Uptick Rule: Round Two

Warning: Complicated entry below.

Opening graphs of a Fox News story this morning:

Stocks fell sharply Thursday after investors were shaken by problems at Countrywide Financial Corp. (CFC) that confirmed fears of widening credit problems and after the Federal Reserve injected $17 billion of liquidity into the banking system. The Dow Jones industrial average fell 130 points.

In the first hour of trading, the Dow tumbled 130.96, or 1.02 percent, to 12,730.51.

Broader stock indicators also skidded. The Standard & Poor's 500 index was down 14.08, or 1.00 percent, at 1,392.62, and the NASDAQ composite index dropped 21.53, or 0.88 percent, to 2,437.30.

The Russell 2000 index of smaller companies edged down 0.39, or 0.05 percent, at 751.15.

Market confidence, already diminished by months of bad news about mortgages and credit, took a further drubbing after Countrywide, the nation's largest mortgage lender said it was forced to draw on an $11.5 billion credit line to fund operations.

And, Wall Street seemed unfazed as the New York Fed — which carries out the central bank's market operation — announced an overnight repurchase agreement worth $12 billion. This was on top of a 14-day "repo" worth $5 billion announced before the market opened.

In a previous entry, HazZzMat railed about the SEC's elimination of the longstanding "uptick rule" . (The Wall Street Journal called it the "downtick rule" in an article earlier this week that's unavailable via link). That's the old rule that prohibited short sellers in the stock market from shorting a given stock straight down. They had to short it after an "uptick," i.e., a "buy" order. For the uninitiated (Wonker is a former stock broker) "shorting" is selling a borrowed stock, then hopefully buying it back when it goes down, profiting on a negative, rather than a positive move. Back in the bad old 1920s, before the rule was put in place, gangs of rich guys could collude to drive any stock right down via massive shorting, wiping out the little guys and pocketing a profit.

Since this rule was eliminated in July, we've seen a terribly adverse affect on the entire stock market which has become poisonous anyway due to the subprime mortgage meltdown and subsequent drying up of the credit markets. The market was absolutely due for a correction, sadly enough, and such corrections will often show up in the summer doldrum time of July-August when the professional traders (and arguably saner heads) are off in the Hamptons for extended vacations.

But the current correction (Dow down over 200 points today, after quite a few days of similar action) has been extraordinarily swift and violent. Same for the other averages. Everyone is getting hosed.

What is now happening is that the absent uptick rule is increasing the violence of what's already happening in the markets. The unregulated hedge-fund market, that massive Wild West playpen for the very wealthy (and often foolish), which lived to speculate on borrowed money, has seen their game come to an extraordinarily dramatic and bloody close. As the credit markets have tanked, the value of mortgages and other instruments acquired in massive amounts by these funds, has essentially disappeared, as investors suddenly realize that there is no way to objectively value debt instruments that are, frankly, crap and always were.

So hedge fund investors have waded in en masse to withdraw what $$$ are left. To honor the redemptions, the hedge funds are having to dump stocks willy-nilly and in vast amounts to raise cash to meet the redemptions. The market is waterfalling now precisely because of this. EVERY stock is getting dumped, almost without exception, with the more expensive being dumped all the faster, because the object is to raise cash to meet the redemptions. Thus, we are witnessing the spectacle of fantastically profitable companies whose July stock prices were justified, being defenestrated right along with the garbage. The lack of an uptick rule serves to increase the violence of the downdrafts and accelerate the public's growing sense of panic.

In other words, if you haven't gotten out already, there's pretty much no escape except at lower and lower prices. There are no longer any upticks to let you out. The hedge funds are just dumping everything indescriminately to raise cash. The rare up-move in any stock today is simply regarded now as another choice opportunity to get out, initiating yet another wave of unabated selling.

But even this is not enough. Because an awful lot of what the hedgies used to buy or short positions in the first place was done with massive amounts of borrowed money. If I can buy stock XYZ at $100 on 50% margin, that means I can buy 100 shares of XYZ for $5,000. That is, $10,000 worth of stock for $5,000. But now let's say I'm a hedge fund that's in trouble. My investors want to cash out NOW, so I have to start dumping even the good stuff like XYZ. But there's a problem. XYZ is now down to $70 a share. So selling 100 shares here brings me only $7,000, not the $10,000 I thought it was worth a couple of weeks ago.

But wait. I've now got $7K to hand out to my escaping investors, right? Nope. Remember, I borrowed $5,000 of the original $10,000 purchase and I have to give that back now. So now, I only have $2,000 to hand out to my desperate soon-to-be-ex-customers. You don't need to know calculus to figure out how long this can go on before my hedge fund disappears into a vast, multi-year lawsuit.

Again, as we've stated before, HazZzMat generally focuses on the meaning and methodology of message control as excercised by the anti-American left. We are essentially out here in the blogosphere to provide intellectual support for American artistic, cultural, and legal traditions.

But sometimes, as now, these traditions also intrude into the essence of America, its wide-open, competitive, but somewhat regulated capitalism, an adaptive, corrective form of capitalism that Karl Marx never anticipated.

However, at some point, even our peculiar version of flex-capitalism can spring a disastrous leak due, usually, to cupidity or stupidity or some awful combination of both. In this case, we think it's both. Greedy hedge funds and their customers went overboard with exotic tricks to try to beat the markets, not by a few percentage points, but for 25%, 35%, 50% or more if they could get it. The core of this latest round of supreme idiocy was the supremely idiotic subprime market, whose worth, when it was transformed into packaged tranches of securities, proved wildly overvalued.

Now the proverbial chickens are coming home to roost. The current Fed has decided to let a lot of institutions and individuals to get slaughtered here to get inflation neatly tucked back into its low target between 1-2% per annum. But the breezy expressions of confidence in this market are beginning to sound like the platitudes of the Hoover Administration in 1930-32. It's time for Repubs and conservatives to take a look here. The current batch of mortgage lending and hedge fund running thieves today does indeed richly deserve to perish in at least a moderate bloodbath. You don't want to perpetuate bad behavior. You do want investors to realize that extended stupidity can indeed wipe you and that no one, not even the Fed, will rescue you.

But the evils twins of investing, subprime mortgages and out-of-control hedge funds, were benignly neglected by the laissez faire crowd just a bit too long (just as Hoover's engineering types figured markets would take care of themselves way back when). They were allowed to assemble impossible positions which are now turning positively gangrenous. If the government doesn't want this gangrene to wipe out the entire financial system in a spectacular worldwide panic, they are going to have to move beyond the platitudes and the short-term cash injections, and contain this spreading infection. Otherwise, the financial system is going to expire before it gets to the operating table.

Pay attention, Fed. Let the guilty get punished. But don't just stand back and watch every American's 401(k) plans get flushed down the toilet. Social Security is already a bad joke. What will happen when there's nothing left to supplement it? What then?

The country, in spite of MSM propaganda to the contrary, has made great strides toward reconstituting its old get-up-and-go attitude during the long series of Republican presidencies since the 1968 elections. We need to be careful now not to create a 21st century version of economic and actual Hoovervilles that will result in another half-century of leftists in the judiciary and socialists running the country. This will finish us off as a country for sure. Wake up, White House and Federal Reserve. You can still keep confidence in the markets while keeping an eye on inflation. What you're now risking, however, is deflation, 1930s-style. And you know what happened the last time this occurred. Wise up. Now. It is nowhere written that ideological monetary conservatism must necessarily trump common sense.