The New York Times reports that Morgan Stanley (NYSE: MS) CEO John Mack approached Citigroup head (NYSE: C) Vikram Pandit on Wednesday about a merger. It quotes Mack as saying "We need a merger partner or we're not going to make it." Fortunately, Citi rejected Mack's advances -- I say fortunately because Citi has enough problems of its own without taking on Morgan Stanley's. Why is Morgan Stanley, which just posted a $1.43 billion profit, in such desperate straits?
It's a brilliant negative feedback loop that short sellers are exploiting to enrich themselves as Wall Street collapses. Here's how it works: the hedge funds sell the stock of 'Bank A' short -- borrowing the shares at a higher price and hoping to pay back the stock loan with shares repurchased in the market at a lower one. As the Wall Street dominoes tumble, investors ask who's next and they sell the shares of the next domino to fall.
That decline leads ratings agencies to lower their debt ratings on a bank which boosts the rates it pays in the $62 trillion market for Credit Default Swaps (CDSs). Those higher rates force 'Bank A' to come up with billions in cash which it doesn't have -- raising fears of a collapse and further depressing 'Bank A''s stock price. And the cycle begins anew until 'Bank A' finds a merger partner or goes bankrupt. This short-selling work is very profitable, but it is also destroying the global financial system.
This is not just an academic exercise. CNNMoney reports that the rates for Morgan Stanley have spiked since last week. It writes that "the cost to insure a $10 million block of Morgan Stanley debt for one year reached $2 million to $2.2 million upfront, plus the annual contract cost of $500,000, at one point Wednesday afternoon." That is roughly seven times the "$325,000 annually, with no upfront cost" that Morgan Stanley paid last week.
This reminds me very much of this summer's concerns with rising oil prices. Despite denials by Hank Paulson -- whose former employer Goldman Sachs Group (NYSE: GS) was profiting from the these trades -- the Commodities Futures Trading Commission (CFTC) found that 81% of oil trades were made by speculators who bought oil and shorted the dollar to profit from the expectation that the Fed would keep cutting rates and weakening the value of dollar - whose drop was fueling the rise in this dollar-denominated commodity. This drove oil up to $147 a barrel in July before Congress cracked down.
The point is that in the oil case, and now in the case of shorting Wall Street banks, a small group of wealthy institutions are profiting from the misery they are inflicting on everyone else. As I posted, the current collapse of Wall Street is being helped along by the CDS market -- one that was deregulated by John McCain economic advisor Phil "Americans are Whiners" Gramm.
The question now is whether our government -- which has been able to "afford" to spend some $800 billion worth of taxpayer money to bail out private companies -- has the power to shut down this negative feedback loop. (I appeared last night on CNN to discuss these bailouts). This shouldn't be too difficult to do -- it could simply force the hedge funds to cancel their short sales through a temporary emergency order. Sure this will hurt a few hedge funds but it might be a great way to stop what looks to be a complete collapse in the global financial markets.
Are a few hedge fund billionaires more powerful than six billion ordinary people around the world? We will soon see.
Peter Cohan is President of Peter S. Cohan & Associates. He also teaches management at Babson College and edits The Cohan Letter
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Reader Comments (Page 1 of 1)
9-18-2008 @ 12:08PM
Byron Yost said...
It was the investment banks that financed these shorting hedge funds and now that the oil game is dead, they have turned on their backers. Poetic Justice? Except that the rest of us are paying for it.
In the old days, a Wall Street firm would break this loop by getting friends to buy their shares. Thus breaking the back of the shorts. Doesn't Mack have any friends?
9-18-2008 @ 12:49PM
RG said...
-- Sept. 17 (Bloomberg) -- The U.S. Securities and Exchange Commission stiffened rules against manipulative short-selling after a market rout pushed American International Group Inc. to the brink of collapse and triggered Lehman Brothers Holdings Inc.'s bankruptcy.
The SEC adopted two regulations today forcing traders and brokers to close out short sales on all stocks, amid concern investors are driving down prices by flooding markets with sell orders. A third rule makes it a securities fraud when sellers deceive brokers about delivering borrowed shares to buyers. --
1) Does this stop it?
2) How many Americans duped by today's
"Trickle-Down" GOP, need a lesson about
how laissez-faire capitalism caused the Great
Depression?
Hint: Chris Cox, was one of it's many Reagan-era
perpetrators.
Barack Obama, is the luckiest man on the planet.
-
9-18-2008 @ 11:50PM
Elliot said...
Obviously the business model of an investment bank doesn't work it it is dependent on maintaining a certain stock price. At times, these investment banks make killings on short positions - now others are making killings on them the same way. The problem is that these banks were and are over leveraged. They had no business being so leveraged - and now they are paying the consequences. Naked shorting is already illegal. Short sellers play a valuable part in free markets - they have to cover and can get slaughtered if they're wrong. For legitimate business - short selling can create buying pressure. Everyone should have to play by the same rules right? You certainly can't change them in the middle of the game like what happened this week - an expiration week at that. Does Mr. Cohan want to regulate the markets to make rules so that investment banks always win?