Is a Ban on Short Financial ETFs on the Horizon?

I received an email from a reader asking me if it was likely that Congress would ban Pro Shares Ultra Short Financials and other Exchange Traded Funds which seek to short the financial industry.

As of this writing, the ban on naked short sales of 19 protected financial stocks is set to expire in thirty days from July 21, 2008, so as of now, this is not a permanent ban. Furthermore, market makers in the exchanges where 19 stocks trade will be able to execute short sales without falling afoul of the rules. This article discusses the remote possibility of bans of short financial ETFs and the more likely development of a regulated electronic open market in conjunction with the Commodities Futures and Trading Commission which may provide some transparency which would lessen the uncertainty as to the total volume and how many short bets each market counterparty is holding which may stabilize current market volatility.

I can't say as to how any short financial ETF achieves its leverage and what percentage would come through naked shorting. It may very well be that a significant percentage comes from naked shorting. But I would suspect, and hope, that many of the positions are achieved through ISDA agreements - over-the-counter swap trades.

As an aside, in the equity markets, one of the big problems with a market creating a "true share price" is the operation of "dark pools" - proprietary trading platforms where blocks of shares can trade hands outside the open market in relative anonymity. Instinet and other exchanges allow large institutions to move lots of shares without the risks of "front running" or other market tactics which, in times of low volume and high volatility, could destroy a firm's position in a hedge, such as what happened with many of the trades of Long Term Capital Management back in 1998.

The tacit allowance for these "dark pools" is that they are a necessary evil to provide liquidity to behemoth institutions in a way to protect the overall health of the market preventing high volatility in enormous share transfers. Conveniently, it would also allow the President's Working Group on Capital Markets (the Plunge Protection Team) to purchase thousands of shares of GSCs to pump up their share prices in the face of concerted downward pressure from short sellers. But pumping money in the system is only a temporary solution. In the mind of the powers that be, it is the short sellers who need to be stopped, or at least, muzzled, in the interest of the quasi-governmental function that the major banks serve in the national and world economy.

So the government is caught in a bind. Clearly, the banks have problems. But how can you differentiate between opportunists looking for a cheap buck as opposed to market participants using a historic tool to set a true market price without distortion?

It seems as though the Powers That Be have decided that naked short selling is out of control, and that there needs to be some official counting of the number of OTC swaps that are out there betting on these banks. The eggheads have rationalized that if we actually displayed all of the notional swaps that are out there, the market would realize that counterparty risk is a much larger factor that needs to be considered in entering into these agreements and the volume of credit default swaps and other forward contracts based on financial stock prices would slow the frenetic activity in this largely unregulated area.

If Congress established a clearinghouse or market for these ISDA agreements, it would provide a certain amount of transparency to allow market participants to have a clearer view of how much risk each market participant has taken on as far as counterparty risk. That is to say, the reason for Bear Stearns' (BSC) collapse was due to a very rapid loss of confidence in its ability to deliver payments or honor swaps and other forward contracts due on the levels of its leverage. Because so much was unknown, it caused a rapid devaluation of the company.

A centralized electronic market would provide transparency to all market participants in a way that many of them are unwilling to provide internally. Would Jerome Kerviel be able to make his "phantom trades" had there been a central clearinghouse which would be able to provide a clear record of his positions for someone other than the attorneys working Societe Generale's compliance? Kerviel's compliance officers had requested that he provide documentation for his phantom trades which disguised his overbalanced and losing positions. He merely brushed them off and before they realized what was happening, his positions were completely underwater.

These "rogue traders" or "snoozing compliance officers" (or whatever you want to call it) cannot continue to disrupt multi billion dollar banking institutions with these type of lax oversight. It is simply unacceptable in this computerized age to allow this amount of risk to be transferred over-the-counter without a third party clearinghouse or exchange to monitor the trading activity, just as we would expect from any other rational commodities or securities trading platform. Institutional market participants have proven unable to handle the simple compliance required for trading swaps and instead of being a reactionary measure, the government is looking forward to be proactive to prevent any future problems with notional values of swaps in the trillions of dollars changing hands with no oversight.

Before the Powers That Be convene a round table to rebuild the oversight that the Commodities Futures Modernization Act obliterated, the effect of the new SEC regulation is not to protect investors. It is to stabilize these 19 financial institutions and give these banks some breathing room to avoid the relentless driving down of these stock prices. As of the day of the announcement of the new rule, the 19 protected banks have gained an average of 15 to 20 percent in value, which could be perceived as an accurate representation of the short squeeze - naked shorts being forced to buy shares at inflated prices through brokerages holding these shares hostages - and opportunistic buying on the back of this short squeeze. Keep in mind that most financial stocks are between 50 to 80 percent off of their 52 week highs.

The fundamentals of the industry have not changed. For instance, the ban coincided with the reporting of Wells Fargo (WFC) as good news spurring a rebound. To give an idea as to how the majority of retail deposits are held in 4 banks, Wells Fargo is the 5th largest bank in deposits in the United States and had revenue of 12 billion dollars. Bank of America (BAC) shelled out 11.8 billion dollars when it paid off Countrywide's outstanding credit facilities. It will write that off over several years but it shows the huge disparities between banks like Citibank (C), Bank of America, JP Morgan Chase (JPM), Washington Mutual (WM) and everyone else.

The United States financial industry can't be saved through domestic legislation and government spending. The old Wall Street adage says "When Wall Street sneezes, the World catches a cold." Recently, commercial banks have looked to sovereign funds and foreign institutions to invest in what seems to be discount prices, but a lot of money is still on the sidelines until higher volume levels into the fall stabilize the high volatility that is the hallmark of a thinly traded market.

The only legislation that will allow the rest of the world to come to America's rescue would be legislation that curbs spending and seeks to reduce the borrowing from the government. An increase in the Fed rates would strengthen the dollar and show that the United States is serious about fighting inflation. The Fed cannot do that while banks require low rates to recapitalize through borrowing money to purchase Treasuries and use the spread to lend out for loans.

The political establishment seems to think that once the oil bubble pops, then inflation will retreat to its corner obviating the need for rates to rise in the short term. Its true effect will be that by coddling the banks, inflation will still continue to rise into the winter where its effects will seem much worse. At that point, with a new administration in office, the Fed will have no choice but to push the lever up, and the banks will have their water wings removed. This 30 day short sell ban is part of a concerted effort to get the banks' financial house in order for the coming rate change, and to give the Brain Trust de Jour time to figure out what to do with twin titans of terror, Fannie Mae (FNM) and Freddie Mac (FRE).

So the banks are on their diet program, trying to run off all of those "legacy" loans. Imagine the police coming to your house and asking you about the blood, hair clothing and bike parts imbedded in the grill of your Cadillac and you say "I hit the bicyclist drinking and driving, but I consider that a 'legacy' accident and I'm moving past it." [Legal disclaimer: Do not offer that excuse if you are in that situation]. Even if we make an enormous stretch and assume the subprime mess has been completely written off, the financial industry still faces substantial hurdles.

One, many banks still retain mortgage-backed securities which were purchased under the assumption that the monoline insurers would guarantee their triple AAA rating. Those ratings are gone. I am sure there are a wide range of valuations that may be given to these securities which may be accurate or inaccurate. The problem is, the margin of error in valuation of these securities may be enormous, which makes all earnings reports totally suspect.

Second, some banks may, under the terms of the trust agreements under mortgage backed pools, be required to replace non-performing loans with performing loans or back those loans with payments to replace any income lost for senior tranches of these securities. Remember, we are talking about trust pools made up of thousands of 30 year mortgages, packaged in these pools which may be impossible to unwind. The gift of securitization - spreading risk among a greater number of market participants - may be its greatest curse.

Third, rising inflation and higher commodity prices will lessen the purchasing price of the dollar and increase pressure on consumer debt. There is a growing awareness in the political scene that the Bankruptcy Reform Act may cause an undue hardship on the American public and the new efforts to prevent predatory lending may spill over into consumer debt relief, which would shrink margins further. High oil prices bring equity prices down which stunt economic growth as a whole, putting more pressure on US companies leading to increased unemployment, downsizing, increased unemployment and further strain on the consumer, who can no longer refinance or obtain more credit to provide relief to their situations.

Fourth, we have not seen the full extent of commercial loan defaults as the overall economy shrinks consumer spending, resulting in store closures, malls unable to retain tenants and projects stalled by environmental reviews or other bureaucratic hold ups simply go belly up.

Finally, the weakened condition of the financial sector makes it extremely vulnerable to overseas crises. Just as the Russian default of debt obligations in August of 1998 drove Long Term Capital Management into oblivion, a big correction in an overseas market may exacerbate the situation. The SEC, the CFTC, the Fed, the Treasury's and Phil Gramm's tirades end at the border.

It may very well be that this brief run up of financials is just a "suckers rally" to allow existing shareholders to regain a portion of their losses and sell into another downward slide once their conditional orders have hit, leaving unsuspecting bargain hunters holding the bag. The financial sector has left a period of unsustainable growth and has entered a time of consolidation and merger. As long as Jamie Dimon sits on the Board of Governors of the Federal Reserve, JP Morgan Chase shall be spared the tough times that will affect other smaller regional and community banks.

Vikram Pandit has publicly resisted the calls to split Citibank's retail banking from its investment advisory arm. And as for Bank of America, well, it should be no surprise to anyone that the new short selling rule's effective date coincides with the same day that Bank of America is scheduled to release its earnings.

I have no idea if financial sector inverse performance exchange-traded funds will be banned. I wouldn't expect the Powers That Be to kill the messenger, especially when many banks invest in these funds to hedge against their own ineptitude.

If they were banned, I would just see it as a reflection in the political methods used by the new owners of the United States - the Chinese, the OPEC nations and Russia - whose authoritarian and state dominated economies have slowly infiltrated our nation purchasing our Treasuries, real estate, securities and bonds through our own lax regulatory oversight, industry profligacy, a loose money supply, excessive consumer spending beyond income levels and grossly wanton government spending through bloated budgets controlled by the financial industrial lobby. Meet the new boss. Same as the old boss.

Comments

[AmesTiedeman]

BAC just announced excellent numbers.

[vaduz]

excellent article, partly funny to read. thks.

[xtronics]

"I can't say as to how any short financial ETF achieves its leverage and what percentage would come through naked shorting. "

Well, you might start by reading the prospectus. Why write such an article without doing basic research. From my read of the prospectus, it appears they are doing swaps and options - not shorts.

The naked-short ban is yet another move into socialism. Letting these corrupt institutions die will provide the scare to keep it from repeating (They call the very real risk of bailing out these thugs "Moral hazard" - a most opaque term)

[carey_jim]

It is more accurate to describe The Powers That Be as the American plutocracy and not 'eggheads.'
It's only under socialism that eggheads are in control.

The plutocrats view alpha traders as upstart crows who are using their intelligence along with available financial instruments to leverage economic trends into profits.

You said, "Imagine the police coming to your house and asking you about the blood, hair clothing and bike parts imbedded in the grill of your Cadillac and you say "I hit the bicyclist drinking and driving, but I consider that a 'legacy' accident and I'm moving past it." [Legal disclaim: Do not offer that excuse if you are in that situation]"

The financial institutions have the blood and guts of America all over their metaphorical Cadillac grills and their egghead lawyers, who we all know so well from the movies, are coming to their rescue.

Alpha traders see this carnage as an opportunity for profit. They think of it as a true fire sale: everything (really) MUST go.

The Chinese, OPEC and the Russians are not the new owners of the United States. But you got one thing right:

"Meet the new boss, same as the old boss."

[adan]

long but great read, well worth while

re the inverse etf's, aren't they sorta the transparency type answer you'd suggested needed at the beginning of the article?

so my guess, especially since the tally of how many is clearly know, and commissions are even more easlily collected, they'll survive

at least i hope so :-)

[Aalan]

You could have made your point in about 1/3 of the verbiage.

[mike00501950]

"The naked-short ban is yet another move into socialism." And this is bad? I am not a financial genius but I like many others have put my life savings in 401K and IRA's. When I see a few getting rich while my account dwindles it's a little disconcerting to say the least. This is capitalism and this entire financial mess is it's offspring. We need more oversight because people can not be trusted to do the right thing.