I have really started to dislike municipal bonds as an asset class. They have seen a huge rally along with almost every other financial asset but the underlying fundamentals are weak because of financial distress at states and municipalities.

Last week, I wrote a first piece on this topic, based on some work by Philip Greenspun and Fred Sheehan. I also just wrote a piece about Ambac Financial’s likely bankruptcy, which will impact this market because of Ambac’s municipal bond guarantees. But, a Barron’s piece about Jim Chanos of Kynikos called “Short Seller: Dump Munis” piqued my interest and precipitated this particular article.

Chanos is bearish

The Barron’s piece by Tom Sullivan said:

James Chanos, the famed short seller who was among the first to foresee the collapse of Enron, recently sounded the alarm on the municipal-bond market — in the hallowed halls of the New York Historical Society, no less.

The "cracking of state and local municipalities is coming," he predicted at a recent meeting attended by Barron’s staffer Susan Witty, adding that he wouldn’t touch munis.

In a subsequent telephone interview with this columnist, Chanos said, "State and local municipal finance are a mess and going to get worse."

It’s not just the recession, which has reduced tax receipts. Rather, he says the poor economy "is masking real problems in municipal cost structures." The big problem, he says, is "the platinum-plated health-care and retirement benefits" given to state and local workers. "It’s all coming home to roost" as boomers start to retire.

California faces a $60 billion deficit, and the politicians there believe that in "a worst-case scenario, the federal government will bail them out," says Chanos. "If the feds do bail them out, as I believe they will," the state’s bonds will likely lose their federal tax exemption, he adds.

Sullivan went on to use New York and New Jersey as other examples of what is amiss for state bonds.

Revenue shortfalls

A New York Times article which I linked to this morning makes the situation in New York plain, ending with this:

The comptroller’s office numbers are more pessimistic than those from Mr. Paterson’s budget office. They project that the deficit for the remainder of the current fiscal year stands at $4.1 billion, with deficits of $7.8 billion and $15.7 billion in the succeeding years.

Mr. Ravitch, who helped steer New York City through its financial crisis in the 1970s, said, “The numbers are real and my own personal view is that they’re going to get worse.”

New York and New Jersey are suffering the same problems that California suffered, namely a huge fall in income and property tax revenue. This is true all over the country in places as far apart as Oklahoma, Hawaii, Texas, and Georgia.

Assets falling, liabilities ballooning

But, it’s not just about revenues versus outlays – the income statement. It’s also about assets and liabilities – the balance sheet. recently I spoke to Peter Schweich, a retired vice president of Boston University and founder of Boston University Academy, who had done some research on municipalities in Massachusetts and he explained that his research indicated that municipalities had seen a 30% fall in investment portfolio values during the credit crisis (much obviously gained back since). Even worse, he pointed me to enormous looming liabilities not reflected on balance sheet or considered by the ratings agencies.  In a recent Forbes article, he wrote:

While municipalities are able to raise property taxes to cover current salaries, not without considerable pain to the taxpayer, few of them, if any, are prepared for the future financial demands of their grossly underfunded or completely unfunded Other Post Employment Benefits (OPEB) obligation. OPEB obligations are primarily associated with health benefits for retirees.

In 2006, the Federal Reserve Bank of Chicago held a pension conference. In a short note, it reported that a "back of the envelope guess" for OPEB was $700 billion and that "other estimates suggest that OPEB exposure could range from five to 10 times current outlays for retiree health care."…

Cambridge, Mass., now known to most Americans as the city where a homeowner can be arrested for "breaking into" his own home, serves as a good example of the overwhelming burden residential and business property owners across the country are about to confront. Current and future Cambridge residents are now facing a completely unfunded OPEB obligation of $602 million. That figure, alone, is nearly one-and-a-half half times greater than the city’s entire 2009 budget. In addition, like most municipalities, the recent economic downturn has resulted in a significant loss to Cambridge’s regular pension fund: a 28.6% loss in 2008 in the amount of $225 million.

In addition, Cambridge has an unfunded liability for its regular pension fund (distinct from the OPEB fund) to the tune of nearly $70 million, and, of course, Cambridge also carries bond obligations, as do many municipalities. The Cambridge bond obligation exceeds $300 million. This means Cambridge, with approximately 75,000 permanent non-university student residents, one municipal employee for every 22 residents, and 22,000 taxable parcels, has current financial liabilities of nearly $1.2 billion…

Not surprisingly, the Cambridge city manager boasts of Cambridge’s financial stability each year in the introductory letter to his submitted budget. To bolster his claim, he proudly points to the Triple A bond ratings that Cambridge holds from Moody’s, Fitch and S&P. Cambridge, therefore, has 75,000 residents, 22,000 taxable parcels, $1.2 billion in financial liabilities–and a Triple A bond rating from Moody’s, S&P and Fitch.

These are circumstances that are being repeated across the United States. Expect scandals involving alleged improprieties to mount when financial distress hits. One notable example in the news is San Diego, where the top pension administrator is exiting after last year’s over 25% loss and where the fund is also being buffeted by two separate scandals: a conflict of interest scandal and a scandal where overtime pay was counted toward the formula in firefighters’ pension overtime. San Diego was also in the news a few years back because of a separate scandal where an alleged special pension benefit for the fire chief was under attack. See also San Diego’s Pension Scandal for Dummies from 2005, which details the conflict of interest case to that date.

Ratings agency problems

Then there are the rating agencies. Remember the whistleblower scandal from last month? It was all about municipal bonds and the Moody’s allegedly putting their revenue generating relationship with municipalities ahead of the rating function. If you recall, it was exactly this conflict of interest which led to Arthur Andersen’s downfall in the Enron scandal.

This is what Reuters said about the Moody’s whisteblower scandal last month:

Two former Moody’s executives — Scott McCleskey and Eric Kolchinsky — testified that senior managers were willing to silence employees who raised concerns about the ratings process or compliance efforts.

McCleskey said that while he was the head of compliance at Moody’s, he voiced concerns that the firm was not properly monitoring ratings on municipal debt. McCleskey, who was dismissed by Moody’s in 2008, said he was instructed not to mention the issue in e-mails or writing.

Kolchinsky, a Moody’s managing director who was recently suspended by the firm, said senior managers pushed revenue over ratings quality and were willing to fire employees who disagreed.

The two whistleblowers were flanked by Moody’s current chief credit officer, Richard Cantor. Cantor sat impassively, staring straight ahead as his former colleagues described their concerns to the lawmakers.

In his testimony, Cantor said Moody’s had recently hired an independent law firm to review Kolchinsky’s allegations.

That was criticized as an empty gesture by Chairman Towns, who said the law firm had no deadline and would not produce a written report.

Kolchinsky told lawmakers that Moody’s compliance group was understaffed and lacked independence. He also alleged Moody’s knowingly issued misleading ratings on complex securities and that analysts were "bullied" by managers, who overrode their decisions to protect revenue.  Kolchinsky said he would soon meet with the SEC to discuss his charges. SEC officials said the regulator had contacted Kolchinsky about his concerns in March 2009.

McCleskey, meanwhile, sent the SEC a letter in March 2009 warning about Moody’s weak compliance department and ratings process. He said Moody’s management had ignored his warnings that the company failed to properly monitor municipal bond ratings.

The company also spurned his suggestion to erect a firewall between the compliance department and its revenue-generating units, he said.

No doubt, there are those who are still recommending munis because of their tax-free status, as a recent WSJ article demonstrated. But, the fundamentals are weak and getting worse – both in terms of the income statement and the balance sheet. These governments are soon to lose their guarantees from Ambac (and eventually MBIA despite hiving off the muni business). To my surprise, these governments are getting no federal government backstop as the California situation has demonstrated. And the Fed and Treasury are on record as saying they will not guarantee any municipal bonds. Finally, I question whether one should rely on the ratings these bonds have to make an informed investment decision. Even the junk-bond king Michael Milken, a credit analyst of note, is now warning that credit ratings are inflated.

Municipal bonds are a clear case of buyer beware.

Related posts:

• The coming collapse of the municipal bond market
• MBIA and Ambac sued by LA
• Ambac may file bankruptcy soon
• California starts issuing IOUs as bankruptcy nears
• State and local government weighed down by housing

Gold hit a record high of $1,044.30 an ounce, beating the previous record of $1,032.35 set back in March and up a monster $26 on the day. The impetus is the crashing dollar, brought down by a report (later denied) that OPEC states and the Chinese were organizing a secret abandonment of the US dollar (see story here).

It is still rising.  In fact all commodities are rising sharply against the dollar. WTI Crude is up 2%, oat futures are up 3%, wheat futures are up 4 1/2%,  and corn futures are up almost 7%. And, we are seeing parabolic moves in silver (up almost 6%) and copper (up over 3%) as well.

But, of course, the Dow is up over 160 points despite this news of dollar revulsion. A little gallows humor over at Zero Hedge captures the mood amongst the shorts (hat tip Scott). This rally is absolutely turbo-charged. Can nothing take it down?

Sources

Spot gold – Kitco

Commodity futures – Bloomberg

Related posts:

• The dollar collapses
• The dollar rally spells trouble for some investors
• Has anyone noticed the Dollar has gone into freefall?
• US Dollar rising dramatically
• Chart of the day: US Dollar

Evidence is now surfacing that Timothy Geithner and Gordon Brown were among policymakers warned in April 2007 of an impending financial crisis. Famed fund manager and shortseller Jim Chanos met with the policy makers at the time, along with several other hedgies during the G-8 Summit in Washington, D.C.

Their worry: an impending financial crisis.  Recalling the events, here’s what Chanos has to say.

Jim Chanos: Well, there was a lot of sort of – you have to keep in mind this was Sunday afternoon. You’re at the end of the conference. But I think we were seen probably as much as an annoyance as anything else from people who wanted to catch a plane or get home.

But there was some uncomfortable paper shuffling. There was sort of, you know, that looking at the ceiling across the table. There was a bit of eye rolling. There’s no doubt about that.

And at the end of my talk the fellow running the meeting asked if there was any questions. There were literally no questions and at that point the Chair of the meeting said, “Well, that’s all very interesting and now what do you think about insurance.”

And it was just that complete realization that we’ve got – it just didn’t sink in, the import was not grasped, certainly by the Chair, that they were gonna move on to the next item on the agenda with nary a bit of discussion.

And then shortly after the meeting ended, a few hours later, there were two central bankers, both EU central bankers who came up to me and with their assistants and we exchanged contact information, and both said they thought that my presentation was very interesting and if I had anything additional please send it to them, and to keep in touch and blah, blah, blah.

And that was sort of it. I was thanked by the U.S. delegation and we went on our way. And both Paul Singer and I left the room sort of incredulous that the presentation…really elicited no official questions or comments.

It sort of reminds one of the famous intelligence memo declaring “Bin Laden Determined to Strike in U.S.”

More here. If you’re really interested in this story, the

audio is here

Transcript (in pdf) here (makes for a pretty good read).

Related posts:

• Jim Chanos: “It’s a bear market rally”
• Jim Chanos: short sellers are heroes
• Geithner testifies before Congress on financial reform
• Weekend Video: A Conversation with Tim Geithner at CFR
• Bank of Canada blames Geithner for financial mess

Oppenheimer has a research note out today that calls Tim Geithner an “evil genius. (hat tip Scott)” The genius moniker comes from the steady creep up the capital structure, giving Geithner access to huge pools of money as the Treasury dials for dollars. The evil part has everything to do with the pain this strategy is going to mete out to preferred shareholders and, eventually, bondholders.

The end of Oppenheimer’s piece is worthy of a quote as it demonstrates great analysis from a team that just lost start analyst Meredith Whitney.

Geithner’s Message to the Capital Markets

In his actions if not his words, Secretary Geithner is saying something very pointedly to all the key capital-market participants, and he is saying it to all participants industry-wide–not just Citi shareholders:

To common equity shareholders, he is effectively saying this: “You will be treated fairly and you will be allowed to raise substantial new equity at the reference price, which is roughly the prevailing price at the time that I took office. However, if you bought a $2 or $3 bank stock in hopes of earning leveraged, warrant like returns, on the assumption that Treasury would supply infinite capital and liquidity on favorable terms in perpetuity, guess again. You will be diluted until the right-hand side of the balance sheet has a reasonable mix between common equity and more senior capital.”

To preferred and subordinated debt holders, Geithner is effectively saying the following: “If the bank holding company in which you hold capital instruments is in dire need of common equity capital, then come to terms with them or we will do it for you! You knew at the time that you purchased this paper that they were not FDIC insured deposits, but rather capital instruments of a bank holding company. If the company in which you invested is in dire trouble, you too should share some of the pain and not expect 100 cents on the dollar.”

To the short-sellers of bank stocks, Geithner is effectively saying this: “Take your profits and go home; you cannot drive another major BHC stock to zero. We will never let another Lehman Brothers catastrophe happen. If need be, we will drill through the next $18 billion of preferred equity which would add another percentage point to the TCE ratio, and if that is not enough then there is another $192 billion of Citigroup holding company debt obligations which can be converted and add another ten percentage points to TCE (all of which at $3.25 per share would result in another 65 billion shares being issued), but at the end of the process, however far it needs to go, we are going to end up with a viably capitalized, publicly traded company trading under the “C” symbol. The only thing that is really at issue how many shares of this stock will be in circulation at the end of the process. It is this way with Citi, and it will be this way with any other large BHC.”

Source
Geithner’s Evil Genius, Intraday Report – Oppenheimer (no link)

Related posts:

• TARP dividends are killing bank profits
• The Citigroup Bailout
• Some banks not paying TARP dividends
• Buffett to invest in General Electric
• BofA, Citi, Wells and GMAC biggest losers in stress test leaks

Judging from recent events, the bond vigilantes are right to suspect that Ben Bernanke is all talk and no action when it comes to keeping long-term rates low. If you recall, I had actually believed the Fed would support bonds because it was concerned about long-term interest rates. This is part of the reason I believed that Treasuries would rise despite being in bubble territory but it looks unlikely.

The Federal Reserve is looking increasingly unlikely to purchase long-term U.S. Treasury securities any time soon, as the central bank gears up to launch a different program aimed at jumpstarting the market for consumer loans.

Federal Reserve Chairman Ben Bernanke raised the idea of purchasing Treasury bonds in November and the Fed has tipped its hand to the possibility of such purchases in its last two policy statements.

Such a move could help to bring down long-term interest rates, something that could indirectly help consumers and businesses since many loans are benchmarked to Treasury yields.

But Mr. Bernanke notably left the idea out of his testimony to the House Banking Committee Tuesday.

Fed officials could be preoccupied by a new program aimed at jumpstarting consumer loan markets, an effort being coordinated with the Treasury Department. That program represents an enormous commitment by the Fed. The Term Asset-backed Securities Loan Facility, which will help finance asset backed securities tied to consumer loans, could result in as much as $1 trillion in new Fed loans, a huge expansion in its balance sheet.

Now, if the U.S. federal government massively increases spending and the Feral Reserve does not buy long-dated treasuries, that is bearish for bonds. Buying junk assets like asset backed-securities will artificially prop up their prices by lowering their spread to treasuries but will have zero impact on the steepness of the yield curve.

Bernanke had warned that he was NOT repeating the Japanese experiment of quantitative easing when he spoke at the LSE (London School of Economics) in January. He said the Fed was focusing on the asset side of the balance sheet – what I would call qualitative easing (see my post from Jan. 13th on this).

The evidence is piling up that Bernanke is not going to buy Treasuries. I’ll leave it to Ambrose Evans-Pritchard to tell us what this means:

The yield on 10-year US Treasury bonds – the world’s benchmark cost of capital – has jumped from 2pc to 3pc since Christmas despite efforts to talk the rate down.

This level will asphyxiate the US economy if allowed to persist, as Fed chair Ben Bernanke must know. The US is already in deflation. Core prices – stripping out energy – fell at an annual rate of 2pc in the fourth quarter. Wages are following. IBM, Chrysler, General Motors, and YRC, have all begun to cut pay.

The “real” cost of capital is rising as the slump deepens. This is textbook debt deflation. It was not supposed to happen. The Bernanke doctrine assumes that the Fed can bring down the whole structure of interest costs, first by slashing the Fed Funds rate to zero, and then by making a “credible threat” to buy Treasuries outright with printed money.

Mr Bernanke has been repeating this threat since early December. But talk is cheap. As the Fed hesitates, real yields climb ever higher. Plainly, the markets do not regard Fed rhetoric as “credible” at all.

Shorting Treasuries was a lot better bet than I had anticipated.

PS. – Bill Gross is all over this one.

Source
Fed Looking Unlikely to Buy Treasurys – Real-Time Economics, WSJ
Bond market calls Fed’s bluff as global economy falls apart – Ambrose Evans-Pritchard, Telegraph
Gross Bought Mortgages, Sold U.S. Debt Last Month – Bloomberg.com
Real Treasury Yields Moving Lower – EconomPic Data

Related posts:

• Another take on the treasuries bubble
• Don’t underestimate the power of printing money
• TALF’s first recipient will be Nissan Motors of Japan
• Quote of the day: Stephen Roach
• Video: Andrew Barry says stay away from treasuries

I ran across a very disturbing news item today that is getting a lot of press in Germany. Apparently, the leveraged finance community is getting routed at the German Automaker VW. The crux of the situation is that Porsche, which controls VW, upped its stake in the company causing shares to rise.

For whatever reason, a number of hedge funds were actually short VW – meaning they were betting against the shares. A short squeeze ensued and the shares rose a massive 50% – making VW the world’s largest company – at least temporarily.

The result: losses in excess of 20 billion euros. And I have heard that the rise in VW alone made the DAX (Germany’s equivalent of the Dow Jones Industrial Average) rise 7%. Truly amazing.

Volkswagen briefly became the world’s largest company by market capitalisation on Tuesday as panic-buying by hedge funds desperate to cover losses caused its value to shoot up by up to €150bn.

Shares in Europe’s largest carmaker soared as high as €1,005 in early trading, having closed at about €210 on Friday. That gave it a market capitalisation of around €296bn ($369bn), higher than that of ExxonMobil, the oil company that closed on Monday with a value of $343bn……

“I have hedge fund managers literally in tears on the phone,” said one London-based auto analyst. Hedge funds had bet that VW’s share price would fall but after Porsche disclosed it held 74 per cent of the carmaker rather than the previously assumed 35 per cent there was a huge scramble to cover positions.

Analysts and investors said some hedge fund failures were likely because of the size of the losses, which reached about €20bn-€30bn on Tuesday. They also called for a full investigation by Bafin, Germany’s financial regulator, into whether there was market manipulation.
-Financial Times

See the video at the FT article.

I still think much of the recent market turmoil – especially in currencies – has a lot to do with forced selling by hedge funds. These hedge fund managers on the phone crying deserve zero sympathy.

I am a fan of short sellers and the transparency they bring to the market. But, these leveraged players were simply playing with fire and they got burnt.

This is further reason we need to regulate these funds.

Related posts
Random musing: forced liquidation

Related posts:

• Is the short covering rally over?
• Hedge funds collapsing
• Reflation watch hedge fund edition
• Australia bans short selling too
• Jim Chanos: short sellers are heroes

I just watched a great clip of an interview Jim Chanos, the famous head of hedge fund Kynikos Associates, did with the FT’s Gillian Tett (Hat tip FT Alphaville). Chanos does a very good job of arguing hat short sellers are being unfairly victimized by government. Basically, he and other hedge fund managers like John Paulson have been warning al of us for months that what we are seeing now would come to pass and that the financial services sector was over-leveraged.

Banning short selling is like shooting the messenger. It doesn’t get at the root of the problem, but rather scapegoats the very people warning us of the pitfalls ahead. Chanos also says that we are kidding ourselves if we think the Paulson plan Economic Patriot Act is going to solve the mess America is in. You have been warned.

Below is the video.

Related posts:

• Jim Chanos: “It’s a bear market rally”
• Massive short covering at VW and massive losses for hedgies
• Short-selling financial shares is now illegal
• Chanos: I warned Brown and Geithner of financial calamity
• John Paulson: Distressed assets best opportunity in a lifetime

Firms are being added left and right to the list of companies that cannot be sold short due to the market meltdown. GM, GE and Ford wanted in. Blackrock now has in too. If there is one feature about the new crisis protections put in place by the Fed, the SEC and the Treasury that I find manipulative, it is this short-selling ban.

The list of companies that regulators are protecting from short-sellers keeps growing, as do the questions surrounding it.

By Monday evening, the number of companies on the list rose to nearly 900, from 799 on Friday, when the Securities and Exchange Commission sought to restrict bearish bets against financial companies to help stabilize the markets.

Nearly every major bank is now included, along with large insurance companies and others. Trading in bank stocks withered on Monday amid uncertainty over the rules and the sweeping bailout that the Bush administration has proposed for financial companies.

But many questions remain. Some analysts — and a few firms initially left off the list — complained that the initial S.E.C. roster was incomplete.

By the weekend, the S.E.C. delegated the task of adding more companies to the initial 799 to financial exchanges like NYSE Euronext and the Nasdaq. On Sunday afternoon, NYSE Euronext, which operates the New York Stock Exchange, sent out an e-mail message to all of its listed members, asking them to submit reasons why they should be given short-selling protection. Companies had to fit one of seven categories of financial firms listed by the S.E.C. Applications were reviewed by NYSE Euronext’s listings division.

Many financial firms that might seem like natural members of the list — banks like Credit Suisse, the money managers AllianceBernstein and Legg Mason and American Express — did not make the cut until Monday. BlackRock, the big investment firm that has done work for the government during several crises this year, was not added until Monday evening.

A few additions seemed a bit more puzzling. Both General Electric and General Motors were added Monday morning, prompting a few jokes from pundits. But the companies argue that they fall under the guidelines set out by the S.E.C.

General Motors, for example, notified the regulator on Friday that it owned the National Motor Bank, a savings and loan that qualifies it for inclusion on the list, according to Julie M. Gibson, a G.M. spokeswoman. The S.E.C. responded and, after a series of talks between the two, added the carmaker to the list by Monday.

By Monday evening, the Ford Motor Company, which also owns a bank, was added to the list.

Yet as others sought to be added, one company chose to remove itself from the list.

The Diamond Hill Investment Group, a small investment manager that is listed on the Nasdaq, said Monday that it opted out of the protection program. When the firm learned on Friday that it was a part of the no-short list, it asked to be removed, according to Rob Dillon, the firm’s chief executive.

Source
Short-Sell List Grows, and So Do Questions – NY Times

Related posts:

• Financial shares now diving
• Welcome to The United Socialist States of America
• Short-selling financial shares is now illegal
• The short-selling rule and unintended consequences
• Goldman and Morgan Stanley are now banks

It seems incredible – this rollback of the free markets. But, six countries have now banned short sellers of financial shares as if they are solely responsible for the market meltdown we suffered in the wake of the Lehman bankruptcy. The latest to join in the curbs is Australia.

The country has yet to see the attacks on financial services shares that we have seen in the U.S. and UK in particular. So, perhaps they are preemptively striking against the shorts lest they be the next country to suffer systemic risk.

Obviously governments around the globe are turning to market manipulation in order to tame animal spirits.

Australia’s corporate regulator extended a ban on short selling to so-called covered transactions, following similar moves in the U.S. and U.K. in an attempt to cut volatility in the stock market.

Traders won’t be allowed from today to transact covered short sales, in which stock is borrowed for the purposes of betting on share price declines, unless they are hedging positions, the Australian Securities and Investments Commission said on its Web site yesterday. It abolished so-called naked short sales, in which traders never borrow the shares, last week.

The ban covers all stocks traded on the Australian exchange and follows the U.K., Germany, France and Belgium in barring short sales to defend banks from trading blamed for helping wipe $3.8 trillion of value off global stock markets this week. The U.S. Securities and Exchange Commission halted short selling of financial companies to stop speculators benefiting from the credit crisis that led to the collapse of companies including Lehman Brothers Holdings Inc.

“Anyone who’s got a short position this morning is in trouble,” said James Chirnside, who manages the equivalent of $63.3 million at Asia Pacific Asset Management, a Sydney-based hedge fund manager. “This decision directly affects about 150 hedge funds, some of which may be forced to close as a result.”

Short sellers try to profit by betting stock prices will fall. In a short sale, traders borrow shares from their broker that they then sell. If the price drops, they buy back the stock, return it to their broker and pocket the difference.

Unwarranted

“Short sellers are not agents of the Devil,” said Ed Rogers, chief executive officer at Tokyo-based hedge-fund adviser Rogers Investment Advisors Y.K. “The current market hue and cry on the part of individuals such as John Mack seems completely self serving and totally unwarranted.”

Australia’s benchmark S&P/ASX 200 Index jumped 3.5 percent as of 11:23 a.m. in Sydney. Macquarie Group Ltd., Babcock & Brown Ltd. and Allco Finance Group Ltd., among the stock market’s biggest losers as they blamed short sellers for targeting their stock this year, surged.

ASIC and the Australian Securities Exchange said the ban on covered short sales did not include hedging positions placed before today. The regulators abolished naked short selling on Sept. 19, raising concerns that investors are flooding markets with sell orders to drive down prices.

The changes will be reviewed in 30 days, ASIC said yesterday.

Related posts
Short-selling financial shares is now illegal

Source
Australian Regulator Extends Ban on Short Selling – Bloomberg

Related posts:

• The short-selling rule and unintended consequences
• Welcome to The United Socialist States of America
• Short-selling financial shares is now illegal
• Everyone wants in on the short sell ban list
• Massive short covering at VW and massive losses for hedgies

Given the fact that the regulatory authorities in the U.S. and the UK have taken the unusually manipulative step of banning all short sales of financial institutions outright, it bears remembering that all actions have consequences, both intended and unintended.

My guess is that these actions will have greater unintended consequences than intended. What is the law of unintended consequences? Wikipedia explains.

The “law of unintended consequences” (also called the “law of unforeseen consequences“) states that any purposeful action will produce some unintended consequences. A classic example is a bypass — a road built to relieve traffic congestion on a congested road — that attracts new development and with it more traffic, resulting in two congested streets instead of one.

This maxim is not a scientific law; it is more in line with Murphy’s law as a warning against the hubristic belief that humans can fully control the world around them. Stated in other words, each cause has more than one effect, and these effects will invariably include at least one unforeseen side effect. The unintended side effect can potentially be more significant than any of the intended effects.

-Wikipedia

Sources
Unintended consequence – Wikipedia

Related posts:

• The short-selling rule and unintended consequences
• The unkindest cut: the BoE got it wrong
• The irony of falling prices and first-time homebuyers
• Quote of the day: Nationalized banking predators
• Cognitive Regulatory Capture

The latest government intervention into the capitalist system is the move by the UK and U.S. governments to ban short-selling of all financial stocks outright.

In the wake of the severe market turbulence unleashed by the failure of Lehman Brothers, the government has decided to insert itself into the marketplace and prop up share prices by banning short-selling outright. This is a clear violation of free market principles.

This is quite ironic because the Federal Reserve and the U.S. Treasury allowed Lehman Brothers to fail in order to demonstrate the Governments commitment to the free market. Obviously, their experiment in free market economics has been a disaster, and they are doing a complete 180-turn. The next thing you know, they will ban private citizens from owning gold.

Below is the list of firms which cannot be shorted and links to a number of good commentaries on the issue.

U.S. financial companies whose shares can’t be shorted – Market Watch
The FSA’s endangered species list – FT Alphaville

Commentary
Short Selling Ban: Why is the Bush SEC Scared of the Market? – Beat The Press
SEC tries to bankrupt Wall Street – Bronte Capital
UK Temporarily Ban Short-Selling 18 Sep 2008 – CNBC
FSA bans short-selling of banks – FT
Banking shares rise more than 30% – BBC News
The Next Target: Asset Managers – Market Beat
Fear and loathing in the financial markets – Willem Buiter
SEC: Ban All Short Selling – Barry Ritholtz

Related posts:

• The short-selling rule and unintended consequences
• Australia bans short selling too
• Everyone wants in on the short sell ban list
• Welcome to The United Socialist States of America
• Is the short covering rally over?

Recently, the SEC restricted short selling on a list of 19 stocks because of turmoil following the Fannie-Freddie worries last week. In effect, the SEC was signaling that these institutions are too big to fail because a number of these companies were not subject to rumors of massive losses while a number of institutions not on this list were. Obviously, then, this begs the question as to what financial institutions are too big to fail.

My subjective opinion is based on asset size. Here is a list of the top banks by assets from infoplease.

United States’ Largest Banks
(in millions of U.S. dollars)
Rank	Name (city, state)	Consolidated
		assets
1	Citigroup (New York, N.Y.)	$2,199,848
2	Bank of America Corp. (Charlotte, N.C.)	1,743,478
3	J. P. Morgan Chase & Company (Columbus, Ohio)	1,642,862
4	Wachovia Corp. (Charlotte, N.C.)	808,575
5	Taunus Corp. (New York, N.Y.)	750,323
6	Wells Fargo & Company (San Fransisco, Calif.)	595,221
7	HSBC North America Inc. (Prospect Heights, Ill.)	493,010
8	U.S. Bancorp (Minneapolis, Minn.)	241,781
9	Bank of the New York Mellon Corp. (New York, N.Y.)	205,151
10	Suntrust, Inc. (Atlanta, Ga.)	178,986
11	Citizens Financial Group, Inc. (Providence, R.I.)	161,759
12	National City Bank (Cleveland, Ohio)	155,046
13	State Street Corp. (Boston, MA)	154,478
lass="xl26" style="border-top: medium none; height: 25.5pt; width: 56pt;" num="" width="75" height="34">14	Capital One Financial Corp. (McLean, Va.)	150,608
15	Regions Financial Corp. (Birmingham, Ala.)	144,251
16	PNC Financial Services Group, Inc. (Pittsburg, Pa.)	140,026
17	BB&T Corp. (Winston-Salem, N.C.)	$136,417
18	TD Bank North, INC. (Portland, Maine)	118,171
19	Fifth Third Bankcorp (Cincinatti, Ohio)	111,396
20	Keycorp (Cleveland, Ohio)	101,596
21	Northern Trust Corp. (Chicago, Ill.)	77,480
22	Bancwest Corp. (Honolulu, Hawaii)	74,808
23	Harris Financial Corp. (Wilmington, Del.)	69,172
24	Comerica Incorporated (Dallas, Tex.)	67,167
25	M&T Bank Corp. (Buffalo, N.Y.)	66,085
26	Marshall & Ilsley Corp. (Milwaukee, Wis.)	63,432
27	BBVA USA Bancshares, Inc. (The Woodlands, Tex.)	59,953
28	Unionbancal Corporation (San Fransisco, Calif.)	57,933
29	Huntington Bancshares, Inc. (Columbus, Ohio)	55,985
30	Zions Bancorporation (Salt Lake City, Utah)	53,597
NOTE: As of May 30, 2008.
Source: Federal Reserve System, National Inform ation Center.

I have highlighted the first 9 banks with assets over $200 billion as banks I reckon the Feds would not allow to go under. Below that line, what the Feds would do is unclear. But certainly, banks with assets less than $100 billion are not going to be bailed out.

Some of these companies are subsidiaries of foreign banks, so the U.S> would not be the place to look for bailouts. These institutions include Taunus (part of Deutsche Bank), HSBC, BBVA, and TD Bank North (Part of Toronto-Dominion).

However, this list does not include investment banks like Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch or Insurance companies like AIG, MetLife, Prudential and Berkshire Hathaway or other financial institutions like American Express and General Electric, all of which are to big to fail. Nor does it include Fannie Mae and Freddie Mac, which we have seen are definitely too big to fail.

Conclusion
So, who would I put on my list? I would at least put the 7 banks I mentioned with assets over $200 billion (not including Taunus or HSBC). I would add Freddie and Fannie, plus the major Investment Banks: Lehman Brothers, Goldman Sachs, Morgan Stanley, and Merrill Lynch. As far as other institutions go, AIG, MetLife, Prudential, Berkshire Hathaway, GE and AMEX would be on that list as well.

Obviously, most of these institutions are in no way imperiled, Berkshire Hathaway being the most obvious example. And there are lots of examples of institutions with over $200 billion in assets like The Hartford, which I have not put on the list. None of the brokerages like Schwab and T. Rowe Price are on this list. But, on the whole, this covers most of the institutions the Feds are interested in saving.

So, this is a backstop for 19 U.S. financial institutions to match the SEC’s list of 19. That’s my list.

What’s yours?

UPDATE: 1324 EDT
WaMu is not on this list because they are a savings and loan. But, they do have more than $300 billion in assets. So, for consistency sake, I’d have to add them. But I think Washington Mutual is the prime example of a financial institution which did NOT receive SEC help from short sellers, but that would need it more than the likes of Goldman.

WaMu really shows how unfair the list of 19 is. Regulation on the fly, in crisis is never pretty

Related posts:

• FDIC list of problem banks
• WaMu on the brink of disaster: has agreement with regulators
• Question: How is Fannie Mae a AAA company?
• IndyMac: Another Banking Bankruptcy
• FDIC steps in at two more failed banks

When you start monkeying around with markets, strange things happen. This is what the SEC is about to learn as market makers from the seven options exchanges are preparing to ask for exemptions from the new anti-free market SEC short-selling rules. See the article below (emphasis in article).

Tennille Tracy of Dow Jones Newswires reports:

The seven U.S. options exchanges are preparing to ask for an exemption from a new Securities and Exchange Commission rule aimed at slowing short-selling of stock in financial companies, people familiar with the effort said Wednesday.

By putting the kibosh on so-called naked short-selling in companies like Fannie Mae, Freddie Mac and Lehman Brothers, the SEC has complicated life for the market-makers in the options market.

Options market-makers routinely engage in short-selling to hedge positions they take with clients. The SEC’s July 15 decision disrupts that commonly used trading strategy and makes it more expensive to conduct business as usual.

“My book makes a market in nearly every name on [the SEC] list,” said Andy Schwarz, founder of AGS Specialist Partners. “This affects our book in a big way.”

Short sellers are betting that the price of a stock will fall. They do so by selling borrowed stock and then repaying the stock later, hopefully at a lower price. Some investors making such bets hoping to profit when a stock gets cheaper. Others, like options market makers, may merely be trying to offset the risk they take on when selling customers options that rise in value when stock prices fall.

-WSJ, 16 Jul 2008

The short-selling rule smacks of obvious panic. It is a regulatory anti-free market solution slapped on in a hurry. Obviously, the Feds want to prop up Fannie, Freddie and other weak financial institutions by any means necessary.

This rule will almost certainly stop naked short-selling. But, it’s the unintended and unforeseen consequences about which one has to worry.

Related posts:

• Australia bans short selling too
• Welcome to The United Socialist States of America
• Short-selling financial shares is now illegal
• CDS Market: Did Fannie and Freddie Default?
• Federal takeover of GSEs now in the works

The USSA is now taking form. As the housing debacle turns nasty, politicians and regulators are looking to turn away from the free markets toward I don’t know what. And that ain’t good.

First, there is the Dodd bailout bill that passed the Senate, then there are the absurd Fannie-Freddie bailout proposals. Now, its the rules on short-selling, specifically of Fannie and Freddie, but soon for the whole market.

The Wall Street Journal reports the following regarding short-selling (my highlighting added):

The Securities and Exchange Commission announced an emergency action aimed at reducing short-selling aimed at Wall Street brokerage firms, Fannie Mae and Freddie Mac, and will immediately begin considering new rules to extend new requirements to the rest of the market.

SEC Chairman Christopher Cox said the SEC would institute an emergency order requiring any traders to pre-borrow stock before shorting Fannie Mae and Freddie Mac, the embattled government-sponsored entities that own more than half the nation’s mortgages. It would also apply to the stocks of Lehman Brothers, Goldman Sachs, Merrill Lynch and Morgan Stanley. The order is a near-term fix and will expire in 30 days.

Mr. Cox said the SEC “will undertake a rulemaking to address the same issues” across the market.

The move will likely limit short-selling for the two mortgage entities, which have seen their stock prices fall sharply in recent weeks. Wall Street has been calling for the SEC to address short-selling, which some believe is contributing to market volatility and could be used to manipulate shares of financial stocks.

It comes as short-interest, or the amount of outstanding short positions, is at an all-time high for NYSE Euronext-listed stocks.

Short-selling, a legitimate trading strategy geared to profit from falling stock prices, has long been a lightning rod issue, so changes that cover the entire market will likely be hotly debated. Companies have complained that short-sellers target their stocks with the purpose of driving them down, while short-sellers have been credited with identifying a company’s true market value.

Under current rules, a short-seller must locate shares to borrow, which are later replaced with stock bought at a lower price. Some market watchers have been concerned that traders were borrowing the same shares from the same lender over and over, and driving down stock prices.

Under the emergency order, traders will be required to borrow the stock and the lender would then take it out of the market and not allow other traders to use it to satisfy requirements that they’ve located stock.

No wonder Prudent Bear David Tice sold out. Smart move.

Are these guys serious? Who’s going to buy shares when they fall? Not short sellers as is usual because they won’t be around.

I tell you, its looking like the 1930s more and more every day. Next thing you know they’re going to confiscate your gold.

Related posts:

• The short-selling rule and unintended consequences
• Australia bans short selling too
• Short-selling financial shares is now illegal
• Action in Asia portends a strong open in Europe and North America
• Federal takeover of GSEs now in the works