Hedge Funds Taking Pain From Government-Orchestrated Squeeze of Financial Shorts

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.

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  1. Molcool

    As an avid option trader (who lost a large amount of coin in the last 24 hours) I can assure you that the timing of this action was perfectly calculated and timed to bail out investment banks and brokers who bet on the upside or against the downside in derivatives. Didn’t you know? Friday was a “quadruple witching” expiration day for equity options, index options, index futures and single-stock futures. The Wall Street firms who were choking on their derivatives positions at 1:00pm yesterday got bailed out with a 1000-point rally in 3 hour, and they were able to take billions of Dollars away from people who had bet against them. The close today wat 1250 is conveniently right at the medium price range for July and August, where most of the contracts were probably written.

    Nevertheless, this was not about the money, this was about sending a message.

  2. Cash Mundy

    Ol’ Cash sure got whacked yesterday and today too. Why, SKF couldn’t even trade for a while, and SRS really dumped. And we won’t even get into the puts on politically-connected investment banks and such.
    It’s amazing how they can do that, just change the rules and take a bunch of money from evil shorts like Cash and Molcool and give it to them Wall Street boys. It’s just like magic or something, and Cash agrees it sends a message:

    Wall Street Boys
    Market Cap: Trillions of Dollars
    Political Connections: Priceless
    have a posse


  3. Richard Kline

    No all y’all trader jos out there are of the rugged individualist persuasion, so I ‘spect you’ll take your lumps. If y’all were more of a, er, _collectivist_ minded sort I’d suggest mass non-cooperation by no-bid on SEC-frozen financial stocks come Monday. Let it gap, boys and girls, and then see who has the power. Don’t like their rules?: don’t play, and see how they like them vectors.

  4. Anonymous

    “Let [the stock market] gap, boys and girls, and then see who has the power. Don’t like their rules?: don’t play, and see how they like them vectors.”

    Yes indeed. Paulson/Bernanke are increasing political risk that the US government will destroy investments through taxes and inflation. The market will sell off because of this increased tax and inflation risk. The rally is just a suckers rally. If the government printed enough money to try to prop up the entire stock market, there’d be a run on the dollar, and all currencies pegged to it.

  5. Anonymous

    Another options trader here with a couple of points.
    Molcool: you suggest the market found 1250 at expiration because that’s where most of the contracts were written. I would have thought it found 1250 because most of the contracts were written out there on the wings, so by bringing the market back to 1250 the buyers of those options experienced the maximum gain. Thus producing the maximum gain to those who wrote those contracts; namely the boys who have been given a green light for collusive manipulation of the market fully supported by Fed and Treasury. Hence the move back to 1250.

    Second, I’ve been very pleased with the results of non-directional strategies the last month. Credit spreads out there on the wings seem to take advantage of the one sure thing in the markets (fluctuation) and also have the benefit of aligning my positions with the interests of the boys as expiration approaches.

  6. Matthew Dubuque

    Matthew Dubuque

    95% of those who trade in options lose money.

    Coincidentally, those 95% who lose money ALL think they are smarter than everyone else.

    What never ceases to amaze me is that I have NEVER met a retail options speculator who knew the formula for how to calculate the THETA of an option.

    The ones who shout the loudest about how much they know about deltas and gammas don’t even know what the THETA represents. It’s EASILY the most important Greek.


    As we used to say on the floor, while laughing, “Let them eat premium!”.

    And of course Black-Scholes, Merton and Cox-Rubinstein ALL assume a Gaussian distribution of prices.

    My, my. People think that one year of calculus makes them a mathematician.

    Tragic, yes?

    Matthew Dubuque

  7. Dave Raithel

    I want to juxtapose Yves Smith’s assertion above that “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)” against Willem Buiter’s suggestion in his column yesterday (Fear and Loathing in the Financial Markets) that the prohibition is due to “the collapse in the share price of a number of politically well-connected banks and other financial institutions …”

    … So would it have been possible for a hedge manager to borrow money from the fund’s prime broker and then short that broker’s stock? (Since transparency is not the rule of the day …) And if shorting is funded (at least in part) by financial institutions, might the practice be stymied or curtailed if finance were not forthcoming? On the other-hand, politically well-connected finance institutions benefited from the practice by which OTHER (it would have to be?) politically well-connected institutions were harmed.

    Is the game to trash your competitor and do marginally better than a pyrrhic victory? (The last one standing doesn’t fall but is propped up on the fallen.)

    I can’t see the trees, I see nothing but forest; so I don’t see ANY move by anybody that doesn’t require making somebody else worse off and that in turn, disposing some facet of the finance scheme toward a downward spiral…And I don’t even claim that I present a coherent thesis. I only claim to make honest (as best I can not being fluent in the lingua franca) observations.

  8. fink2ice

    In 1938, the SEC adopted the uptick rule, more formally known as Rule 10a-1.

    The rule was put in place after short sellers were blamed for the Wall Street Crask of 1929. It was supposed to prevent “short attacks” and price manipulation. However last year, the SEC thought it would experiment with if there rule was effective at all.

    And, to experiment, the SEC eliminated the rule.

    It’s high-time they re-establish this rule. To little, to late for some but all is not lost.

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