A rant

[Norbert Schlenker]

Please excuse me. This is going to be a long winded ramble about what's happened over the last week. Rather than sprinkle comments in a bunch of threads, I figured I would just collect it all in one place. I made a couple of acid comments Friday re a rigged game and my mood as a result being apoplectic. I have been asked for an explanation and feel obligated to reply.

To start, let me say that I am a very prosaic investor in real life. I am long only and have a very diversified portfolio. I don't short anything outright to make a profit, although I will occasionally employ a short sale on a very short term basis in order to accomplish something else, e.g. converting currency to avoid being jacked around by a bank.

I believe (broadly) in market efficiency. I acknowledge that there are pricing anomalies, but I have little faith in my ability to identify or exploit them, particularly when it comes to equities. I accept market prices as a good faith and unbiased estimate of "true value". I am unwilling to stake my long term financial goals on the assumption that I am somehow smarter or more visionary than anyone else with intelligence and capital. In the end, I know that I must rely on the market to turn an investment into spendable cash. I have no power to force liquidation at my own estimate of true value. At the far end of my investment horizon, a very simple truth holds. Realizable value turns entirely on what others think. Not true value. Not my beliefs. Consequently, I am also willing to accept that, if I'm buying today, today's market value is someone else's realizable value, unlikely to be true value, perhaps too high, perhaps too low. Someone is making a mistake, either me as buyer or someone else as seller. A hundred years from now, we'll know who. But I don't know today and, quite honestly, I've got better things to do than worry about it.

Why the short selling restrictions enrage me
A market is, first and foremost, a price discovery mechanism. I rely on markets - we all rely on markets - to set reasonable prices on goods. Reasonable. Not perfect. Just reasonable.

(There are other ways of setting prices in economies. We've seen them tried. Our luck is that we've seen them tried mostly in other countries because then someone else somewhere else bore the burden of a mechanism that generally slows economic growth, fails perhaps gently and sometimes catastrophically, and enriches the politically connected. I'm one of the lucky beneficiaries of not having been subjected to such ridiculous experiments. Believe me, I count my blessings.)

Part of the price setting mechanism in a free market is people selling something that they believe is overvalued. The market isn't going to produce an unbiased estimate of the true value of any good, whether it's avocadoes or shares, if sellers are prevented from offering goods that are priced above true value. If we decree[1] that no seller be allowed to act on her own judgment that an avocado or share is trading above true value and thus offer it for sale, with the seller bearing the financial consequences of his judgment, the market price is no longer an unbiased estimate of true value. The market price of avocadoes becomes a joke, something to be gamed by those in the know.

Two objections often get raised at this point, first that avocadoes are qualitatively different from shares, second that sales are not the same as short sales. I deny the first absolutely.[2] I deny the second as well but that requires an argument. The objection usually turns on the abstract nature of a short sale, offering to sell something you don't own. There is something viscerally wrong with a short sale. People go to prison for selling things they don't own. If you see a car for sale in the want ads, call the advertiser, go visit, hand over your money, drive away in the car only to find that you can't register it because it wasn't the advertiser's to sell, you expect to see someone go to jail. If your son Tommy hands a dollar to Joey in the schoolyard expecting to get a couple of chocolate bars and Joey stiffs him, then you expect unpleasant consequences for Joey.

But that's not what a short sale is about. Short sellers have to deliver the goods.[3] Forget avocadoes and shares for a minute. Take something simpler, say a sofa. You can walk into a furniture store and buy a sofa off the floor, a display model. Hand over your cash or credit card and you can have the sofa delivered the next day. More likely though, you walk in, see a style you like, but the fabric is wrong. You want this style but the fabric on the one over there. Or the fabric in some book of swatches the store hangs on a rack in the back. The probability is near zero that you will have a sofa tomorrow. You pick your style and your fabric. The store will have your sofa built. You will wait two months. You will also put down a deposit today, probably for at least half the value of the sofa.

Did the store sell you a sofa today? I don't think so. The store has just made a short sale. They have taken your money for a product they don't own. It's even more egregious than a short sale of shares. When someone sells shares short, they'll borrow them to deliver. It's not as if the shares don't exist. This sofa you just "bought" can't be borrowed. It doesn't even exist.

Should the furniture store be legally barred from selling you a sofa that doesn't exist? I don't think so. I'll bet you don't think so either. Vast swaths of the economy operate on the basis that items that don't even exist at the time of sale can be sold. Sofas. Airplanes. Ships. New houses. They're all short sales. Think about the effect of banning short sales of new houses by home builders. The effect on you. The effect on the economy. How many houses would get built if every house was required to be a spec house?

So what's so special about the shares of financial institutions that it's reasonable to decree that they can't be sold short? I submit that there is no good reason for this. Don't get me wrong: I think there's a reason it's been done. I just don't agree that it's a good reason. It's an attempt, which will ultimately fail IMO, to paper over the rot on bank balance sheets. In the end, there's a simple fact that can't be papered over. The banks have crappy assets. They did it to themselves. They must bear the consequences themselves. Creating a temporary (?) rule to prevent people who believe that the banks have crappy assets from selling the bank's shares is somewhere on a continuum from folly through delusion to criminal.

No one should believe the share prices at Friday's close on those 799 institutions that the SEC protected. I'm not saying that the mid-day Thursday crash low prices are correct, either. But if I were a betting man, I would bet that Thursday mid-day is a better estimate of true value than Friday's close. Thursday afternoon and all of Friday were a government induced ramp job, one of the greatest pump-and-dump operations ever seen.

And everybody's going to pay for it except the people who should.

The Paulson rescue plan
The US government, either as Treasury or the Federal Reserve, has already spent[4] close to a trillion dollars keeping the financial system running this year. Thursday, the Secretary of the Treasury and the chairman of the Federal Reserve went to Congress to ask them for another trillion dollars. (Hundreds of billions have been mentioned in public. Trust me, it will be a trillion at least.) The legislators are said to have exited the meeting white as sheets. They probably had reason to be shaken.

There are real liquidity problems, which the Fed has been trying to handle over the past year. Bernanke made his bones on the causes of the Great Depression, much of which was due to undue contraction of liquidity in the US economy. The Fed has been beavering away trying to keep that from happening again. In the process, they've ballooned their balance sheet. The Fed is now levered about twice as far as Bear Stearns and Lehman when they collapsed. In theory, there is no limit to the Fed's balance sheet. However, this is not a theoretical world. Put enough pressure on the Fed and something has to give.[5]

Liquidity problems are appearing everywhere. Short T-bill yields traded through zero last week. LIBOR and the TED spread spiked because no one was willing to lend to anyone other than the Treasury itself. Money market funds collapsed, generally not because their assets were actually bum, but because they had promised absolute liquidity on their liabilities and liquidity disappeared for their assets. I'm of two minds about the measures Paulson announced re MMF guarantees. It's a misuse of the $50b slush fund[6] he has sitting around but the system was sufficiently seized up that something had to be done. Maintaining liquidity happens to be the Fed's job but, as noted above, they are overstretched already. I can live with it. Paulson had legal authority (not that he should have such authority in the first place IMO, but that's another story) and, with sand in the gears and no more oil at the Fed, he did what he had to do. In the end, it will be a complete ballsup, because only the MMFs with crap on their books will pay the insurance premium, i.e. if your MMF is in the program, you know it's larded with crap. Investors will flee and the Treasury[7] will get the bill.

However, the problems don't end with lack of liquidity. Lack of liquidity is a symptom, not a disease. The problem is solvency. Large parts of the US financial system are not just illiquid. They are insolvent. Their liabilities exceed the fair value of their assets under any fair mark. The problem is not that they can't sell their paper because the market is illiquid. The problem is that they hold paper on their books at a dollar or 75 cents when it is actually worth a nickel. Not bid a nickel. Worth a nickel. Banks in the hot real estate markets of two years ago are stuffed to the gills with mortgages that are not paying and will not pay. When you wrote second mortgages or extended lines of credit at the top and the collateral is worth half what you lent, your dollar asset is worth a nickel.

People were paid big money to put those "assets" onto the books of US banks (and through securitization, investment banks and pension funds and mutual funds worldwide). Those assets are impaired. They were impaired from the word go but the chickens have finally come home to roost. The people who got paid the big money? They're gone, pockets full. There aren't enough jails to hold them all or prosecutors to send them to jail. They got off scot-free, top to bottom. From the high school dropouts who made hundreds of thousands a year telling people that real estate could only go up or that this option ARM with a teaser rate was way better than the stodgy old 30 year fixed rate, to the CEOs who made hundreds of millions shopping asset backed paper that was really toilet paper, they lived large. Lucky them. There were no losers.

Oh, there were whiners, the people who complained about being priced out of houses, the skeptics about house prices, the people who just couldn't keep up with the Joneses down the street with the Hummer and the BMW and the ATVs and the big screen and and and. Screw them. Nothing ever got done with a negative attitude like that. Screw them. Look at the GDPeeeeee!

And here we are today. Everybody is whining now. So what happens? Paulson is going to produce a plan over the weekend and Congress is going to ram it through.[8] It's designed to help the new whiners. I urge you to follow the money, both where it comes from and where it goes. It's going to come from everybody. US taxpayers and lenders to the US, many of whom are outside the US these days, are going to pony up the money. If they can't find the money there, they'll print it, i.e. it will come out of US hides in the form of inflation.

Where's the money going? There is no plan yet so it's hard to be certain but it's a fair guess that it will be used to buy the crap assets out of US financials. There can be no winner here. If Treasury pays too little for those assets or even fair value for those assets - which the talking heads will insist is going to happen - then banks are going to fail. Lots of banks. Big banks. Banks today have liquidity problems because they've got nickels that they're calling dollars and no third party will fund that fairy tale. If Treasury takes the asset worth a nickel off their hands for a nickel, their liquidity problems are over but the bank is finished. So it seems to me exceedingly unlikely that nickels will be swapped for nickels. The Treasury will get a nickel worth of paper and the bank will get fifty cents of cash. And the bank, while weakened, will survive.

Note who gets the pony: the same people who already got paid for making those nickels look like a dollar get paid again to sell their nickels for ten times what they're worth.[9] And who gets the shovel to walk around and clean up after the pony? That would be you and me.

What I'm going to do
In normal circumstances, I take market price as a fair estimate. If I want to buy bank shares, I would generally buy them at market. What does the short selling ban mean to me? It means that any observed market price is almost certainly an overestimate of true value. In these circumstances, I will lower my bid. I am but one investor among many and I'm not stupid or vain enough to think that what I believe here will change things, but I will lower my bid anyway. If it is decreed that certain people cannot sell, then the game is rigged. I will lower my bid. I will be a willing participant in blowing out the spreads. There are consequences to what the SEC has done. Up 1000 points Thursday and Friday is one consequence. But it's not the only consequence. I don't play rigged games. And in the long run, I doubt I will be alone. That +1000 will disappear. Short sellers had nothing to do with it. The jump at the end of the week is a short run thing and what they've done is unsustainable. (Think Dow +1000 means happy days? You haven't looked at the bond part of your portfolio, have you?)

In the long run, the real danger comes from the rescue plan. There's real trouble hiding in the banks. There's been a big party. Quite a few people enjoyed themselves immensely, but not everybody. Party's over. Time to clean up. We're not going to enjoy this nearly as much. And just about everybody gets to help, either through higher taxes or higher interest rates or inflation. Probably some of each.

I'm not happy. I was always at the fringes of the party, as were most investors. Buy and hold has been kind to us all. Sandwiches and punch made it out to the periphery and I was happy with what I got. But what a mess now. I'll do everything I can to minimize how much I have to shovel. I'm outside the US physically and I'll get what I can out of the US financially. To be honest, I don't know at this point where I'll go.

I am a generally happy investor, understanding that there's always a house rake on everything I invest in, content to live on what's left after management and the government have had their share. I understand those rules. I will play that game. I will live with the ups and downs of Mr. Market, because he's randomly insane either way and in the long run it will all work out. I will not play a crooked game, one where the rules get changed in the middle. I like symmetry. Everybody gets a turn on the pony and everybody gets a turn on the shovel. When the rules change so that some just get to keep riding on the pony, based on who you know, not what you know, i.e. politics, I'm a lot less interested.

I still have a bid. It's just gotten lower. A lot lower.

--------------------------

[1] I use "we decree" because the securities commissions act under authority we grant.
[2] I'm prepared to argue the point, but (a) I'm right, (b) you're wrong, and (c) this is too long already.
[3] There's another objection in here regarding naked short selling, which is selling short with neither intention nor means of delivering. That's something different and I agree it should be penalized.
[4] The press releases all say "loaned" or "invested", not "spent". We'll see.
[5] Force me to guess and what has to give is the value of the dollar. Inflation is coming.
[6] He used something called the Exchange Stabilization Fund.
[7] Treasury (noun): A siphon into the wallets of the taxpayers.
[8] I have little faith in legislation crafted in 72 hours. How about you?
[9] I was watching CNBC for a short time Friday when they happened to have Bill Gross on. When asked if he'd be interested in helping out Treasury with the management of all this crap they're going to buy, there was no disguising the grin.

[Edited to replace asterisks with endnote numbering per Goofyboy's suggestion.]

[parvus]

I'm looking forward to the encore. A word of caution, however. I remember thinking after the collapse of Enron that by the time that litigation is finished, we'll be knee-deep in something else. Similarly, by the time the U.S. financial system is rebuilt, there will be some new shenanigans in play.

[active]

Nice rant, well written and all true. You should sent it to the Globe to be published as a commentary.

I'll get what I can out of the US financially

To actually do this is a challenge. In a global economy/marketplace you will always be widely exposed to the ups and downs of the US market, directly or indirectly. There is no alternative to fixing the mess.

[Goofyboy]

May I suggest you change the footnote references from asterisks to numbers. Once you get more than "****" it gets very hard to follow. (1)

To actually do this is a challenge. In a global economy/marketplace you will always be widely exposed to the ups and downs of the US market, directly or indirectly. There is no alternative to fixing the mess.

I do agree with you, but I think the point is to minimize the impact.

(1) - Something like this!

[biker]

Thanks for posting your analysis and thoughts Norbert. I don't claim to understand it all but do get the general idea and I do respect your views having paid attention to your posts for many years.

Could you please expand/explain on this part......"I'm outside the US physically and I'll get what I can out of the US financially. To be honest, I don't know at this point where I'll go."

Do you mean that you plan to get out of US investments?Plans for investing in Canada? Other alternatives you would consider at this point?

[scomac]

Now I'm beginning to wish that I hadn't asked.

You make a very compelling argument, Norbert. One that I'm inclined to accept, yet I have to wonder what was the alternative and would the ramifications of letting all these "players" fall on their own swords been worse than what will play out? The urge to preserve capital is hard to resist under this backdrop. Needless to say, this isn't doing anything for the state of my stomach or the restfulness of my sleep. Sometimes ignorance is bliss.

[Orcbait]

I'm sorry, maybe I'm the only one who thinks this after reading this, but do you honestly believe that Mr. Market is randomly insane and the "game" isn't crooked in a hundred different ways all along? sorry, but your view of how this all really works strikes me as fairly removed from reality. And when it comes to investments, we had better live in the real world, or will get our heads handed to us.

Yes, the price to be paid from all this will be huge. But still the Fed did what had to be done. It's like the analogy I read somewhere about your house being on fire, and the fire department shows up and first fails to take their shoes off at the front door and what's worse causes significant water damage saving your house. Still beats the alternatives.

[and yes, I know this is all after the Fed under the "great maestro" first helped create some of the greatest bubbles in history, all the while claiming that you couldn't spot a bubble until it popped and bit you - when Greenspan makes comments like that, he's either disingenuous or utterly idiotic]

Orcbait

[lystgl]

You did not address naked shorts. No one was "borrowing" anything, hence the problem.

[George$]

... Did the store sell you a sofa today? I don't think so. The store has just made a short sale. They have taken your money for a product they don't own. It's even more egregious than a short sale of shares. When someone sells shares short, they'll borrow them to deliver. It's not as if the shares don't exist. This sofa you just "bought" can't be borrowed. It doesn't even exist. ...

Norbert: I'm still mulling your wonderful rant! Great style.

My mind is stuck trying to reconcile the shorted sofa with the shorted Stanley Morgan shares.
How does shorting sofas drive down confidence in the viability of sofas (or their manufacturer)?
Drive it into bankrupcy?
Or make the shorter rich beyond belief?
Are you sure your analogy carries?

[George$]

Needless to say, this isn't doing anything for the state of my stomach or the restfulness of my sleep. Sometimes ignorance is bliss.

Keep remembering that - "this too shall pass". or
It's all only numbers on a monitor or on a piece of paper (until you go to the cashier's box). or
Enjoy the spectacle while it lasts. No admission charge for the show. or
The alternative is not worth it.

[scomac]

Needless to say, this isn't doing anything for the state of my stomach or the restfulness of my sleep. Sometimes ignorance is bliss.

Keep remembering that - "this too shall pass". or
It's all only numbers on a monitor or on a piece of paper (until you go to the cashier's box). or
Enjoy the spectacle while it lasts. No admission charge for the show. or
The alternative is not worth it.

I keep telling myself that. Still, I wonder. My concern isn't with what the gov't has done, it is with the magnitude of problems that would illicit what has been an unpresidented response. What if all these cheap securities aren't as cheap as they appear? What if the collective wisdom of the market is making a reasonable estimate of true worth and much of the perceived value is illusory?

[George$]

... What if all these cheap securities aren't as cheap as they appear? What if the collective wisdom of the market is making a reasonable estimate of true worth and much of the perceived value is illusory?

On this I never forget Buffett's words - that the securities don't matter as much as the future profit and dividend stream they represent. The market is perception, whim, fear and more. Profits on the sale of a can of Diet Coke (which I'm drinking as I type) are real.

True, the financial economy (stock market) could seriously savage the real economy (goods and services) for a while but never too long. Folks will always work to eat and keep warm.

My simple minded outlook.

[parvus]

My concern isn't with what the gov't has done, it is with the magnitude of problems that would illicit what has been an unpresidented response.

Illicit magnitudes of risk now ballooning further because of an absent president! Your Freudian slip is showing some harsh truths.

[Nemo2]

The market is perception, whim, fear and more.

Which is why, although I believe Obama epitomizes the proverbial self-aggrandizing empty suit, I'll be happy to see him elected if the world perceives that the Messiah hath returned and thus the mark(et) of Lazarus is reborn...........and my holdings appreciate accordingly.

[tidal]

Did the store sell you a sofa today? I don't think so. The store has just made a short sale.

No it didn't. It made a forward sale. Entirely different mechanics.

[mudLark]

The problem is solvency.

Norbert, ISTM this root problem goes far beyond the US financial sector.

An insolvent government is bailing out an insolvent financial sector using future income (taxes) from a public that has never been more insolvent.

A very interesting post.

[kcowan]

Thanks for an insightful contribution, Norbert. I guess I really get uneasy when any government tries to "play God". They have a really bad track record anticipating side effects. So they end up with a series of patches on the subsequent symptoms, meanwhile quite likely just exascerbating the root causes.

Speaking of "Playing God", why are CIBC and TD excluded from the short list of 799 companies but Scotia is included?

[yielder]

Why the short selling restrictions enrage me
A market is, first and foremost, a price discovery mechanism. I rely on markets - we all rely on markets - to set reasonable prices on goods. Reasonable. Not perfect. Just reasonable.

I guess you're opposed to circuit breakers as well. I don't know what you were doing in October 1987 but I was sitting in an office at Fidelity and watching Fidelity systems freeze solid because of the volume of phone calls and sell orders as panic ensued. And Fidelity was state of the art at the time and had very deep pockets, both financial and talented personnel. This is far worse that 1987.

FWIW, the price discovery mechanism has been broken for a long time although in stages, it's now more of a GIGO mechanism : inadequate transparency in hedge fund reporting; removing the barriers between investment banking and commercial banking; no reserve requirements on investment banks allowing for whatever level of gearing they thought they could get away with; relaxed accounting standards, eg, things such as replacing amortized goodwill with impairment, off balance sheet items, etc.; executive compensation that encourages short-term pumping the company rather than sustained long-term growth.

I sense that you believe that the US gov't should not be intervening the way that it has been in financial markets and that prices should find their own levels through price exploration. Were you willing to let AIG go down and trigger a domino collapse of the $2.5 trillion structured credit market? AIG is a viable business except for its structured credit business. The crap business would have taken down the good businesses as well or at least created massive uncertainty and fear. Are you willing to accept a global financial collapse followed by a global depression? Or do you think that wouldn't happen, that a global financial collapse won't occur or, if it does, that it won't be followed by a global depression?

I don't think for one second that what is being done is to solve the problems that exist because that will take time perhaps decades. I think that you misunderstand the reasons for the current actions such as limiting short selling. It's being done to prevent an immediate melt-down in hopes of buying time to allow an orderly melt-down. Will it work? Maybe. Maybe not.

We're way past the point of making those who are responsible pay. We're at the point of trying to contain the damage to those who aren't responsible.

Large parts of the US financial system are not just illiquid. They are insolvent. Their liabilities exceed the fair value of their assets under any fair mark. The problem is not that they can't sell their paper because the market is illiquid.

Substitute global for US. It's not just a US problem although the roots of the problem are there.

There is no plan yet

because they are lurching from mess-to-mess. Any plan will be very fluid. Thanks to limited financial reporting and regulation, it's hard to get a good picture of who owes what to whom when.

That +1000 will disappear. Short sellers had nothing to do with it.

They had everything to do with it. No one in his right mind thinks the problems are over. That pop was due to shorts closing positions. Short covering might even flow into Monday.

In the long run, the real danger comes from the rescue plan.

Absolutely. And in the short run, the real danger comes from [s] no rescue plan[/s] not plugging the holes.

Party's over. Time to clean up. We're not going to enjoy this nearly as much. And just about everybody gets to help, either through higher taxes or higher interest rates or inflation. Probably some of each.

Absolutely. We may be viewing the death of the capitalist growth model or, at least, the model that requires growth today and tomorrow simply to pay for yesterday's borrowing.

I'm outside the US physically and I'll get what I can out of the US financially. To be honest, I don't know at this point where I'll go.

CDIC insured cash and t-bills (and even there, the guarantees appear weaker than they were). Yeh, yeh. I know about inflation but some of us are relatively unaffected - we own our houses and are mortgage free, the costs of child rearing are behind us (although we may yet see grown children show up on the doorstep as collateral damage), we don't have job associated costs - clothes, lunches, bar bills. Personally, we've been hunkering down and having a really close look at how we spend a dollar. It's amazing what you find when you look, eg., high speed torrent downloads and popcorn from scratch is one hell of a lot cheaper than driving into town, buying two tickets and negotiating a line of credit in order to buy popcorn and drinks at the snack counter.

Anyone who thinks that this is not different this time has troubles with too many zeros - a trillion is just 3 more zeros than a billion.

[chiaroscuro]

A great rant and I appreciate the time you took to explain things in a straightforward manner.

You are right the game has changed. Thing is, you can't quit. Go into bonds, and they could inflate your money away in short order. Any investment can be trashed in a hurry. I started worrying about that say Wednesday night. To me this game of money has always been about seeing ahead. Take your best guess what is going to happen and invest accordingly. If you guess right all ships rise on a tide. So the rules have changed, that just means sharper observation and perhaps a nimbler response time.

Before I got to the bottom of the page, I took the "****"'s to mean swear words. I thought you were REAL angry.

[Mike Schimek]

IMO there is a good chance that the market was already being rigged by the shorts; they were (IMO) purposefully and actively crashing one company after another and making money doing it.

It came to a crescendo when Morgan Stanley's results came in at a whopping 60-70% above analysts estimates...

the stock popped hard in early morning trading (a solid 10%, which made sense)...

then the shorts tanked the stock 47% that very same day.


This is what I call market manipulation, interference, etc. etc. If you owned Morgan Stanley shares and watched this happen, I think you might agree the market was rigged too, but not by Paulson.

To me this is large hedge funds, or groups of hedge funds purposefully and succesfully tanking companies one after the other.
Step 1- analyze which companies would die if their stock price crashed, Step 2- crash the price,
Step 3- the company dies,
Step 4- cash in the big bucks.
Step 5- return to step 1 above

I don't think this is how the market is supposed to work. I don't think this is what the function of the shorts is supposed to be. I think this is what would constitute a rigged market (to me anyway).

What Paulson did was pull out a bazooka and blow all these clowns to smitherenes.

I'm so happy about it I'd be glad to load the next warhead into his bazooka for him.

[2 yen]

Norbert, I agree nothing has been solved by this week. What should I do, as a Canadian blue chip investor? Sit tight? Sell? Watch my portfolio drop 20+ percent next week or next month? Part of me says that if all hell really breaks loose, because I think it hasn't yet, is to hang on and accept a smaller portfolio and maybe the deflation that would accompany a true crash.

[IdOp]

Thank you Norbert for taking the time to explain your thoughts so well. I do have two questions related to things you mentioned (and possibly to each other):

(1) You said (non-naked) short-selling is necessary for the price discovery mechanism. If such short-selling is banned, what about the original owners of those stocks (whom the short-seller would borrow from), is their ability to sell not good enough for price discovery?

(2) Related to symmetry, if short-selling (borrowing a stock to turn into cash, and then go back again) is banned, should then also margin/leveraged purchases (borrowing money to turn into stock, and then go back again) be banned too?

I don't have any strong views on these questions, they just have been in the back of my mind and I would be interested in your thoughts on them, if you wish to expand. Thanks again.

[Norbert Schlenker]

Do you mean that you plan to get out of US investments?Plans for investing in Canada? Other alternatives you would consider at this point?

I am out of US equities as of the close Friday. I can't really be out of US$ before those trades settle Wednesday. I can't ever be out of the US entirely because ~10% of our net worth is in IRAs, i.e. hostage to whatever comes.

Now I'm beginning to wish that I hadn't asked.

Sorry, Scott. I don't mean to upset you. I don't mean to upset anyone. I needed to rant. I hoped it would be cathartic. I admit it isn't working.

do you honestly believe that Mr. Market is randomly insane ...

I do.

... and the "game" isn't crooked in a hundred different ways all along?

I believe that too but I can live with that. Whenever you invest, there are a thousand little frictions that grub money out of your pocket. You minimize them as best you can. (Forget investment management fees. We talk about that a lot here but they're pretty controllable.) With equities, there are huge principal-agent problems. Shareholders have to design mechanisms and controls that prevent management from out and out thieving. Every once in a while, something blows sky high, a new chink in the armour gets exposed, and everyone beavers away to weld the hole shut. In the US and Canada, the armour is pretty good these days. Yes, we still have frauds like Enron and Worldcom, or management slurping the entire free cash flow a la Hollinger, but these are comparatively immaterial in a widely diversified portfolio. I believe business and trade to be a positive sum game and am willing to tolerate the rake, including the occasional catastrophic rake in the case of mismanagement, because there's enough left over for me as investor.

I just don't see much alternative to that approach. I don't believe it's possible to invest under the assumption that the management of every possible public company are engaged in thievery.

You did not address naked shorts. No one was "borrowing" anything, hence the problem.

See [3], but I will not stipulate even now that naked shorting had anything to do with this at all.

First, some naked shorting has to be done. You can't get volume through the exchanges the way it is now without allowing market makers to short naked. That's barred as of Friday morning and I confidently predict that it will be unbarred by Monday morning. The SEC has no choice. If they prevent the market makers from shorting naked, spreads will blow out on every one of those 799 shares (and I confidently predict that there will be more than 799 by Monday morning too).

Second, naked shorting for every stock - not just financials - was outlawed at the open Thursday morning. The Dow still collapsed 400 points in a few hours. Was everyone breaking the law? I think not.

Third, I have heard and seen anecdotal reports that hedge funds had no trouble whatsoever all week borrowing shares to short. (Until Friday, of course.) They didn't need to do it naked. There were lots of shares lying around.

Fourth, and this is as far as I'm concerned the killer, everyone lays the blame for naked shorting at the feet of hedge funds. Hedge funds don't have direct access to the markets. They trade via prime brokers. Goldman. Lehman. Morgan Stanley. Et cetera. So the villains engaged in their villainy with the consent, nay connivance, of the nominal cops. The investment banks were victims? Gimme a break.

How does shorting sofas drive down confidence in the viability of sofas (or their manufacturer)? Drive it into bankruptcy?

Beats me but this seems like a red herring. How does shorting Lehman drive Lehman into bankruptcy? If Lehman had a viable business, if the asset side of their balance sheet wasn't a toxic waste dump, how could shorting have driven them into bankruptcy? The shorts would have had their heads handed to them.

forward sale

Shall I start quibbling terminology and semantics in the GW thread?

I guess you're opposed to circuit breakers as well.

No, I don't think so. In the rant, I confessed that I agreed with Paulson's use of the ESF to stop the run on MMFs. I see that as another circuit breaker, something to slow the panic. I don't have much philosophical objection to slowing things down and letting people think things over.

because of the volume of phone calls and sell orders as panic ensued.

Fair enough but where was the panic on Thursday? The Dow was down about 500, say 5%. Big deal. It never even hit a breaker.

Were you willing to let AIG go down and trigger a domino collapse of the $2.5 trillion structured credit market? AIG is a viable business except for its structured credit business.

You put those two sentences together and I think my answer has to be yes to the question. AIG has many viable healthy businesses. But not its structured credit piece. That piece is going belly up, whether AIG went bang or AIG went to the Fed. If the structured credit part of AIG is toast no matter what, then what is preventing the domino collapse you're afraid of? The Fed's deep pockets? IMO they're not deep enough.

Are you willing to accept a global financial collapse followed by a global depression? Or do you think that wouldn't happen, that a global financial collapse won't occur or, if it does, that it won't be followed by a global depression?

I don't know what would have happened and I'm only guessing at what will happen now. I don't see that the solution we're going to get is all that much better. For one thing, I'm not sure it will work. For another, all the wrong people - the people who created the mess in the first place - get to keep their ponies. Which means they'll do it again. And again. Do we gain anything by putting off the day of reckoning?

That pop was due to shorts closing positions.

Nope, I don't think so. That was the band starting up again after Uncle Hank poured a trillion into the punch bowl.

It came to a crescendo when Morgan Stanley's results came in at a whopping 60-70% above analysts estimates...

the stock popped hard in early morning trading (a solid 10%, which made sense)...

then the shorts tanked the stock 47% that very same day.

This is what I call market manipulation, interference, etc.

You won't be surprised to hear that I don't agree. Morgan Stanley's "earnings" were rubbish. I wouldn't describe them as a "whopping 60-70% above", rather a "whopper 60-70%". They have these cool new accounting rules in the US these days that lets companies mark their outstanding debt to market and flow the change onto the income statement. Rubbish your credit, turn your own debt into junk quality, and you can report the difference as "income". It's magical.

The realization that that's what they'd done is what cratered the stock. But keep blaming the short sellers. They're finished with MS now. So who will you blame when the whopper really hits the fan?

Step 1- analyze which companies would die if their stock price crashed, Step 2- crash the price

How exactly does this work? How does the company die if the stock price crashes? Is there some magic transmission mechanism that turns a lower stock price into bullets?

(To be fair to Mike, there is such a transmission mechanism and it might - maybe even probably does - apply to Morgan Stanley et al. They may have entered into contracts which will bankrupt them if their stock price falls. That's called gross stupidity on the part of management. Should we reward stupidity?)

What should I do

I'll be honest. It beats me. I know that's not helpful but you have to make up your own mind.

(2) Related to symmetry, if short-selling (borrowing a stock to turn into cash, and then go back again) is banned, should then also margin/leveraged purchases (borrowing money to turn into stock, and then go back again) be banned too?

Great idea! I like it. While we're at it, let me say something about the uptick rule which was being loudly and repeatedly recommended on Thursday and Friday. I say we go for it. Let's have an uptick rule for short sales. But here's that symmetry again. With the uptick rule, we also get a downtick rule. You wanna go long? You can only do it on a downtick.

Fair's fair, right?

[Shakespeare]

I am out of US equities as of the close Friday.

And would you have recommended that to yourself as a client?

[My own US exposure is nominally 10%; I don't intend to exit - bearing in mind your confessed 10% US in IRA's, which I assume could all be put into non-US ETFs.]

[tidal]

Forward selling and short selling are not the same thing at all. It's not semantics. The distinction may not go to undermining your broader rant, but the extended "real commerce" analogies you describe - as you decry limits to short selling and point to "real commerce" rationales to bolster your point - are not themselves examples of short selling. Just saying.