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Thursday, September 18, 2008

 

Market Manipulation

If you're thrown by developments in the financial markets the last few weeks and especially the last few days, that's understandable. We've essentially had three government takeovers, one bankruptcy and a forced merger, all of major financial services players. We have several other near-giant or mid-sized players teetering, and the last two independent investment banks have seen their stocks pummelled as well. Why is this happening?

We have detailed the massive fraud that took place in the residential mortgage business before. Because of ill-advised, though well intentioned, accounting rules, these deficient mortgages and securitizations have been forced to be written down by staggering amounts. There is simply not enough readily available capital to restore the impacted balance sheets.

However, there is more going on, in my opinion, than a simple deleveraging crisis. I strongly suspect that some conspiracy has operated to exacerbate our economic weakness and exact this terrible toll on our companies and our economy. (This follows the advice I received from an actuary who mentored me for a while: "If you think they might be trying to screw you, they are.") In short, I suspect financial terrorism.

I have no information or unusual insight that leads me to this conclusion, only a set of events for which this conclusion is the one that best fits the fact pattern.
In a "normal" panic, everything goes down, except maybe gold and certain commodities. Strangely, in this panic, the industrials have held up pretty well, and gold was going down until the last few days (it retreated today, too). The oils were also going down, and seem to have been trading for weeks independent of the action in the financials. Interestingly, after today's short covering rally, the Dow Industrials are back over 11,000, barely in bear market territory, if at all.

Perhaps most eerily, the financials haven't even moved together in concert. The initial raid on Bear Stearns, forcing its fire sale to Morgan Chase, was followed after some time by an attack on Fannie and Freddie, resulting in the Government conservatorship. After that, the Bears moved onto WAMU (which is actually fundamentally unsound) and discovered a weakened AIG to attack. With AIG on the run, it was a simple matter to dispose of Lehman Brothers the same week, since it was long rumored to be weak, despite its own protestations.

Now this week, you have the short sellers devastating the stock of Morgan Stanley despite a strong quarterly report, and even Goldman Sachs among a few others. So you have serial attacks on all the IB's, plus the world's largest insurer whose main failing seemed to be that it provided the default insurance on all kinds of debt(basically selling naked puts on bonds. In this role, they were acting like an IB).
Meanwhile, the small local banks have not gone down at all! You mean their mortgages are all fine, and they somehow don't own any of this weak paper debt?

If you were out to undermine the US economy, what better way than to exploit whatever weaknesses existed in the providers of capital. By hitting their equity investments, you could make it impossible for them to raise new capital. Once the providers of capital have all been forced to rein in credit, or driven out of business, the shorts can attack whatever types of companies they choose. Without credit, the economy's expansion must be limited anyway.

The Fed's loose money policy admittedly had caused credit to become too readily available, particularly for home buyers. But now, obtaining credit of any kind is difficult. Many industrial companies and service providers are extremely concerned about their ability to roll over their debt capital as loans become due.

Now, who would be interested and have the resources to orchestrate this cascade? A possible answer would be an alliance of sovereign funds, Al Queda benefactors, and certain oil producing nations (Iran, Venezuela, Russia). A few large international hedge funds could also be involved. Given that a confluence of regulatory mistakes by the US left us vulnerable to market manipulators (the aforementioned mark - to -market accounting rule for impaired assets, lifting of short selling restrictions, replacement of market makers by computers), the possibility for success by conspiring short sellers is much higher than it used to be.

What can we do to end the crisis and reduce the possibility for future manipulation? There are several steps, most of which are now belatedly under consideration, that could be taken. First, the old short selling rules should be restored and enforced. This means no more naked short selling, and restoration of the "uptick" rule. Second, something on the order of the Resolution Trust Corp that helped resolve the S&L crisis of the 80's, should be established as a buyer of last resort for the impaired debt instruments. Third, when a company is being targeted, the SEC should allow them a stock trading holiday, and also a brief period during which they have relief from creditors' demands to give them time to reestablish sufficient liquidity. This is infinitely better than government takeovers or forced mergers that erase jobs on a grand scale and wipe out legitimate equity holders.

Unfortunately, the casualties that have already been taken can not be brought back any more than human victims of terrorist violence can be restored to life.

So is the simple explanation that the housing crisis forced a deleveraging panic that migrated to the stock market also reasonable? I thought so until today. But today, some manipulators made an awful lot of money taking certain stocks down to absurd levels, and triggered a short covering rally that brought those stocks back. If there is no follow through tomorrow or Monday, but instead the short selling attacks resume, you can be pretty sure there is more to what's going on than what can be attributed to a market's reaction to an economic crisis.

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By the way, I agree with the Presidential candidates (and Jim Cramer) that SEC Chairman Cox has done a lousy job. When the experimental restriction on naked short selling helped matters, it should have been extended to all stocks instead of being allowed to expire. And the uptick rule should be restored immediately.

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Now that the House has passed its phony "bi - partisan" drilling bill, it's time for the GOP Senators who agreed to this "compromise" (led by Lindsay Graham) to pull the plug on it.

By the way, the most ridiculous talking point I have ever heard is the endlessly repeated Dummycrat complaint that drilling won't do any good because it will take years to bring in the new oil. Of course it will! The reason there are no new oil sources now is because they have prevented drilling for the last five years. if we don't allow the drilling prohibition to really expire now, we will be having the same conversation five years from now. The other silly Dem talking point is that oil companies should be drilling on the leases they already have. But obviously these are leases where the geologicals indicated LITTLE OR NO OIL! Why drill there? Does anyone honestly believe that oil companies would be ignoring viable fields at $100 per barrel?

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I finally understand the deal that the Clinton's struck with the Obama people at the convention. The best guess is that Hillary will get Barack's support to move Hopeless Harry Reid aside and take over as majority leader of the Senate. I would expect she will do a much better job than Reid, and be much more effective, both for Dems and for the country. Despite her lefty views on health care, on most other issues, she is a centrist, especially by Dem standards.

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The Dems are making a serious mistake by continuing to dwell on Sarah Palin's inexperience and alleged lack of readiness for office. They are setting a very low bar for her debate with Biden. Basically, they have equated her with Dan Quayle, and that is an awfully easy standard for her to outperform. Assuming she does, this will only increase her standing and impact on the election.

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On 9/8, I sold my last 300 shares of Longs Drugs (LDG) at 71.87. That was immediately followed by the surprise $75 bid by Walgreen, $3.50 above the CVS bid. So, I left a little money on the table, but my guess is that the Walgreen offer is not going to be pursued. This is another example of irresponsible hedge fund behavior, wherein they got a company to put up a phony offer to increase their profits on the deal. Of my 300 shares, all were bought in 2003, 100 at 15.21 and 200 at 16.76. So this was a great transaction, even though I passed up a few bucks. On 9/10, I bought 100 shares of Ladish (LDSH) for my IRA at 23.94.

Because in the long term, off-shore drilling has to be a winner, I added Transocean (RIG) to the buy/hold list and bought 17 shares Monday for 118. I already had a few shares from the spinoff out of Schlumberger. Yesterday, I bought 100 shares of BDC at 31.39 for my IRA. BDC and LDSH are both recommendations from my excellent full service broker, who has provided quite a few good ideas for the buy/hold list over the past year or so.

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