and shares the other. The price at which the transaction takes place depends on how badly Trader B wants to own shares, not how many money market shares are in his account.

Also, money market fund balances represent very liquid short-term loans; they reflect an amount of money that’s already been spent in the economy and will be paid back over a very short time frame. John Hussman — one of the best mutual fund managers, in my view — refutes the “cash on the sidelines” fallacy best. It’s worth reading and remembering the next time you hear a talking head arguing that the rally can keep going because of liquidity.

Washington Federal Closes Offering; Now We Wait for Earnings

Yesterday, Washington Federal (WFSL) announced that its secondary stock offering would generate net proceeds of $333 million. This works out to a per share price of $13.79, including underwriting discounts and expenses and assuming full exercise of the underwriter’s overallotment. Here is an example of cash going “into” stocks, because these are newly issued, rather than existing, shares in the secondary market.

As I noted in Monday’s flash alert, I expect the offering will be necessary to absorb a mounting wave of net charge-offs in the future. It’s possible that this offering plan became a necessity after a friendly suggestion from regulators to raise more capital.

On Wednesday, WFSL stock rallied on high volume, but did not reflect organic demand for the stock. JP Morgan was the sole book-running manager for the Washington Federal offering. Knowing that it would likely receive a few million WFSL shares as a form of compensation in the underwriters’ overallotment, JPM’s trading desk probably established a short position that it plans to cover by delivering the shares it will receive upon the closing of the deal. This likely explains the bizarre trading moves in the stock this week: When institutions were more interested than expected, resulting in a higher offering price of $14.50, JPM likely covered some of their short position.

As for the analyst reaction to the offering, the two analyst notes I saw might as well be corporate press releases, because they expect this new capital to be deployed into an FDIC-assisted rollup of lots of zombie banks in the Pacific Northwest. Also, these analysts cite WFSL’s “strong” capital ratios without adjusting for future credit losses. One might suspect that these analysts have not even read the asset quality footnotes in Washington Federal’s SEC filings.

The big losses WFSL will take on construction loans are obvious, no matter how long management claims it will be able to sit on them. But what’s not obvious to the market — yet — is the rapid future loss formation in its $6.7 billion mortgage book. Management has set aside practically zero allowance for loan losses against its mortgage book. See the chart below for the allocation of WFSL’s allowance by loan type.

WFSL carries a mere $18.8 million loss allowance against its $6.7 billion book of mortgages — a ratio of just 0.28% of assets. The harsh reality of the mortgage crisis tells us that this $6.7 billion asset value is overstated, along with capital ratios (or equity); it should be marked down by far more than $18.8 million. Yet WFSL’s accounting translates as follows: Management does not expect more than $18.8 million in cumulative credit losses in mortgages (defaults, net of recoveries after foreclosure) through the rest of this credit cycle, despite the fact that the majority of these mortgages are now underwater and the job market remains weak.

As you can see in the chart, the ratio of loss allowance to nonperforming loans (by category) has shrunk dramatically. In December 2007, WFSL’s residential mortgage loss allowance was $13 million, and its nonperforming mortgages were also $13 million. As of June 30, this loss allowance had been built up to $18.8 million, but nonperforming mortgages had grown to $119 million (and will keep growing). This loss coverage ratio has shrunk from 100% to 16% over the past six quarters (as shown in the chart’s blue line) and needs to be built back up to a respectable level. And the only way for WFSL to build it up is to book large credit provision expenses in future income statements.

Washington Federal’s “strong” capital ratios are a function of hopeful accounting. I expect the market to come around to this view — not only for WFSL, but also for the entire banking sector. Ever since the loosening of mark-to-market accounting rules last April, the creators and users of financial statements have collectively chosen to deny reality and bury their head in the sand about the future direction of market values for collateral backing loans — and the value of the loans themselves.

Everyone is waiting and hoping for a miraculous rebound in housing prices and the labor market, when we have yet to see the bottom in either. When reality sets in, this will not end well for owners of bank stocks, REITs, and other financial stocks. These stocks are claims on assets that are marked to fantasy levels.

Mark-to-market suspension has slowed the rate at which losses are recognized, but this self-delusional accounting practice cannot make the losses disappear, and will likely make these cumulative, stretched-out losses even bigger in the future by rationing credit to the healthier parts of the economy.

Regards,
Dan Amoss

September 23, 2009

GDP’s Debt to Credit was originally featured on Whiskey and Gunpowder

Drivers in the U.S. no longer determine the global price of oil. So oil prices can remain high despite a weak labor market — as we saw in the 1970s. If this winds up being the case, it’s bad news for owners of financial and consumer stocks and good news for owners of energy stocks.

Andy Xie, formerly of Morgan Stanley, is a great strategist who, while most other economists sought to justify the housing bubble, warned of the unsustainable U.S./China vendor finance trade model that grew so rapidly between 2001-2008. He recently wrote an article for Caijing magazine on the factors that might drive oil prices in the future. He writes:

Conventional wisdom says inflation will not occur in a weak economy: The capacity utilization rate is low in a weak economy and, hence, businesses cannot raise prices. This one-dimensional thinking does not apply when there are structural imbalances. Bottlenecks could first appear in a few areas. Excess liquidity tends to flow toward shortages, and prices in those target areas could surge, raising inflation expectations and triggering general inflation. Another possibility is that expectations alone would be sufficient to bring about general inflation.

Oil is the most likely commodity to lead an inflationary trend. Its price has doubled from a March low, despite declining demand. The driving force behind higher oil prices is liquidity. Financial markets are so developed now that retail investors can respond to inflation fears by buying exchange-traded funds individually or in baskets of commodities.

Oil is uniquely suited as an inflation-hedging device. Its supply response is very low. More than 80% of global oil reserves are held by sovereign governments that don’t respond to rising prices by producing more. Indeed, once their budgetary needs are met, high prices may decrease their desire to increase production. Neither does demand fall quickly against rising prices. Oil is essential for routine economic activities, and its reduced consumption has a large multiplier effect. As its price sensitivities are low on demand and supply sides, it is uniquely suited to absorb excess liquidity and reflect inflation expectations ahead of other commodities.

Xie’s entire article is worth a read. You can find it at this link.

The Chinese government is sending strong signals to its banking system that it wants lending to slow down from its blistering pace. It remains to be seen whether this will actually result in a contraction in Chinese bank lending or whether lending may just shift from one sector to another. If I had to guess, I think oil prices will have a sharp correction this fall as Chinese stockpiling slows down and as oil and refined product inventories remain more than adequate to meet sluggish U.S. demand.

But this correction will offer trading and investing opportunities on the long side. As you see in the two charts below, the linkage between oil prices and U.S. inventories during the entire post-2002 bull market was not as close as you’d expect:

Here’s why I think a correction in oil prices will offer a buying opportunity: Inflation fears and stabilizing in global demand are not the only reasons the price of oil has doubled from its lows. Oil prices are up because the marginal cost of new supply — including from Canadian tar sands and from under thousands of feet below the ocean surface — is so high.

To Andy Xie’s important point about oil as an inflation hedge, I’d add that OPEC planners understand that they are trading a scarce, extremely energy-dense, nonrenewable, depleting asset for paper money. They also are beginning to grasp that indebted oil importers plan to ease their debt burdens by employing the heavy guns in the inflation arsenal: “quantitative easing.” So their portfolio preferences will shift away from government paper and toward retaining scarce oil in the ground for future revenues. In other words, “Why should we trade oil for dollars now if we receive higher prices five years down the road?”

This is just one of the many intricacies governing how the global oil market operates, and it helps explain why those who are perpetually bearish on oil prices waited for years and years for a rational, free-market supply response to higher prices that never arrived in force. That is, until last fall’s panic brought demand far enough below supply that prices crashed. Now, the conventional wisdom says that several million barrels per day of spare OPEC capacity will keep a lid on prices for years. We may discover by next year just how quickly this alleged spare capacity will come back online, and at what price.

The question then becomes why should national oil companies rush into the risks of making the enormous capital investments necessary to maintain production — let alone grow production. Nancy Pelosi and Ben Bernanke are not promoting policies to make energy cheaper; in fact, their playbooks virtually ensure the opposite. Privately owned exploration and production (E&P) companies that take smart risks will be the ones that deliver more supply at lower prices to help ease supply constraints.

Now, when you consider how the U.S. economy currently functions, you come to understand that rising energy prices induce enormous headaches for practically every consumer and business. Call rising energy prices a “deflationary force in the real economy” if you like. The point here is the irony of the situation: The Fed and Treasury are trying to reinflate a deleveraging private economy, and much policy could wind up accelerating the deleveraging process by adding pressure to the prices of nondiscretionary items like food and energy. After all, these are both global commodities, and capacity in these sectors is tighter than most market participants realize.

Bottom line: There is no easy, painless way out of a credit-financed asset bubble that artificially pumped up consumption. This artificial growth in consumption prompted entrepreneurs to misallocate resources into unproductive sectors that were temporarily pumped up by what looked like sustainable demand. Meanwhile, there are many sectors, including oil and gas, that have been underinvesting relative to the long-term global demand for mobile, modern lifestyles.

Sure, oil prices could correct sharply this fall as traders panic about a temporary glut in aboveground supply at storage terminals. But to use manufacturing terms, it’s the “raw material” and “work in process” inventory that really matters. That type of inventory, sitting higher up in the supply chain, is much tighter than the “finished goods” inventory sitting in storage terminals like Cushing, Okla. I expect we’ll see this tightness reflected in prices by 2010, even if demand remains stagnant.

Production capacity in oil and gas looks plentiful right now, but capacity naturally falls every year, and requires hundreds of billions in global capital expenditures just to keep supply steady. According to an exhaustive analysis published by Neil McMahon of Bernstein Research on Aug. 10, non-OPEC oil supply will keep declining in the coming years, despite healthy levels of investment. Outside of OPEC (where information regarding capacity and investment plans is murky at best) explorers are targeting smaller formations, as production from giant, decades-old fields declines. McMahon writes:

In the long term, we believe that oil prices will increase in line with the marginal cost of supply, which continues to rise as the complexity of new wells increases and production rates from established fields decline. Basically, not enough significant discoveries have been made in non-OPEC countries in recent years to help the supply situation before 2015. Additionally, flow rates from the few discoveries that have been made do not give rise to much optimism and, as in the past, the drop in absolute oil demand will be offset by rapidly declining mature field production with the recent fall in industry spending. So the continued decline in non-OPEC supply will provide an additional support for prices, as it feeds through to OPEC spare capacity. We believe that 2010 will see the next inflexion point in prices, as OPEC spare capacity begins to decline and demand shows positive growth for the first time in a number of years and we expect to see oil average $80 in 2010, $103 in 2011, $111 in 2012, and increasing to $140 in 2015.

You can imagine what this type of price trajectory will do to U.S. businesses that rely on cheap fuel, and have no ability to push through price increases. Considering how many more trillions of U.S. dollars will be floating around the global economy in 2015, and savers’ willingness hoard them declines, $140 per barrel might be conservative.

Global oil production capacity, rather than demand, will eventually drive prices. Bernstein projects 2020 oil production capacity will be about the same as it is now: 85 million barrels per day. We must consider net exports too; the global trade flows of this oil will certainly change. Over time, more tanker shipments will be diverted away from the U.S. and Europe and head to Asia. Also, in recent years, OPEC countries have been consuming more of their own product at home. Plus, the Chinese government has shown that it will beat any and all comers in the competition to secure supply under long-term contracts.

Regards,
Dan Amoss

August 28, 2009

Inflation and Oil Prices: Our Next Move was originally featured on Whiskey and Gunpowder

Consider this likely scenario: The heavy retail investor inflows into corporate bond funds last spring (far in advance of the peak in defaults, by the way) undoubtedly helped push corporate bond spreads down. The quant funds’ models detected this movement, concluded that the recession might be over, and proceeded to buy stocks that are highly sensitive to future U.S. consumer spending — including banks and REITs. This scenario likely explains some of the rally in bank and REIT shares, which occurred far in advance of the peak in credit losses.

This type of scenario could easily reverse this fall as experienced stock and bond fund managers start to question why they own barely solvent financial companies at valuations that imply 4-5% real GDP growth over the next two years. Huge swathes of the financial sector are insolvent (the mark-to-market value of assets is less than liabilities), and the debate over mark-to-market accounting boils down to whether losses should be recognized up front or over long periods of time. The losses are not going away, and were baked in the cake as soon as the bubble-era loans were made.

Last fall’s panic was not really a “black swan” event; it was the realization that much of the banking system was insolvent and at the mercy of electronic bank runs. Last fall, I thought that at the very least, the authorities had a plan to wind down Lehman in a controlled manner. Instead, Lehman went into forced liquidation and took the “shadow” banking system down with it. Our Lehman puts were huge winners, but even I was surprised at how quickly Lehman stock went to zero.

The issue facing REITs parallels that of the banks: an industry-wide solvency crisis. Only REITs lack access to enormous subsidies from the Federal Reserve, which include the manipulation of borrowing rates down to the range of 1%, resulting in a profitable spread on new lending.

If you carefully consider the combined statistics on commercial mortgage debt, equity, and future rental cash flows, you come to the conclusion that the value of many REITs is permanently impaired. Even if a core group of higher-quality REITs escapes bankruptcy, their equity will still be impaired because lenders will only refinance properties on very tight terms: strict covenants, high interest rates, and requirements of hefty equity infusions into upside-down properties. This is a transfer of wealth from REIT shareholders to creditors. This wealth transfer is occurring through many channels, but the most important one relates to claims on future rental cash flow, which will be bleak regardless of who owns it:

1. Creditors will take a higher share of those rental cash flows via higher interest rates
2. Of the cash flows that trickle down to shareholders, they will be divided up among more and more REIT shares as we see more and more dilutive secondary offerings

This unprecedented collapse in commercial real estate fundamentals means that for the next few years, you can throw out the analyses that rely on “cap rates” to value REITs. Distressed sellers and vulture buyers will make up the bulk of commercial real estate transactions for at least the next few years. Equity looking to invest will be scarce, so it will demand very low prices and high potential returns to invest.

Between now and 2013, $1.6 trillion in commercial real estate debt will mature. Bankers know this, so they’re going to keep conditions very tight for any refinancing that they grant. Plus, a hefty chunk of this debt is held by commercial mortgage-backed securities (CMBS), in which the lenders cannot sit across the table and renegotiate with stressed borrowers; owners of senior CMBS tranches will want to liquidate the collateral to get paid back, while owners of the junior tranches will want to refinance and pray for a recovery in value. I expect the motives of the senior lenders to win out, resulting in lots of property liquidations.

REITs Selling Must Compete to Dump Properties

Lots of REITs have plans to sell properties to pay down debts but… Sell to whom? And at what sort of price? Yet REIT investors seem unaware the hundreds of billions in new equity that creditors will require to refinance mortgages that were made during the 2006-2007 peak in values — and what that catalyst will do to the value of their equity.

On Wednesday, The Wall Street Journal ran a story that relates to this theme: “Tishman Faces Office Downturn.” Link in Web Version Only. The article describes the tough choices facing privately owned real estate investment partnership Tishman Speyer, which owns Manhattan landmarks like the Chrysler Building and Rockefeller Center.

Tishman also owns a levered portfolio of Washington, D.C., properties named CarrAmerica. You’d think that with all the crony capitalists flocking to Washington the lobbying business is booming. But apparently, even lobbying is not a strong enough business to justify CarrAmerica charging the pricey rents it needs to pay its mortgages. The WSJ describes the financing problem:

The Tishman partnership that bought the CarrAmerica portfolio has been in talks with its lenders, led by Lehman Brothers Holdings Inc., since late 2008 about modifying the credit agreement, according to S&P. But so far, nothing has happened and, until now, the talks have been kept quiet. “We have confidence in the long-term value of the properties,” Rob Speyer said.

S&P warned even if Tishman wins new covenants, its ability to refinance the loans in 2011 “will likely require additional capital investment or a recapitalization.” [emphasis added]

The Tishman mortgages were one of many credits that Lehman was marking at fantasy levels. As it turns out, the bears on Lehman were right: The loans that Lehman provided to Tishman to finance its acquisition of Archstone-Smith were impaired soon after they were underwritten.

What will the Tishman family do about its privately held portfolio? How much debt is carried against Tishman Speyer’s properties? I get the impression that it’s a lot, considering Tishman’s aggressive behavior at the market peak (as opposed to, say, Sam Zell, who unloaded a ton of properties onto Blackstone and Maguire, which will both wind up losing most or all of their equity). Tishman Speyer will probably hit a lot of low bids on its second-rate properties to raise the cash that banks will require as new injections in order to refinance — and keep to deeds to — its trophy properties.

The smart money in commercial real estate — including Sam Zell — certainly sees the mountain of debt maturities coming down the pike. Investors will certainly be looking for bargains in commercial real estate, and they will find the best deals in either foreclosure auctions or purchasing commercial mortgages from stressed banks at a discount.

Regards,
Dan Amoss

August 27, 2009

REITs Racing to Bankruptcy was originally featured on Whiskey and Gunpowder

Right now, the market has priced bank stocks for perfection, but the earnings outlook remains bleak. Investors are excited about the wide yield curve that’s enabling banks to borrow at ultra low rates and lend at much higher rates. But starting a few years ago — and going forward a few more years — losses on loans made during the bubble will matter more than the wide yield curve. More bank failures, capital shortfalls, dividend cuts and shareholder dilution are in the cards for most bank stock fans.

Because bank stocks usually act as a canary in the coal mine, a continued bear market in banks translates into a continued bear market in most other stocks. The evidence tells me we’re experiencing a bear market rally, not a new bull market. The promoters of the idea that this is a new bull market are ignoring one of the worst enemies of stocks: uncertainty. Right now, especially considering aggressive government policies, uncertainty about the future business environment is very high.

As regular readers of Whiskey & Gunpowder know, the government’s land grab is going to make things worse. It seems that there’s no end to the threats facing corporate profits, which will make corporate loans that much harder to pay back. This is not a garden-variety recession. It’s more like a depression, so the so-called economists parroting the “recession is over” message will have a rude awakening soon enough.

Let’s briefly consider the sentiment toward overall market. Aside from the investor sentiment polls, you can tell how bullish investors are by the multiples they are willing to pay for stocks. And right now, after the sharpest 5-month rally since the 1930s, the market is trading at valuations that require a strong economic recovery, and a return to credit bubble conditions. The rally was powered entirely by P/E multiple expansion, not earnings growth. That sort of rally would be justifiable if corporate revenues and earnings were about to soar, but they’re not. Most earnings surprises were due to cost cutting, rather than top-line growth, which is like burning your furniture to stay warm.

The market is not even that cheap when you consider how artificially inflated earnings were at the 2007 peak. Financial earnings made up 18% of the S&P 500’s earnings in 2007 — much more if you add the “earnings” from the finance divisions of industrial conglomerates like GE and GM. Any claims that the S&P 500 is cheap because 2007 somehow represents “normalized earnings power” are bogus. The corporate profit margins and earnings won’t return to that level for many years.

The talking heads are getting more creative in their rationale for owning stocks right now. Most money managers seem to be thinking: “I don’t believe in this rally, but I’ll ride it until it looks like it’s over, and then I’ll sell.” This is the type of dangerous crowd psychology that consumes most people during bubbles. When enough investors share this Ponzi sentiment, and nobody’s investing on the basis of sober, rational fundamental analysis, the result is sometimes a crash.

Bank Accounting: Educated Guesses about the Future

This brings us to the poor quality of earnings, particularly at commercial banks. Accounting — especially the accounting that produces income statements at banks — is more art than science. It’s as much opinion as it is fact. Bank executives have a lot of leeway in how and when they recognize credit losses. As you’d imagine, some of them have more creative imaginations than others. Some are actively engaging in “extend and pretend,” a practice in which banks refinance deadbeat borrowers to avoid reporting loan losses.

Banks make loans expecting to receive interest and principal payments in a timely fashion. Banks book revenues, expected credit and operating costs, and profits associated with every loan upfront. But as we’ve discovered, the credit costs, or losses, often wind up being much larger than originally expected. When this happens, banks must dramatically ramp up their “loan loss provision” expense, which cuts into earnings, often pushing earnings into the red.

So the ultimate credit costs associated with bank revenues often take a year or more to be reflected in earnings and capital cushions. That’s why regulators require banks to maintain an “allowance for loan losses.” This allowance is a contra account on the asset side of a bank’s balance sheet, and its purpose is to absorb credit losses from loans as they run through the default and recovery phases. Loan losses, net of recoveries, deplete the allowance. Banks can rebuild their loan loss allowance by booking larger provision expenses, but this process cuts directly into earnings.

The chart below shows how under-reserved banks are right now, so they still have a ways to go in accounting for the losses on loans made during the bubble. These numbers are the combined figures for over 7,000 U.S. commercial banks insured by the FDIC. In blue, you see the combined loan loss allowance climbed to $156 billion by the end of 2008. In red, you see that noncurrent loans — the raw material for credit losses — had soared even faster to $200 billion by the end of 2008, and are still climbing sharply. As a rule of thumb, to remain well capitalized, and to prevent their allowance from shrinking to dangerously low levels, banks should book provision expenses in line with the increase in noncurrent loans.

But since the credit crisis began, this has not been happening. As the green line shows, the ratio of loss allowance to noncurrent loans for the entire banking system has fallen below 100%. To rebuild the industry wide loss allowance back up to an adequate level, provision expenses will have to rise faster than delinquencies. Some banks can only catch up by raising new capital from investors. Those banks that are too far behind, and cannot raise capital, will be taken over by the FDIC. All of this translates into a strong headwind for bank earnings over the next few years.

Recall that bank executives have lots of control over the timing of loss recognition. Evidence that banks are delaying loss recognition is springing up all over the place. For instance, some banks that provided unsecured revolving lines of credit to highly indebted REITs have waived some restrictive loan covenants. In residential mortgages, we’ve seen lots of instances where banks are stringing along underwater homeowners with modifications that do little more than kick the can down the road.

It would make more sense to restructure mortgages on underwater properties where the bank receives a property appreciation right in exchange for a large reduction in mortgage principle. This makes more sense from a societal perspective, and would help accelerate the return to a healthier, less “zombified” banking system. But this idea is not popular among bankers, because doing so would force the bank to immediately recognize lots of losses, which could cut heavily into the bank’s capital.

This state of bank accounting is not limited to the U.S. In fact, in some instances, the accounting at some foreign banks is even more detached from reality than it is in the U.S. For readers of Strategic Short Report, I recently uncovered a non-U.S. bank that’s been especially tardy in disclosing its credit losses. It’s a very attractive short sale right now, especially because the market loves this bank, and is totally ignoring the wave of credit losses to come in the near future.

Regards,
Dan Amoss

August 13, 2009

Bank Accounting Fudges Loan Losses was originally featured on Whiskey and Gunpowder

Predictably, we’re likely going to see the addition of another big bureaucracy in reaction to a crisis partially caused by a poorly structured banking system and toothless enforcement of existing regulations. The answer to the sloppiness of bureaucratic regulators is, apparently, another layer of bureaucratic regulators. Regulatory reform will not be effective if its architects incorrectly diagnose how the system blew up under the existing system of oversight.

The popular narrative is that that the financial crisis was a failure of the free market, but this narrative glosses over the fact that banking is far, far from a free market. Those who describe the banking business as a wild, woolly free market simply do not understand how banks operate — especially how, with government subsidies and backstops giving them the confidence to make insane loans, banks had grown large enough to blow up the entire global economy.

Last year was less of a failure of free markets than it was the failure of the “shadow” banking system built on a weak foundation: bankers’ lack of connection with the risks they underwrote, government guarantees and tax incentives for mortgages, and misapplication of statistics to exotic fixed income securities, to name just a few things. The shadow banking system could not have grown as large and dangerous as it did without banks’ subsidies from taxpayers and the Fed’s manipulation of the price of money. The Fed’s interest rate targeting creates illusions about default and liquidity risks and distorts the natural relationship between savings and capital investment.

The banking system shares much in common with the federal government, especially in their common isolation from the discipline of the free market; Free market discipline refers to the fact that if you make mistakes, your customers will let you know about it by leaving, and if you don’t reform and improve your product or service, you’re out of business. By promoting competition, free market discipline imposed on business has done more for “the little guy” than any government handout by spurring advances in productivity and living standards.

The banking system hasn’t been subject to free market discipline for decades, and it’s still not. Case in point: Bank bondholders and shareholders were bailed out — at taxpayer expense — from the consequences of their poor lending and investing decisions.

Unlike most businesses, banks don’t earn their profits by serving customers, but mostly by extracting huge economic rents from savers and borrowers. Otherwise, the financial system couldn’t have grown to be such a large percentage of GDP.

Banks are supposed to be intermediaries between savers and borrowers, allocating credit in a manner at prices (interest rates) in line with default risk. But they largely failed in this role. Most banks — especially the “too big to fail” banks — did a horrifically poor job of pricing credit risk at the peak of the credit bubble. Credit spreads were ultra low in early 2007, when it was one of the riskiest times in history to be making loans.

How did the banking system make such colossal errors in judgment about credit risk? I described a few critical weaknesses in the banking system in a September 2007 Whiskey & Gunpowder article (see link here). It wasn’t rocket science to figure out how interest rates were sending a distorted signal about credit risk; all you needed to do was follow the new credit back to its ultimate source and ask the right questions about the connections (or lack thereof) between saver and borrower. One would think thousands upon thousands of federal banking regulators — and those responsible for designing our financial regulations — would have the resources at their disposal to identify the structural weaknesses in our financial system.

Unfortunately, instead of providing a road map to designing a system that connects savers with borrowers in a more sane, responsible manner, it looks like the proposed banking reforms will give us more of the same. Such economic power concentrated in the hands of banks not subject to enough free market discipline is a problem, and the real economy will likely suffer from it.

Regards,
Dan Amoss

June 23, 2009

Banking, the Federal Government and the Free Market was originally featured on Whiskey and Gunpowder

Dozens of stocks come to mind that were sold down to insanely cheap levels as hedge funds scrambled for cash. That scramble is probably not over, so we may be in for more turbulence. Plenty of stocks come to mind that are still trading too high relative to their earnings potential. We’ll be looking to bet against those in 2009. Plus, many companies will not make it out of 2009 without going through bankruptcy. I expect to find a few more “short to zero” stocks — like Fleetwood Enterprises (NYSE: FLTW) — in 2009. We sold Fleetwood short in March at $4.43 and covered in October at 27 cents, for a 94% gain.

When asked by family and friends over the holidays what I think about the 2008 stock market and economy, my response has been, “I expected a nasty bear market in 2008, but the carnage since September took me by surprise. The economy will remain weak, but I think the worst of the widespread market carnage is behind us. Future damage should be concentrated in sectors with horrible fundamentals. Thankfully, 2009 should be a year when fundamental analysis should start to matter once more.”

This will be a welcome development, because 2008 was a year when the following strategy worked best:

1) Sell short any stock or ETF, without bothering to do any fundamental research
2) Invest the proceeds in Treasury bonds, preferably with as much margin as possible
3) Repeat Steps 1 and 2, over and over.

Clearly, this “deflation trade” strategy is not sustainable over longer time frames — not in an era of worldwide paper money standards. In fact, I’d expect that such a shotgun-based investment strategy of short S&P 500/long Treasuries could lead to big losses in 2009.

I think the key to approaching 2009 markets will be to view everything form the perspective of the Treasury and the Fed. Everyone knows that the real economy stinks and that America is overly indebted. But I doubt everyone realizes just how extreme Treasury/Fed will be in using the deficit and the paper money system to stop the Great Depression II scenario. Theses tactics will be inflationary at some point.

The U.S. banking system became destabilized because its core collateral – houses and mortgage-backed securities – collapsed in 2008. While the authorities may not be able to re-inflate old bubbles in these assets, I’m betting they can employ cheap Treasury financing to cushion the decline. This involves refinancing homeowners out of toxic mortgages into conventional mortgages. They’ll also find some way to deal with the problem of negative home equity, even if it involves highly inflationary tactics like Treasury assuming losses from principal reductions via Fannie and Freddie. And even if foreigners balk at absorbing new Treasuries, the Fed will monetize them – i.e., buy them itself. Again, these tactics would be highly inflationary.

So let me enumerate a few predictions for the New Year:

1) It’s far too easy and popular to be bearish on everything but Treasury bonds, so odds favor a sharp rally in early 2009 — a rally in the S&P 500, led by stocks with the most sustainable fundamentals, including energy, commodities, and infrastructure. Stocks with weak fundamentals may participate, but quickly roll over as economic reality sets in. Many will go to $0 in bankruptcy.

2) The SEC will suspend mark-to-market accounting, or at least modify it to allow more management discretion in marking values of securities. The era of wholesale shorting of financial stocks is likely over. A massive wave of refinancing is also a backdoor way to recapitalize the banking system; perhaps the most efficient way to increase the value of exotic mortgage-backed securities, (and bank capital) is for many of the mortgages backing these securities to “prepay” upon refinancing. Bankers will re-emerge from their bunkers and look to make new loans to creditworthy borrowers, since a sub-1% cost of funds courtesy of the Fed is too low to ignore.

3) Oil will rebound to $80 per barrel on lower than expected production, despite weak demand. If demand rebounds, oil could go to $120.

4) Gold will rally beyond $1,200 on weakness in the U.S. dollar, unprecedented Treasury bond issuance, and tepid foreign demand for U.S. dollar assets. Weaker foreign demand for Treasury bonds will prompt the Fed to step in as buyer of last resort and monetize debt. In its December policy statement, the Fed signaled that if foreign lenders look to sell Treasuries, it would step in as a buyer to keep rates low. If this happens, more savers and bond fund managers will look to invest in inflation hedges like gold and energy.

5) Many more hedge funds will fold in 2009, but this is good for the long-term health of the market. Most of the new funds should not have been started because they just went “long” everything on margin. Their closure will result in a more efficient – and less volatile – market.

6) 2009 will be a “stock picker’s” market. Nothing worked consistently in 2008 other than indiscriminate shorting of stocks and buying of Treasuries. The worst of the wholesale liquidation of stocks is likely over, so 2009 will offer lots of opportunities to buy and sell short individual stocks using fundamental analysis.

That’s the good news…So let’s end on that note.

Regards,
Dan Amoss

January 12, 2009

Stock Strategies: Random Predictions for 2009 was originally featured on Whiskey and Gunpowder

Yet their demise hurts anyone trying to manage an investment portfolio in a prudent manner — similar to how Bear Stearns and Lehman Brothers permanently stained the entire investment banking industry. It’s a case of a few bad apples spoiling the whole barrel. Unfortunately, it remains to be seen how regulators and politicians will punish every investor, including those who have acted prudently.

For example, I just read a publicly released copy of a letter dated Oct. 2, sent from the U.S. Congress to Harbinger Capital Partners. It asks Phil Falcone of Harbinger Capital to reveal practically everything that’s confidential about his funds and to testify before a committee. Let’s hope U.S. regulators don’t take action to drive even more investment talent overseas, because we need them here to help keep our markets efficient.

It amazes me how long this environment of panic has lasted. Last Thursday was one of the most violent days I’ve ever experienced in the markets, including the bursting of the tech bubble, and the turmoil continues this week. Quality companies in the oil services, coal, steel, and agriculture sectors were liquidated in violent fashion — many of them down 20% in a day and 50% over the past month. These are real companies performing vital functions necessary to keep the lights on and food on shelves, not speculative Internet stocks.

The list of victims includes companies that are very likely to deliver good earnings over the next few years. The list includes several of the stocks I’ve recommended in past issues of Strategic Investment, and still follow closely. If you’re a long investor, there are some screaming bargains out there — unless, of course, half of the world’s population stops using food, electricity, and oil. I doubt that will happen in a world of unfettered deficits and central banks, but anything’s possible. I’ll have more to say about this in an upcoming issue of Strategic Investment.

For immediate ideas, I strongly recommend considering the long list of bargains that my colleague Chris Mayer has recommended in Capital & Crisis and Mayer’s Special Situations. It’s mind-boggling how cheap some of them have become. Chris is an excellent stock picker. He goes to great lengths to find safe, cheap investments.

Government Inflation vs. Private Deflation

The money managers that survive this environment will probably look to own some of the dirt-cheap stocks in the energy, commodity, and agriculture sectors, rather than expensive stocks that thrived on spending from home equity loans. Once this credit market panic subsides, I expect we’ll see this shift in sector focus. Fund managers will have to start distinguishing between earnings that resulted from fake, bubble-induced consumption, and earnings that resulted from real, sustainable demand. I’m looking forward to earnings season, when analysts and fund managers can finally get some guidance about which companies’ earnings will hold up best during this recession.

Even the best fund managers and stock pickers in the world — several of them listed in this Bloomberg article — are down for the year. A few of these managers saw the credit crisis coming, and made nice profits shorting financial stocks. But the SEC’s totally arbitrary rule changes in recent weeks have created an environment that’s very difficult to navigate.

The SEC’s short selling ban has not changed much, other than taking efficiency and liquidity out of the market. For example, Allied Capital was on the “do not short” list. Yet it crashed earlier this week upon announcing the bankruptcy of Ciena Capital. That was a case of long investors all trying to squeeze out of a narrow door of liquidity.  It was not a “short attack.”

Uncertainty about the banking system is causing this panic in the credit markets. Innocent bystanders are suffering from the fallout from this credit bubble.

For example, I’ve read several accounts of hedge funds whose assets are stuck in the black hole that is Lehman Brothers’ balance sheet. I’m not referring to people who own Lehman bonds, I’m referring to funds that had custodial agreements with Lehman. Custodial agreements are supposed to ensure that Lehman could only execute trades for the pool of assets under its custody — not take actual possession of the assets.

It seems that in the days and hours before declaring bankruptcy, Lehman moved certain assets — many of which it did not own — to its subsidiaries all around the globe. Now, hedge funds with no perceived credit exposure to Lehman are joining the line of creditors, fighting to get their clients’ assets back in bankruptcy court.

This total destruction of confidence in counterparty risk is the reason why credit is drying up. So what has the Federal Reserve been doing as the lender of last resort?

It has nearly doubled the size of its balance sheet in the past few weeks. The Oct. 3 issue of Grant’s Interest Rate Observer describes:

“After a flat-footed start, [the Fed] had shown its ability to degrade its balance sheet by selling off its Treasuries and acquiring dubious mortgages. But it had not really put its back into dollar debasement. The sum total of its earning assets, i.e., Reserve Bank credit, was rising at year-over-year rates of just 3% to 4%. Where was the push to print up enough dollar bills to smother the debt crisis of 2007-8 — assuming the problem was susceptible to smothering through money printing?

“Mystery solved: Reserve Bank credit is suddenly flying. It surged by $203.6 billion, to $1.135 trillion, in the banking week ended Sept. 24. And if Merrill Lynch’s guess is on the mark, it has soared to $1.730 trillion in only the past few days, a near doubling since May 2007 [emphasis added], when the latent crisis became manifest.”

After the panic subsides, the Fed will rein in much of this new money. Right now, banks are “stuffing it under the mattress,” so to speak. Banks and individuals are crowding into the perceived safety of Treasury bonds. That’s why consumer prices aren’t immediately rising; private market credit is contracting as fast as the Fed’s balance sheet is expanding. The Fed will always lend when no one else is willing to do so. “The U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost,” said Fed Chairman Bernanke in November 2002. This means that there will always be paper money available to lend. However, the U.S. dollar is getting debased on an unprecedented scale.

The printing press may be the only way to prevent a self-sustaining credit panic, but it doesn’t come without a price; it lowers the U.S. dollar’s stature even further in the eyes of our foreign creditors.

I’m betting that government inflation will defeat private market deflation. However, when the dust settles, I expect the Treasury and Fed to have its own set of negotiations with foreign creditors. The obligations they are assuming and monetizing are simply too enormous without inciting a potential panic among our generous foreign creditors. Maybe we’ll see a Bretton Woods-type agreement in 2009 — one where the U.S. dollar is devalued by 50% against certain foreign currencies overnight.

Best regards,
Dan Amoss, CFA
October 9, 2008

Strong Resource Companies Will Survive… The Dollar May Not was originally featured on Whiskey and Gunpowder

“Give me control of a nation’s money and I care not who makes her laws.”

— Mayer Amschel Rothschild

Let’s observe a moment of silence to mourn the slow demise of capitalism in the U.S.

Our government is now overtly manipulating the stock market. We have “crossed the Rubicon.” We can no longer pretend to be a free market capitalist country while also maintaining confidence in the U.S. dollar as reserve currency. After this panic subsides, the investing environment will be very different.

Make no mistake about it: The last two weeks will go down as one of the most pivotal periods in financial history. The financial landscape has changed so dramatically that few have had a chance to catch their breath. I’ve spent the entire last week reading and thinking through the free market’s ultimate response to this unprecedented, rapidly changing situation.

Last week, the SEC announced a temporary ban on new short sales in 799 specific financial stocks. Short selling is one of the most important weapons in an investor’s cache. It allows the market to react to foul play and sloppy corporate leadership. This is an even more important tool to use against poorly run small caps. That’s why this ban is so significant.

Before I go on, let’s first clear something up: This new ban doesn’t mean that existing short positions must be covered. But many are clearly closing short positions to limit risk anyway. The SEC might well have sparked a panic liquidation in other areas of the market, as hedge fund managers liquidate long positions to offset losses on short positions. As I write, the market is well off its highs just one hour into Friday’s trading day. Odds are good that the SEC will realize that its decision only sucked a huge amount of liquidity out of the stock market and reverse its decision to something more sensible, like reinstating the uptick rule.

While on the subject of the SEC’s new short selling rule, allow me to state the obvious: Short sellers did not bring down the investment banks. Once the investment bank executives made the decision to operate their balance sheets like Long-Term Capital Management on steroids, the writing was on the wall. They relied far too much on “quant” models, rather than good old-fashioned common sense.

Rather than target the individuals who had been warning about this situation for years, why doesn’t the SEC investigate the proprietary trades of the banks’ trading desks? I’d expect it would find evidence that the investment banks were short selling each other’s stocks at the same time that they were cutting each other’s lines of credit. In the autopsy of Lehman Brothers’ balance sheet, we have discovered that Lehman management wildly overvalued its toxic assets. Why wasn’t this taken as evidence that the lack of transparency at investment banks is at the root of last week’s crisis?

The SEC’s decision to ban short sales of financial stocks is throwing sand into the markets’ gears. Like most government action, it pays lip service to consequences. Convertible bond traders use short selling to hedge equity risk. After this ban, the price of convertible bonds will probably fall.

Hedge fund managers use short sales to offset the risk in holding long positions. After this ban, fund managers will have to use other means to cut risk, which include selling off huge chunks of their long positions.

Finally, at market bottoms, short sellers provide demand for stocks when they buy to close out short positions. Without this buying pressure, the market could possibly go “no bid” at crucial periods when long investors want to get out at any price.

The SEC would really benefit the market if it cleaned up the system of trade clearing. “Naked short selling” occurs when brokers take orders for short sales and don’t locate the shares to borrow. If a broker cannot locate them, then it shouldn’t tell the short seller that it is able to execute the order. Since the broker doesn’t want to lose the short seller’s business, it probably executes short sales of “hard to borrow” stocks anyway and hopes it can locate the shares in time for settlement.

“Quant funds” — the ones that use computers to trade millions of shares every minute — are lucrative brokerage clients. These funds are most likely to be the ones unknowingly requesting “naked” short sales. The orders come in so fast that it’s hard for the broker to say no, we cannot locate those shares to borrow.

In my view, the SEC can solve the problem of naked short selling with better enforcement of existing rules. Brokers should not be allowed to execute orders to short shares that they have little chance of borrowing. It’s vital that we restore liquidity to our stock market, rather than implement poorly thought-out decisions made overnight.

Best regards,
Dan Amoss, CFA
September 23, 2008

Government Regulation of Short Sellers was originally featured on Whiskey and Gunpowder