A Mini-Credit Crisis?

Summary

• My view of what's happening.
• My view of why it's happening.
• My guess about the ultimate outcome.

The old rules of finance and investing are giving way to an entirely new financial market structure dominated by spontaneously-forming leaderless swarms of anonymous traders with one primary motivation: destroy the status quo. These trader swarms gravitate towards the weak segments of the capital markets where establishment firms have the greatest vulnerability: thinly-traded stocks with high short interest, stocks with abnormally high call volume, or shares with limited public float held by owners who will not, or who cannot, sell their positions at any price. The goal of the trader swarm is very simple: force establishment firms (particularly hedge funds) to cover short positions at a time when there is not a sufficient number of shares currently available to cover all those short obligations. By doing so, trader swarms can force hedge funds into bankruptcy within a short period of time and leave brokerages on the hook to cover those losses - with limitless liability since stock prices can in theory rise by an infinite amount irrespective of value.

These weaknesses in the financial system now exposed, brokerages are certain to react and in so doing, expose the very truth that motivated the trader swarms in the first place: that the system is rigged in favor of the Wall Street establishment elite. As we saw this week, brokerages such as Robinhood limited trades in certain short-squeeze stocks like Gamestop (GME) and AMC Theaters (AMC), buying just enough time to enable some customers (particularly hedge funds) to cover short positions in those shares.  In a nutshell, Robinhood changed the rules of the game midway through to help get its wealthiest clients off the hook. Robinhood didn't have any real choice in the matter - if their hedge fund clients cannot make good their bets, Robinhood must do so out of its own pockets. But either way, the trader swarm proved its point. 

My sense is that Gamestop (GME) is only the beginning. There are countless small, thinly-traded stocks with relatively high short interest and high volumes of outstanding call options. Any one or more of these stocks makes a perfect target to engineer a gamma squeeze and having proven the point with (GME) and (AMC), and in some cases profited handsomely in the process, trader swarms will not only press the attack. They will broaden it out to hit as many available targets as possible.

Unlike any other investors in history, the goal of the trader swarms is not simply to generate capital. It is to destroy it. The fundamental assumption upon which the financial system is built - that all players will invariably act to maximize profits - is completely inapplicable in this instance. The trader swarms are, in a nutshell, the financial equivalent of the Trump supporters who stormed the US Capitol and at the moment, there don't appear to be many Capitol police on the beat.  

So for the time being, expect to see shares of companies you've never heard of soaring by 1,000s of percents per day for no obvious reason. At the same time, you can probably expect broader markets to falter as hedge funds unload assets to raise liquidity to cover shocking losses on their short positions. There could be a short liquidity crisis if brokerages become leary of extending credit to one another. At some point, exchanges will impose trading curbs on shares of companies like (GME) and (AMC), and the companies themselves will act quickly to take advantage of their soaring share prices by selling more freshly issued stock at wildly elevated prices - thereby alleviating any temporary shortages of supply. Fundamentally, the problem today is a supply/ demand imbalance. The systems already exist to address that problem, but take time to work. But when prices are swinging 1,000% per day, a shortage of time is just as dangerous as a shortage of stock. 

In the longer term, I expect brokers will dramatically raise the price for securities lending, or restrict that lending altogether for thinly traded stocks. Having suffered losses of 100% on certain investments, institutional investors will lose interest in hedge funds that engage in short selling. If either or both of those outcomes should come to pass, then I think there will be less short selling in the market going forward. Less shorting means lower selling pressure which could actually push overall stock prices much higher. In that sense, at least, I'd view a quick, violent market crash as an opportunity.