Once the excitement is over, short-selling can resume its legitimate place in the market.
THE ban on short-selling and euphoria over the US Government's plan to create a BadCo to buy distressed debt securities from the private sector makes this sharemarket rally unreliable.
Another important hurdle was cleared yesterday, when Morgan Stanley and Goldman Sachs announced that they had been granted approval to convert to banks.
But several hurdles remain. They are: agreement between the Republicans and Democrats for the creation of the $US700 billion-plus
($A840 billion) BadCo; liquidity injections into struggling groups including Washington Mutual in the US, either through BadCo or another vehicle; the return of short-sellers, who despite their bad press are important sources of liquidity; and the final assessment of the meltdown's impact on economic growth, corporate earnings, dividends and share prices.
Things are moving very quickly, however. Before the crisis flared last August, there were five major broker dealers on Wall Street: Goldman, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns. One is now bankrupt (Lehman) one has been rescued by JPMorgan to head off bankruptcy (Bear), one has been led by the nose into a marriage with Bank of America (Merrill) and the last and strongest pair have turned themselves into central bank-regulated banks, in doing so ending an era that began after the Great Depression.
The broker-dealers were raising money out of the wholesale markets for funding much more heavily than were the banks, which can also tap their depositor funds. They were competitive ahead of the crisis: former ANZ boss John McFarlane recalled how Morgan Stanley and Citigroup (a bank-investment bank combo) both offered to underwrite a $3.6 billion rights issue to pay for ANZ's $5 billion takeover of National Bank of New Zealand in 2003. It was more than ANZ itself could have offered on a similar deal.
Now, with wholesale debt scarce and expensive, true banks have a funding advantage in their deposit bases, and Morgan Stanley and Goldman have decided to claim the same privilege.
Their balance sheets and the profits they derive from them will be less heavily debt-leveraged than they were when they were outside the official banking family, but they both already have very strong tier-one capital ratios and deposit bases that can now be officially geared — $US36 billion in Morgan Stanley's case, and more than $US20 billion in Goldman's new bank holding company, with more coming.
This is not the best time for the US Government to be paying $US1 trillion to create BadCo ($US700 billion), and to rescue Fannie Mae and Freddie Mac ($US200 billion), and AIG ($US85 billion).
The US budget deficit was already expected to blow out from $US162 billion to about $US410 billion this year. Public debt of $US5.3 trillion is about 40% of US annual gross domestic product, and there is an unfunded $US54 trillion long-term bill for health and pension liabilities looming.
BadCo may well soak up more than $US700 billion if it buys a wide range of distressed debts, which is probably necessary. But as US Treasury Secretary Henry Paulson has been pointing out, the money will be invested, not spent.
The key impact of BadCo will be to remove problem assets that were frozen inside the banks, and replace them with cash, injecting liquidity into the sellers, and transferring the problem assets to a vehicle that is aloof from market pressure and capable of executing a buy and hold strategy.
Its losses or profits at the end of that exercise depend on how many cents in the dollar it pays for distressed debts and underlying assets now, and how much it gets for them when they are finally sold.
The immediate task is to move BadCo from conception to reality quickly, by the end of this week on Paulson's timeline.
There are already reports of friction on Capitol Hill, with Democrats pushing in an election year for BadCo also to help distressed US home owners. BadCo's chances are improved because it is a Republican idea, however. It is the Republicans who usually recoil from government intervention, and they have already made the emotional leap.
More tests loom when the short-sellers return: on October 3 in the US, when short-selling bans covering 799 financial companies are due to lapse; in mid-January in Britain, where 32 financial groups are being protected; and in a month's time on current planning in this market, where the shorts are being totally sidelined.
Short-covering — the acquisition of shares to cover previously committed covered short-sales — is fuelling the rally, and when that is finished the absence of new short-selling will be a continuing prop.
An accurate read of investor sentiment is not possible until the shorts return — as they will.
Short-selling will not be as loosely regulated in future as it was before the crisis hit, and naked short-selling — the practice of agreeing to sell stock that you do not yet have in your possession — is a dead parrot, regardless of whether allegations that short-sellers have been hunting vulnerable companies in packs are proved.
Curbed of its excesses and conducted more transparently, however, short-selling will still be what it was before the crisis — a generator of liquidity that tends to smooth price movements, not exaggerate them, and a tool for unexceptional investment strategies. These include directional long-short investing that overlays buying with relatively modest shorting; arbitrage plays between share price index futures and the underlying shares in the index, and paired trades, in which investors open up long (buy) and short (sell) positions in companies that are in the same line of business.
