As we noted in a post yesterday, the assault on the evil shorts may wind up being a case of unintended consequences, since the investors targeted, mainly hedge funds, often use leverage supplied by their friendly prime broker (Goldman and Morgan Stanley are far and away the biggest in that business). If funds take big enough losses, investors may redeem (hedge funds were having not such a hot year as a whole prior to this move, with short-oriented funds a major exception). Remeptions beyond a certain level lead to an implosion, where the fund has to sell positions at a time not of its choosing, often leading to unfavorable prices and further withdrawals. This need to sell can create downward pressure in seemingly unrelated markets and also exposes the prime brokers to risk of loss at the collateral securing their loans falls in value.
Note also that hedge funds are no longer the purview of wealthy investors. They are now perceived to be an asset class and pension funds, insurance companies, and endowments are major holders.
The pain has already started; it will take some time to see if any collateral damage results.
The Independent surveys the initial damage on UK shares:
Yesterday, the Financial Services Authority (FSA) named 32 companies in which short selling will now be forbidden until the middle of January….
Tom Hougaard, a market strategist at the spread betting firm City Index, said the FSA’s sudden announcement was disastrous for some hedge funds. “The short-sellers have just been handed a death sentence,” he warned.
The losses could be horrendous. Shares in Barclays rose 29 per cent yesterday…Add in the gains made by the other three big four banks yesterday and hedge funds’ total losses, based on stock-lending figures from Data Explorers, would have totalled just short of £1bn. That’s before taking into account losses on short positions on the remaining 28 financial institutions on the FSA blacklist….
“The knee-jerk reaction of politicians is just mind-blowingly stupid,” said one short trader. “Obvious pressure has been applied on the FSA to be seen to be doing something and they have come up with this little gem – the problem in the markets is nothing to do with short selling.”…
However, Florence Lombard, the chief executive of the Alternative Investment Management Association (Aima), said a crackdown on short-sellers would do little to restore confidence in the banking sector. “We are not alone in doubting whether the recent bans on short selling of financial stocks taken by financial regulators are likely to achieve the intended results over time,” she said.
Ms Lombard pointed out that just 3.5 per cent of HBOS shares were available on Monday for stock-lending purposes. That was nowhere near enough for short-sellers to have been responsible for the havoc on the bank’s share price seen at the beginning of the week.
In fact, Ms Lombard insists that the image painted of hedge funds as irresponsible short-sellers is utterly at odds with reality. “The vast majority of people are both long and short investors. I am not aware of a single pure short-seller in Europe and there are only a handful in the US,” she said…
Some analysts warn that the regulators’ moves against short selling may actually damage the intended beneficiaries of the crack-down, with the prime brokerage units of banks suffering a sharp fall in revenues. “The ban on short selling will mean some hedge funds will not be able to execute strategies they want to do,” Andrew Shrimpton, a partner at the hedge fund consultants Kinetic Partners, said. “It is going to impact the profitability of prime brokers, there is no question of that,” he warned.
One factiod that reveals how knee-jerk this measure was: the SEC implemented without considering the impact on stock options. From Bloomberg:
The U.S. Securities and Exchange Commission may revise its ban on short sales to add financial companies and carve out an exemption for brokerages that pair off brokers in the $1.6 trillion U.S. options market….
The staff also will recommend that options market-makers be exempt from the ban, easing concern the rule would raise investor costs, the agency said in a statement today.
“If they don’t fix it, there just won’t be an options market on Monday,” Steve Claussen, chief investment strategist at OptionsHouse LLC, the Chicago-based online brokerage unit of options trading firm PEAK6 Investments LP. “If they have an exemption for market-makers that they’re allowed to sell stock short, then they can provide a market in the options.”….
Options market makers would have been prohibited from making short sales starting next week under the ban adopted today to keep speculators from driving down stock prices. The Options Clearing Corp., which guarantees all trades exchange- listed options, said a ban would have proved “disastrous.”
And for those of you who want to blame shorts for the demise of firms like Lehman, consider: the firm opened its books and was not able to get any bids. Two prospective buyers, Bank of America and Barclays, would do a deal only with a government subsidy, That says that market prices weren’t wrong, but exposing how weak some major financial players are is politically inconvenient.