RD's Picks

First, if you haven't read Tom's Moral Hazard post on how credit default swaps and short selling can be used in tandem to attack a stock; stop, go read it, then come back if you'd like.

Over the past two weeks we've seen unprecedented gov't intervention in the markets. Nearly complete nationalization of FNM and FRE, a Fed credit line and massive stock dilution to save AIG from probable bankruptcy, announcement of a new gov't agency to create a market for troubled mortgage backed securities, a new Treasury insurance plan for money market funds, an SEC ban on short selling financial stocks and an SEC investigation into market manipulation. I'm sure I missed some things, but that's more than enough highlights for two weeks.

Like most, I have no idea what the ramifications of a FNM, FRE, or AIG failure would have been or even if they would have failed had the market been left to play out. To put the scope of the AIG dilution into context, if the Fed were to exercise the warrants and divide the new shares equally among all 300 million Americans, we'd each get just under 9 35 shares. If you're curious, the Fed's authority for deals like the AIG credit line comes from section 13 (3) of the Federal Reserve Act. It basically states the rules are whatever five members of the Fed Board of Governors say they are.

I want to focus on the SEC short sale ban and the investigation into market manipulation. I've read a number of blogs and articles over the weekend basically saying the SEC is just trying to blame short sellers for all the problems in the financial stocks while ignoring root causes like lax mortgage lending standards. Some point to LEH and claim the short selling had nothing to do with its collapse. Probably true. But AIG is another story. It's entirely possible that bidding up the CDS premiums while aggressively shorting the stock were key factors in their debt downgrades. Without those debt downgrades, AIG may very well have been able to raise enough capital to survive. We don't know the whole story and I don't think the SEC does either - that's the point of the investigation.

I don't think it's a coincidence that the short sale ban and the investigation news releases are adjacent to each other on the SEC website. I don't know anything beyond what's in the press releases, but I believe the SEC has taken an initial look at connections between CDS premiums and short interest and concluded there's a possibility of market manipulation. The short ban indicates they felt there was enough risk of market manipulation to take immediate action. Since they don't have any means of regulating CDS trading right now, the only circuit breaker available to them was a ban on short selling.

The press release makes it clear the SEC ban on short selling is temporary and even states, "Under normal market conditions, short selling contributes to price efficiency and adds liquidity to the markets." All I can say is welcome to the party SEC.

Thanks for reading.

Disclosure: At time of posting I believe I have a beneficial interest nearly 9 35 shares of AIG.

Edited to correct bonehead math error.

Comments: View Comments |  Sunday September 21, 2008