Wednesday, September 17, 2008

Shorts Feeling a Little Tight? Part I: Dumping the Banking System into Oblivion

I hope so. I'm referring, of course, to the nefarious short sellers who are singlehandedly destroying what's left of the banking system, not your tighty whities. Although your knickers might very well be in a knot after the series of mad-slasher horror films we've been seeing unfold live on Wall Street this week in a series of events that's coming very close to the cataclysm of 1929. And the sad thing is, it's kind of an instant replay of that horrific economic event. Except, since they don't teach history in schools anymore, there's almost nobody left to explain a major part of what really happened then and is happening now.

For those who aren't market aficionados, you generally imagine that investing in the stock market means that, say, you buy a stock at $10, and hopefully, within a reasonable amount of time, it goes to $15, giving you a $5 profit less commissions, which are pretty low these days compared to the days when I was in the biz. Your average Joe knows this and that's probably enough. In the trade, it's called going long, or being long a stock. Or having a long position.

I used to teach investment classes in community college years ago. And the toughest thing I had to teach was the concept of the short sale, going short, or having a short position. Quite simply, it's the opposite of what I just described, going long or buying a stock. When you buy that $10 stock, establishing that long position, if the stock goes up over $10 you make money. If it goes below $10, you lose money.

Long positions are established when investors think the company is doing a good job, think other investors will agree, and want to join all of them in riding the stock up when more and more people want to buy it and bid it up. But what can you do if you see a $10 stock out there that's lousy and may very well sink to $5? You probably wouldn't want to get involved because you'd lose money, right?

Well, not necessarily. You can go out and actually borrow that $10 stock, sell it to someone else, and pocket the change for awhile. Then if you're right, and, say, the stock does sink to $5, well, you take half of the $10 ($5) you took in for selling the borrowed stock, buy it back, give it back to the person you borrowed it from, and pocket $5. I.e., you've actually made 5 bucks when the stock went down. How cool is that?

Most of the neophyte investors in my classes needed this explained two, sometimes three times and it still made them uncomfortable. It just seemed so, well, perverse, making money when, presumably, other people were losing their shirts. But in fact, it's good economics. The stock market is in the end an auction market and you always need to match buyers and sellers to have an orderly market. Short sellers pick up the slack in their part of the universe by selling, where as your normal average investor provides the long side.

Up to this point, my explanation is almost ridiculously oversimplified. I haven't talked about margin, about where you find the stock to borrow for a short sale, etc., etc. And you're probably still a little baffled about why the short side of trading is a good thing. But don't worry about that. Because in the market, as anywhere else, too much of a good thing can become a very bad thing.

When we have too many people on the long side bidding up investments at a too-rapid pace--as in the 1999-2000 dot.bomb, the $500,000 house you bought in 2005 that's now worth $250,000, and oil that was $147 a barrel in July and is under $100 at least as of this evening?--when this happens, we get a bubble and it bursts and people who climbed into the investments after, say, the half-way point gets killed when the bubble collapses. In this case, we had too many buyers chasing too few goods.

Well, the opposite thing can happen too. If too many people start dumping (shorting) a stock or other investment too fast and/or with too much fervor, they can actually succeed in crashing it and wiping out the investment. If you wipe out too many investments, well, you shake faith in the markets and can start wiping out the very mechanisms that enabled you to make money both long and short in the first place, which, like a bubble, is no good for anyone.

But no matter. In 1929, and again today in 2008, there are a certain number of predatory investors--many of them involved in hedge funds, but also rich guys (Soros anyone?) and perhaps even foreign governments--predatory investors who have gone so far overboard that their blatant and in many instances almost certainly illegal activities are on the verge of wiping out the entire American banking system. And worse, spreading systemic risk to the entire world banking system. All the economic systems have been slow to act and react, compounding the problem, and the SEC in particular has been asleep at the switch.

Hence, today's latest market catastrophe, the morning after the U.S. government effectively nationalized a huge insurance conglomerate, AIG, in order to "save" it, no less. After a bloody day like today, they didn't get much bang for out $85B bucks, did they?

It's their own fault, it's Wall Street's fault. But in some ways it's our fault too for starting the whole housing-oil-hedge fund-bubble-bust cycle by actually believing that house prices never go down; that it's okay to pay no money down on real estate; and that the 3% mortgage we got two years ago would be no problem when it went up to 8% because the housing appreciation would take care of the jump.

The result of this vicious cycle is now nearing its inevitable crash landing scenario. How bad it is, we should know in a couple of days or a couple of weeks. The sun will come out tomorrow, but I hope that when it does, you and I aren't standing on opposite street corners trying to sell Granny Smith apples starting at a dime and then trying to gain market share by dropping the price on each other until we make no money at all. It's that bad.

Rather than make this post lengthier, I'll finish up in 2 or 3 more posts. It's late now and I have some biz to attend to in the morning, then have to look at what's left of my portfolio. If I haven't jumped out of a building at that point, I'll take you back to 1929 to describe how "short clubs" worked; explain to you today how they're working again, courtesy of your asleep at the switch (or co-opted) SEC; and offer my opinion as to whether, due to some belated actions today by the SEC, we have any chance of regaining trust in the current banking system before you hear that giant FLUSHing sound signifying the end of our portfolios, the death of our retirement funds before our own demise, and the end of Wall Street as we know it.

Have a good evening. If you can.

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