Crossing the Line

The U.S. Government’s historic reaction to the financial crisis firmly puts us in a place not seen in generations. We have officially crossed the line from capitalism to socialism in less than a week. The Fed synthetically owns Wall Street as we speak. The historic checks and balances built into the system, e.g., the ability to freely buy and sell, have been suspended for a large segment of the market. While the sayings "Wall Street privatizes gains and socializes losses" and "When there is too much capitalism you need a little socialism, and when there is too much socialism you need a little capitalism" have had symbolic meaning to me, they have never sounded so true than they have this week.

I believe in times of crisis that while moral hazard must be noted and managed, addressing systemic problems swiftly and decisively is absolutely critical. And to the Fed and the Treasury’s credit, they appear to have shifted from a one-off crisis management model to a far-reaching, comprehensive approach for dealing with the crisis. However, there is a line between protecting the U.S. citizenry while supporting the health and functioning of the global financial system and pro-actively redistributing wealth based upon the political tides, and I believe this line has been crossed. And the line has been crossed specifically with respect to the temporary ban on short-selling 799 financial stocks.

It is very easy to dislike shorts. They profit if things go badly, and we in this country are an optimistic lot. It seems practically un-American to be shorting stocks, profiting at someone else’s expense. The problem is, both ordinary citizens and those in Washington simply don’t get it. Short-sellers keep companies honest. How many recent examples have we seen of companies being economical with the truth in order to prop up their stock prices and fatten the wallets of those in the executive suite (see FNM, FRE and AIG, for starters)? It is the shorts who sniff this out and make other investors aware in order that they can re-calibrate their expectations, and to perhaps sell before it is too late. This is how Enron was busted, with one of the catalysts being that now-famous conference call when Jeff Skilling went stark-raving mad on one of the Managing Partners at Highfields Capital who had factually cornered him.

We are now in the midst of a witch hunt, in order to pin the financial sector devastation on this particular group people love to hate. A scapegoat – how convenient! Of course, it was those shorts ganging up on those poor, well-managed financial firms with those sterling portfolios! Do rational people who know anything about the markets, capital structure and investor motives really believe this drivel? Consider some quotes from a recent Bloomberg piece, and think about the motives of those being quoted:

“The shorting rules gave investors the belief the world is not coming to an end,” said Phil Orlando, New York-based chief equity strategist at Federated Investors Inc., which oversees $334 billion. “You had a lot of the hedge funds ganging up on these financial companies and putting them out of business.”

What Mr. Orlando really is saying is "Praise the Fed for protecting my long-only portfolios, because I’m getting totally smoked here."

Cuomo said he’ll use the state securities-fraud law, the Martin Act, to pursue investors for illegal sales. The law permits criminal and civil actions. “The federal government has been ineffective when it comes to regulating these markets,” he said. “I want the short sellers to know today that I am watching.”

Mr. Cuomo has now found his populist issue around which to mount his Mayoral campaign, following in the footsteps of fellow muckrakers Giuliani and Spitzer.

“You have to enforce the rules with regards to short selling,” said Mario Gabelli, who oversees about $28 billion as chairman and chief executive officer of Gamco Investors Inc. in Rye, New York. “Shorts were running amok.”

Mario, Mario, Mario. Just a little self-serving, no? You’ve taken lots of heat for your own comp package and now you are going to dish some out, huh?

“There is no rational basis for the movements in our stock,” wrote Mack, who contacted Cox and Treasury Secretary Henry Paulson. “We’re in the midst of a market controlled by fear and rumors, and short sellers are driving our stock down.”

So when the dust settles, I’d recommend that Mr. Mack might just consider shutting down the stock loan piece of his prime brokerage operation, in order to conform to his views on fairness. Except that might drop revenues by, oops, several hundred million dollars?

“We seem to have capitalism on the upside and socialism on the downside,” Chanos, one of the first to raise questions about Enron Corp.’s accounting, said on Bloomberg Television. “That’s a pretty heady brew for country that holds itself out as a free market paragon.” Chanos said his firm isn’t shorting any of Wall Street’s largest investment banks and is the “least short the financial sector as we have been in three years.”

Quite possibly among the most feared (but respected) hedge fund managers on Wall Street. He’s tired and frustrated by people telling him and his colleagues that they’re crooks, bad guys, bad for the market. He puts out great research, has surfaced dozens of scandals yet gets no respect.

“Regulators are stepping in and saying, `This needs to come to a stop and this is how we’re going to fix it,”’ said Kelli Hill at Ashfield Capital Partners in San Francisco, which oversees $4 billion. “This is the thing the market needed.”

No, Ms. Hill. This is not what the market really needed. What the market needed was for the Fed and Treasury to adopt a broad-based approach to the crisis, set up a Good Bank/Bad Bank vehicle to break the liquidity logjam, bridge Fannie Mae and Freddie Mac, and work on regulations that focus on disclosure and transparency in reporting. The market did not need a ban on shorts. The big institutional money management lobby needed it. The politicians who wanted to look strong, decisive and "in support of the people" needed it. But this type of move destroys confidence in the integrity and fairness of our the U.S. financial system. It communicates that the game is rigged, and undoes some of the good provided by the certainty of an RTC-type solution. It will hurt capital flows and market efficiency if investors believe its effects will be anything other than short-term. And in the long run, this is good for no one.

Addendum:

Please read my friend Howard’s post here.