By Thomas Kirchner

So what exactly was the impact of the SEC's July 15 emergency order against naked short selling? Not much, shows a study by Arturo Bris, a professor at Lausanne's IMD business school. He shows that by some measures, it even had a detrimental effect on the market of the very stocks that the SEC sought to protect. For those who missed it, the list included:
Allianz Aktiengesellschaft (AZ), Bank Of America Corp (BAC), Barclays PLC (BCS), BNP Paribas (BNPQF/BNPQY), Citigroup Inc (C), Credit Suisse Group (CS), Daiwa Securities Group Inc (DSECY), Deutsche Bank Group AG, Fannie Mae (FNM), Freddie Mac (FRE), Goldman Sachs Group Inc (GS), HSBC Holdings plc (HBC), JPMorgan Chase & Co. (JPM), Lehman Bros Holdings Inc (LEH), Merrill Lynch & Co Inc (MER), Mizuho Financial Gp Adr (MFG), Morgan Stanley (MS), Royal Bank of Scotland Group plc (RBS), UBS AG (UBS).

The SEC ordered that before anyone could execute a short sale in any of 19 stocks on its list, the hopeful short seller had to locate shares that could be borrowed. For most investors, this was just a reiteration of regulation SHO. We heard from one brokerage firm that went well beyond the scope of the order and banned all short sales in the stocks on the list.

Bris' study shows that as is often the case when the government gets involved in the markets, the law of unintended consequences took over. Market quality declined in the 19 stocks, which Bris shows through a number of metrics:

-Daily price volatility decreased after July 15. Bris calculated several measures: intraday (open-to-close) volatility, interday (close-to-close) volatility, trade price (high-low) range and positive and negative semi-variances.
-Bid-offer spreads have increased more than for other financial firms, and much more than for non-financial stocks. This means that liquidity deteriorated.
-Co-movements between the stocks on the list and the overall market increased. In an efficient market, individual stocks should be affected only by company-specific news rather than overall market activity.
-Short selling did not play a role in the deterioration of market quality.

Another findings of the study will give the SEC some food for thought about future restrictions on short selling:

-The performance of the stocks on the list has been worse than that of comparable firms, but not because of short selling. Weekly short selling activity has little effect on weekly returns. “After controlling for short sales, the performance of [these] stocks is still worse than for comparable firms.” The group underperformed its peers by 10 percent.
-Shorting activity before the SEC emergency order was highest for firms that were issuing convertible bonds. The implication is that much shorting is done by convertible bond arbitrage funds rather than vicious short sellers who try to destroy companies.

In short (no pun intended), the usefulness of the SEC's emergency order is highly questionable. The SEC should concentrate on implementing the existing provisions of regulation SHO rather than dreaming up ever new rules.

Besides, we never quite understood why almost half of banks included on the list have their main trading venue outside SEC jurisdiction. Last time we checked, trading volume for UBS, Daiwa, BNP Paribas or Deutsche Bank was infinitely higher in Zurich, Tokyo, Paris or Frankfurt than in the U.S. It looks like regulators wanted to give the appearance of not favoring Wall Street houses by including some stocks for which its order is completely pointless.

Let's wait and see what the SEC comes up with next. The climate is not favorable for shorting, and in an election year, someone has to take the blame for poor market performance. At least, it's safe to assume that SEC rules will not be as ridiculous as a recent proposal in South Dakota to ban short selling altogether. And while we're at it, here's our tip for overzealous regulators: the housing market won't recover if you ban short selling of real estate.

Thomas F. Kirchner, CFA is the founder and portfolio manager of the Pennsylvania Avenue Event-Driven Fund (PAEDX), a mutual fund that invests in merger arbitrage, proxy fights, distressed securities and capital structure arbitrage. He is responsible for the day-to-day management of the Fund and also serves as the President and a Trustee of the Fund. Prior to launching the Fund, he worked as a Bond Trader and Financial Engineer for Banque Nationale de Paris S.A. and was retained by Fannie Mae, a mortgage firm, as a Financial Engineer. Mr. Kirchner holds a B.Sc. from King's College, University of London, a Diplôme from the Institut d'Etudes Politiques de Paris, and an MBA from the University of Chicago Graduate School of Business. He has earned the right to use the Chartered Financial Analyst designation. He writes a blog about mergers that receive little press coverage at http://thedealsleuth.wordpress.com/.

By Thomas Kirchner

From Sovereign (SOV) to JP Morgan (JPM) banks make headlines with writedowns on their holdings of Fannie's (FNM) and Freddie's (FRE) preferred stock, but the obvious question of how stock ever got onto banks' balance sheets is only asked by Felix Salmon – and even he doesn't know the answer. In general, banks are barred from investing in equity securities. However, the government made Fannie and Freddie preferred stock a “permissible” investment to create a sufficiently large market for these securities.

Of course, making the stock “permissible” didn't necessarily make it attractive, so regulators had to pull another trick. Under the risk-based capital rules, national banks may carry agency preferreds at a 20 percent risk weighting, while state-chartered banks and OTS-regulated savings associations must apply a 100 percent risk weighting. This means that banks only have to hold 1.6% or 8% capital against their investments (or should we say 'speculation'?) in Fannie and Freddie preferred stock. This compares to 8% that must be held against senior commercial loans, which have a much more favorable risk profile than any equity, and dollar for dollar capital requirements for other preferred or common stock.

Another appealing feature of the preferreds is their eligibility for the 70% dividends-received deduction under IRS rules. So only 30% of a dividend payment is taxable for the bank. Assuming a 35% tax rate, uncle Sam will get only about 10% in taxes on preferred Fannie and Freddie dividends. So preferreds pay bond-like interest at better after-tax returns. The resulting taxable-equivalent yield is a nice spread above most banks' funding cost. No wonder then that banks loaded up on most of the $36 billion of outstanding Fannie and Freddie preferreds. After all, you have to dance while the music is playing.

So why exactly did banking regulators award this favorable treatment for GSE preferred equity? Because otherwise there would have been no market to place $36 billion of preferred stock. 14 out of 21 of Freddie Mac's preferred issues were sold after 2000. For Fannie, 15 of the 16 preferred issues were issued after 2000, the bulk of them after 2005. This happened to the the time when OFEHO had imposed a capital penalty on the GSEs and forced them to raise additional capital – in preferred stock.

Most preferred stock is bought by corporations seeking tax-advantaged alternatives to bonds. Despite potential interest from corporate treasuries, placing $36 billion of two firms quickly in such a narrow and specialized market is impossible. Therefore, the government had to create a market for the preferred stock of the two GSEs, and what easier way to place it than to encourage the institutions that have the money to buy the stuff. Some of the preferred stock was clearly structured to appeal to banks rather than income-oriented investors. Not many buyers chasing yield will get excited by Fannie's Series F preferred that pays a whopping 2-year CMT rate minus 0.18%. Such a preferred stock only makes sense in the portfolio of an investor that gets a low weighting for regulatory capital purposes and has a low cost of funds at a variable rate. That type of investor looks just like a bank to us.

Effectively, what is considered equity at the level of the GSE's is in fact highly leveraged debt when you look at the financial system as a whole. This is hardly a recipe for safety and soundness.

Now that Fannie and Freddie are in trouble, the government is in a bind. After encouraging banks to buy GSE preferred by loosening safety and soundness regulations, they can not easily make the banking sector take $36 billion of writedowns on securities that banks only invested in because of strong government incentives. Bailing out preferred investors is less a question of moral hazard than of credibility of bank regulators. Predictability and stability of government regulations make for stability. Encouraging banks to invest in GSE preferreds and then making them take a writeoff won't help restore confidence in regulators.

We are curious to see how the government will get out of that quagmire. Too steep a haircut on the preferred is out of the question for the risk of further credit contration. $36 billion of writedowns decreases banks' lending capacity by at least $450 billion. The market tells us that bank's won't take any risk with unpredictable government action. Some adjustable rate preferreds (FNM-PF) are trading at an 80% discount to their liquidation value, whereas fixed rate preferreds (FNM-PT) are only at a 50% haircut. Investors who can tolerate some spread volatility can lock in the spread and profit from liquidity-seeking banks' indiscriminate selling.

Thomas F. Kirchner, CFA is the founder and portfolio manager of the Pennsylvania Avenue Event-Driven Fund (PAEDX), a mutual fund that invests in merger arbitrage, proxy fights, distressed securities and capital structure arbitrage. He is responsible for the day-to-day management of the Fund and also serves as the President and a Trustee of the Fund. Prior to launching the Fund, he worked as a Bond Trader and Financial Engineer for Banque Nationale de Paris S.A. and was retained by Fannie Mae, a mortgage firm, as a Financial Engineer. Mr. Kirchner holds a B.Sc. from King's College, University of London, a Diplôme from the Institut d'Etudes Politiques de Paris, and an MBA from the University of Chicago Graduate School of Business. He has earned the right to use the Chartered Financial Analyst designation. He writes a blog about mergers that receive little press coverage at http://thedealsleuth.wordpress.com/.

Brooksie’s Market blog
September 4, 2008 Thursday (Written Wednesday evening)
DJIA: 11,532.88
S&P 500: 1274.98
Nasdaq Comp: 2333.73
Russell 2000: 741.91

Uncertainty continues to rule, as the blue chip DJIA and S&P 500 remain locked in a sideways, saw-toothed trading range. Breaking above 11,830 suggests an upmove by the DJIA to the 12,400-12,450 area. A break below 11,240 suggests a plunge of 400-500 points to 10,750.

The Nasdaq Comp and Russell 2000 have been more upbeat, however the Nasdaq has been the weaker of the two in recent days and could slip to 2300 before rebounding. Support is good for the Russell 2000 around 715 – 720.

I continue to believe the secondary stocks (Nasdaq and especially the Russell 2000) will be our leaders over the next 18 months.

With the presidential election looming in less than 9 weeks, news, projections, and opinions out of Washington and Wall Street will be positive, and may be enough to break the market out on the upside.

The Republican Party has no choice. We are in the second economic contraction in 8 years, and the economic expansion in the interim was one of the weakest in 60 years. The stock market (S&P 500) is off 6% in 8 years, the second worst record in 100 years, though there are four months left for the Bush administration.

The Democrats aren’t faultless, they have controlled Congress for the past two years.

Bottom line: the pre-election hype may be misleading enough to trigger a premature spike in the stock market, a fake-out, which would be followed by another leg down.

Just keep that possibility in mind if it develops.

I continue to believe we will see another leg down in the market, but the timing may be skewed by the election.

I prefer to write these posts in the morning before the market opens. That way I can draw on the morning news and activity in the futures markets.

I WILL BE TRAVELLING AND OUT OF TOUCH THURSDAY THROUGH MONDAY

George Brooks

Brooksie’s Market blog
September 3, 2008 Wednesday 9:25 am EDT
DJIA: 11,516.92
S&P 500: 1277.58
Nasdaq Comp: 2349.24
Russell 2000: 738.51

It wasn’t the “mother of all storms,” as New Orleans, Mayor Ray Nagin warned about Gustav. Relieved and overwhelmed with excitement, investors stormed stock exchanges with market orders to buy, buy, buy. Consequently, the markets gapped at the open, traded a bit higher, then got pounded by more sober sellers, closing with a loss for the day in what has to be the granddady of all rally failures.

What were they thinking ? Because the Hurricane didn’t cause more damage and because oil dropped after rising, investors (big money investors) panicked, fearing they were going to miss the beginning of a grand new bull market.

If we are now marching to the drumbeat of hurricanes, get ready, here comes Hannah and Josephine, et al.

Never rush to buy the market, or a stock, because you are afraid of missing a move ! This is a huge contributor to losses. In most cases, you will pay-up for the stock and regret it. Worse yet, you find yourself immediately in the hole and confronted with a decision - do I sell here, hold and hope, average your purchase price, what ?.

Rally failures indicate weakness, or at least overhead supply. I see it as a signal that either we have to go lower to shake out sellers and discount uncertainties, or we need time to sift through the collateral damage done by Wall Street’s meltdown, the crunch of the consumer, and a slow motion recession here and abroad. I am a believer in the old saw that opportunity is best when the environment is gloomiest, a point I refer to as the “I can’t stand it any more.” I just don’t see us there yet.

Today should start down and very possibly lead to a further drop in the DJIA to the 11300-11360 area over the next couple days. however, we should first get a rally attempt today, and that could extend upward by 85 Dow points. Then, let’s watch if sellers whack it again.

I WILL BE AWAY THURSDAY THROUGH MONDAY

George Brooks

Brooksie’s Market blog
September 2, 2008 Tuesday 9:10 am EDT
DJIA: 11,543.55
S&P 500: 1282.83
Nasdaq Comp: 2367.52
Russell 2000: 7739.50

A surge in stock futures suggests a strong open for the stock market today, enough to regain more than half of what was lost in Friday’s 171-point drubbing in the DJIA. Credit goes to the fact Hurricane Gustav did little damage to oil producing facilities in the Gulf, as well as to the disclosure the Korea Development Bank is still interested in investing in Lehman Bros. (LEH), which deflates fears of that company’s demise.

I would not buy this open for those reasons. Beware of a gap opening and rally failure.

Friday’s sharp drop after Thursday’s sharp upmove, established a new resistance level beyond which the four indices must cross to have a chance at higher prices.
Resistance is : DJIA: 11,745, S&P 500:1300, Nasdaq Comp.: 2410, Russell2000:745.
Support is: DJIA: 11,360, S&P 500: 1265, Nasdaq Comp.: 2345, Russell 2000: 730.

These are levels where buying or selling can be expected to reverse a trend. They change frequently. Penetration serves as an alert that the trend underway stands to continue. At times these breakouts can be very significant, especially when they happen on heavy volume.

The financial press has been primarily preoccupied with serious problems in the financial, economic, domestic, and international scene, but little is said about corporate earnings. Well, what you see now in the corporate reports is NOT what you will see in 6 months, 9 months, a year, or more in many cases.

And what about that intangible – “Confidence,” or lack thereof ? Isn’t that what really determines whether the overall market sells at 10x, 14x, 18x, 21x earnings ?

Confidence is the big unknown right now. At what price/earnings (P/E) level does the Dow and S&P 500 deserve to sell at in face of a meltdown on Wall Street that has only been averted by a government bailout ? A consumer (70% of GDP) who in many cases is tapped out, needing to borrow to fill the void between income and outgo ? A slow motion recession here and abroad the nastiness of which is compounded by inflation which has a long way to recede before it no longer cuts to the bone ? A country that is gradually losing its grip on world leadership in manufacturing, education, health care, and government finances ?

Read more »

Brooksie’ Market blog
August 29, 2008 Friday 9:16 am EDT
DJIA: 11,715.18
S&P 500: 1300.68
Nasdaq Comp: 2411.64
Russell 2000: 747.79

Look for the market to give back as much as half Thursday’s 213-point gain, as investors head out for the last long weekend of the summer. Expect crude oil and gold prices to jump in face of a weaker dollar, as well as concerns for two hurricanes heading for Florida and the Gulf.

Yesterday’s upmove in the DJIA featured all but one of the 30 Dow stocks (KO). The surge, in response to an unexpected jump in Q2 GDP, moves the support and resistance levels up to:
Support: DJIA:11,350, S&P 500: 1270, Nasdaq Comp: 2370, Russell 2000: 730.
Resistance: DJIA: 11,930, breaking that = 12,250, S&P 500: 1305, breaking that = 1340, Nasdaq Comp: 2470, breaking that = 2520, Russell 2000: 765, breaking that = 780.

The sideways, saw-toothed pattern traced out by the DJIA and S&P 500 has improved, but needs a lot of help to register a breakout to challenge the May highs, likewise for Nasdaq. The Russell 2000 can sneak past its August 15 high of 764.

There’s no rush to buy now. Nimble traders – enjoy. Risk is very high, especially after these sharp upmoves. We haven’t even begun to address the impact of this business slump on earnings next year ( a falling shoe I failed to mention yesterday)

Again, we are confronted by a slow motion economic slump, which I believe will be labeled “recession” when reality sets in. The financial crisis, bailouts, etc have hogged center stage, and the fact the world has not come to an end, investors think no more problems exist, ergo let the bull market begin. A host of other issues await, some will be resolved without damage, others will have an adverse impact (See Thursday’s blog).

The presidential election stands to have an impact on the market. The market has tended to react in fairly consistent ways in the months around the election with respect to incumbents getting re-elected or ousted. I’ll deal with that next week, but stick to facts, not opinion.

George Brooks

Brooksie’ Market blog
August 28, 2008 Thursday 9:16 am EDT
DJIA: 11,502.51
S&P 500: 1281.66
Nasdaq Comp: 2382.46
Russell 2000: 732.95

Odds favor a big move up today, possibly as much as 150-200 points in the DJIA. A better than expected Q2 GDP (+3.3%) report on the heels of yesterday’s good durable goods report will give some investors reason to buy. A sharp move by the DJIA across 11,650 would lead to an assault on resistance at 11,930 with the possibility of a breakout to 12250.

We didn’t get a rally failure yesterday, a good sign near-term. A rally failure today where the market gives back most of its gain would do a lot of damage. I don’t see that, but there are investors looking beyond this GDP report to lower numbers.

Again, I would use strength to raise cash if you do not have a healthy reserve. As I have noted before, we are in a slow motion economic/stock market slump. The consumer (70% of GDP) is hurting with little signs of relief for many, many months. The $92 billion in rebates has mostly been spent – back to reality.

Nevertheless, investors, fearful of missing a new bull market, may rush in. I think that would be a mistake. Nimble traders can play these moves, but even so should sit close to the exits.

We are less than 10 weeks from a presidential election and we can expect positive and negative spin from people in and out of the government who will be trying to give one party or the other an edge. Don’t be quick to jump based on comments or news releases.

The Bush administration has nothing to lose, and will probably pull out all stops. The Democrats would do the same under these circumstances. This is the second recession in eight years, following one of the weakest economic recoveries since WW II and a stock market that is down 7% in eight years, not factoring in a 25% rise in the CPI.

Fact, not opinion, but you must address it because this may have a bearing on the market’s behavior, depending on who gets elected. More tomorrow or Tuesday.

The blue chip DJIA and S&P 500 have been locked in an irregular trading range for four weeks, unable to break out up or down. The Nasdaq Comp. and Russell 2000 have traced out a more positive pattern, re-establishing their position as leaders in a crap market.

Over the past 7 trading days, Investors are telling us they are not prepared to sell at these levels, based on what they know, which includes the Fannie Mae/Freddie Mac and Lehman Bros. dilemma, as well as oil and commodity prices, and plunging house values.

So far, they accept the fact the economy is soft, but I doubt they believe we are in a recession. I suspect they are clueless about the implications of a global recession or the likelihood of additional defaults in loans other than real estate, as well as a crunch in commercial real estate – the other shoes to fall.

I am still bearish near-to-intermediate-term, looking for another leg down and the first of two bottoms during the 4th Quarter. But it is a presidential election year, and emotions will run high, and volatility will mark the activity in the stock market some of which will be on the upside.

George Brooks

Brooksie’ Market blog
August 26, 2008 7:38 EDT
DJIA: 11,386.25
S&P 500: 1266.84
Nasdaq Comp: 2265.59
Russell 2000: 720.54

All four market indices got to my support levels in a hurry yesterday with the DJIA losing 241 points (2.06%), wiping out Friday’s sharp advance with room to spare.

As I said in my Thursday post (“Do not Like This”), bull markets do not act like this, they are more robust. I believe the market action since the July 2008 low, is but a way station in route to lower prices.

The Nasdaq Comp. and Russell 2000 have traced out more bullish patterns, but I see some vulnerability creeping in there, as well.

There was no follow-through to Friday’s upmove, a reminder that there are sellers waiting to dump into strength when it shows up – not a good sign.

I have advised raising cash on rallies, and continue to do so if you do not have a healthy reserve.

Rallies in the market can be prompted by an announcement of a rescue plan for Fannie Mae and Freddie Mac or Lehman Bros., as well as by a stronger dollar and falling oil and commodity prices. However, those developments are already anticipated by the Street.

We are staring right smack in the face of a global recession, and the repercussions of that haven’t been factored into stock prices yet.

When will it be reasonably safe to buy stocks ? For one, another leg down in the market would help discount uncertainties and looming negatives. For another, we need time to engage and digest the problems out there. It’s too early to really get a handle on them. How much of a domino effect will the financial community’s demise have on the world economies ?

My downside target is DJIA 9800 in October for the first of two bear market bottoms, the second coming in December. To get there, the DJIA must break below the July low of 10,731.95 and the S&P 500 below1200.43.

Today :should generate a rally of 80 to 110 Dow points, but may give most of it back. Sell into it. Rally failures where the market gives most of a day’s earlier gains back before the close are what to look for now as a clue to a downside breakout.

Support mentioned yesterday, while minor, is DJIA:11,300, S&P 500; Nasdaq Comp.: 2370; Russell 2000: 725. Both Nasdaq and Russell 2000 broke support yesterday buy a few points. Breaking 2385, Nasdaq’s next support is 2300. The Russell 2000 looks like it is bound for 700.

George Brooks

Brooksie’ Market blog
August 25, 2008 Monday 9:16 am EDT
DJIA: 11,628.06
S&P 500: 1292.20
Nasdaq Comp: 2414.71
Russell 2000: 737.60

It’s going to take a lot to change my reservations about this market at these levels; I seriously don’t think it has adequately discounted the uncertainties and potential dislocations out there.

Nevertheless, I plan to give the bullish outlook as much ink as possible, without sitting on a fence, or wimping out on my convictions.

Fed. Chief Bernanke’s comments Friday about a slow economy leading to reduced inflationary pressures is probably on target and soothing to the ears, but he also said the financial turmoil which began last August has not yet subsided.

What else is he going to say with a presidential election ten weeks away ? What must be considered here is not what the Fed., Treasury, administration and Wall Street leaders know, but what they don’t know about the collateral damage to our economy resulting from the financial community’s demise, as well as a from U.S. and global recessions. UNCERTAINTY ! How do you quantify it ?

The market has held for three days in a row, the third producing a sharp rally in response to Fed chief Bernanke’s comments. We now have support levels, if not a minor ones at DJIA: 11,300, S&P 500: 1270, Nasdaq Comp.:2370, Russell 2000: 725.

Let's see what kind of legs Friday's upmove has.

George Brooks

Brooksie’ Market blog
August 22, 2008 11:22 EDT
DJIA: 11,609.58
S&P 500: 1289.15
Nasdaq Comp: 2403.33
Russell 2000: 732.85

If I was wrong yesterday by saying I didn’t like this market, then I am confirming my fallibility today !

The DJIA is ahead 179 points at this moment, if you do not have a healthy cash reserve, get it. I expect another leg down and it will provide a better opportunity to get in at better prices, in most cases.

On its own, this rally is likely to fizzle, but if an announcement about a rescue plan for Fannie Mae and Freddie Mac is imminent, the rally can be extended into next week.

Please read my August 21st post for my reasoning about what it would take for the bulls to recover the ball (prior to another leg down), and common sense advice about the magnitude of bear markets and bull market opportunities.

George Brooks