Morgan Stanley Shorts Brought the Short Ban

The one question that keeps getting asked is why the SEC took the draconian step to ban all short selling on 799 financial stocks. Banning financial transactions in securities is something that happens in Russia and Malaysia, not the United States.  How could it have come to this?  There is a logical explanation. 

The short sellers sealed their own fate when they picked on Morgan Stanley (MS).  Despite constant claims by to the contrary, I am convinced that huge sums of hedge fund money were raiding "weak" financial institutions.  These bear raids were the exact reverse of the 1999-2000 NASDAQ bubble when hedge funds could mark stocks up by 5-10% a day because of the ebullient investment environment. 

In a panic environment, these funds could destroy weak companies, such as AIG, because the sellers far outnumber any potential buyers.  The cratering stock price destroyed confidence in the company’s core businesses and the ability to find funding in the capital markets.  The short raids essentially created a death spiral, not just for the stock but for the company as well.  Yes, many of these companies would have had to go under or merge eventually, but the short sellers essentially pushed the weak off the ledge.  They forced the hand of managements before they could come up with a credible plan to sell assets or negotiate mergers.

These bear raids were taken right out of the 1930-1932 playbooks of stock operators who could overwhelm the markets with their huge pools of money.  Out of that disaster came such regulation as the “uptick” rule and government offices to oversee the markets such as the Securities and Exchange Commission [SEC].  For reasons that I still do not understand, the rules and regulations in place were not enforced or were repealed, leading to the new era of bear raids.  

The game plan worked perfectly all year for the short sellers.  However, when the short sellers picked on Morgan Stanley, they overplayed their hand.  Morgan Stanley was essentially caught in the death spiral.  Despite reporting a good quarter, the stock sank 50% in less than a week.  The short sellers were piling on - the stock had dropped from $20 to $11 on Thursday afternoon.  Morgan Stanley was essentially being forced into a merger because the sinking stock price was creating a crisis of confidence which prevented it from accessing capital to fund its business – a business that just reported a $1.3 billion profit several days earlier. Click to enlarge:

Source: Bloomberg

The disappearance of Morgan Stanley (MS) and potentially Goldman Sachs (GS) was politically, patriotically and structurally impalpable for the Fed, the Treasury and Administration. 

It was politically impalpable because no Treasury, Fed, Congress or President wanted to be seen as doing nothing as Wall Street, and eventually the economy, essentially collapsed.  Despite the obvious shortcomings and greed of many of the players on Wall Street, the capital markets are what make America great.  They are more important than any government institution in making our economy grow, adjust and advance.  Without capital markets, capital flows less efficiently and companies cannot find money to grow their businesses.

It was patriotically impalpable because Morgan Stanley and Goldman Sachs represent American financial power across the globe.  Companies all over the world, including China and India, try to have Goldman Sachs or Morgan Stanley underwrite their offerings because their names represent credibility to the rest of the financial world.  If these companies had disappeared, America would have lost as much respect in the financial world as it has in the political world.

Finally, it was structurally impalpable for the Fed and Treasury to have no independent investment banks remaining.  Morgan Stanley and Goldman Sachs provide primary dealer services for the Fed in its open market operations.  The firms are almost inextricably tied with Fed and Treasury.  Having this link be broken or altered was inconceivable for Hank Paulson or Ben Bernanke. 

The short sellers pissed off Hank Paulson and he brought out the big guns.  Paulson essentially had to shut down part of the free market to save it from itself.   And while it was draconian and un-American, it was probably a necessary step to save Morgan Stanley and Goldman Sachs - the last two symbols of American financial power. 

Comments

[bbzz24:]

and germany, the netherlands, the united kingdom, ireland, taiwan, duubai.

2008 Sep 22 05:28 AM

[Shorts Are ...:]

Very insightful article. Why give anyone, especially huge secretive hedge funds, incentive to destroy our financial systems and markets and then reward them? Shorts would have no need to spread false rumors and panic if short selling was not allowed. That is insane.

Shorts must be very evil and greedy people that strive for the destruction of man-kind. They dream for the death of individuals, job losses, and all bad things in general.The crazy thing is that they get rewarded if their dreams come true.

2008 Sep 22 05:28 AM

[Shorts Are ...:]

The Shorts use kind of a 3 prong strategic military-like attack with the assistance of the Rating Agencies and Media:

First the Shorts determine who to go after and who they could have the most effect on within the financials. They then spread False Rumors which are picked up by the Media which quote unnamed sources that in turn scares people. Shorts then follow up with a Massive Bear Raid (using naked short selling), which leads to a Downgrade by the Rating Agencies stating that the companies share price are now too low for future capital raises, which lead to possible calls on the companies holdings and further price drops...then onto their next victim to destroy and so on....

2008 Sep 22 05:30 AM

[williambanzai7:]

The Great Subprime “Babel”—A Modern Tale of Biblical Greed

By WilliamBanzai7

Wall Street never changes. The pockets change, the suckers change, the stocks change, but Wall Street never changes because human nature never changes. - Jesse Livermore

The public’s annual loss to Wall Street has usually been estimated in former years at $100,000,000 per annum, but owing to the more recent enterprising methods of the “Street” in manipulating the game, this estimate is now far to small as we shall see.-Franklin Keyes (1904)

Conceit of the Street

Shortly after the explosion of the great “dot.com” bubble something happened that was to change the monetary affairs of all men on Earth.
The investment banking tribes had once again begun to proliferate and fill the Street. They spoke a new tongue--the tongue of rampant financial innovation. It was a strange tongue with words like synthetic CDOs, conduiting, CLOs, SIVs, bespoke swaps, CDOs squared, negative default correlations, binomial expansions and stochastic modeling. A tongue curiously reminiscent of the tongue of the House of ENRON.

The generations of bankers before the “dot.com” bubble, were believers in the fundamental laws of securities valuation and diversification. They were believers in the book of Graham and Dodd.

But the new generation of investment bankers was different. They stressed an opposite code of investing. The smart investor did not count. Their game was a vast pyramid of derivatives and mortgage backed securities. Had they confined themselves to this kind of financial life in a modest fashion, all might have been well. But the obscene fee income made possible by cheap leverage, financial engineering and securitization techniques made them ever greedier and in their hubris they thought they could beat the financial laws of thermodynamics.

They decided to build a great Tower of mortgage backed securities. With the Tower they would pillage the housing markets and at the same time seemingly eliminate all risk for themselves. Heads we win, tails you lose; that was their credo. The symbol of their invincible wealth, as they thought, was to be built in the shadow of the House of Greenspan. It would be squeezed out of Joe Public who was long disdained and exploited by the Lords of the Street. This time they would build tempt Joe with reckless mortgage loans supported by an “irrationally exuberant” real estate market.

According to the Lords of the Street, a new paradigm had emerged: financial risk could be sliced and diced into oblivion, cheap leverage is here to stay and housing prices can only go up. Many foresaw the folly of this enterprise. Buffet, the great chief of the House of Berkshire Hathaway, called the new instruments of invincible wealth, financial weapons of mass destruction. But the aging House of Greenspan was oblivious to the great folly unfolding before its jaundiced eye. The unbelievers were admonished to stay in Nebraska where they belonged.


Their Punishment

Finally, the Market decided to punish the arrogance of the bankers by destroying the tower. First, it, confused them by splitting them up into many greedy tribes, each with a tongue and agenda of its own, (hence the name Babel, meaning “confusion”). A new tribe, the Shorts, arrived and the hunters soon became the hunted. Alas, they were forced to subjugate their vast pools of CDOs and CDSs to the divine force of the Market. This ultimate humiliation came to be known as the “great MTM slaughter.”

When this happened, the Tower had to be abandoned. The various bankers would migrate in different directions. Many were fired. Others headed West to the Valley of Silicon, no doubt dreaming of other Babels ripe for exploitation—nanotech, infotech, biotech and cleantech to name but a few .

The Tower itself was partly burned and partly swallowed by the great Houses of Morgan, Barclay’s and BOA. As for the Great Houses of Goldman and Morgan, they were forced to pledge themselves to the Fed, under the wise and benevolent protection of Gentle Ben, the new master of the House of Greenspan. He who would later come to be known as “Father Moral Hazard”.


(Adapted by WilliamBanzai7 from the Biblical story of the Tower of Babel)

2008 Sep 22 07:05 AM

[Reggie Midd...:]

I have to break rank here and totally disagree with you. Morgan Stanley had a very bad earnings report that was dressed up in lipstick, just like Palin's pitbull soccer moms. Are you saying that MS had a good quarter because you actually went through the numbers yourself, or are you just repeating what you heard others say?

* Morgan Stanley's reported revenues increased 1% y-o-y to $8,049 mn. However excluding a pre-tax gain of $745 mn and $1.5 bn impact of widening credit spreads on firms own debt, revenues declined 27% to $5,804 mn in 3Q2008 over 3Q2007.
* As result of slowdown in capital markets activity, Morgan Stanley's M&A transactions, global IPO and debt volumes declined 63%, 66% and 46%, respectively.
* Morgan Stanley's leverage declining to 23.5x in August 2008 from 25.1x in May 2008. However Morgan Stanley's level 3 assets-to-total assets increased from 6.7% as of May 2008 to 8.0% as of August 2008.
* As of August 2008, Morgan Stanley's exposure towards U.S. subprime mortgage stood at a 44.3% of its shareholder's equity.

Does this sound like a good quarter or earnings report to you???

For more on why Morgan Stanley was really shorted, learn from someone who actually put his money to work to short Morgan: boombustblog.com/index... and most importantly, be careful about repeating what you hear without verifying it for yourself.

2008 Sep 22 10:40 PM