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Financial Times, September 30, 2008 column


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Wall Street dispatch: Blaming birds for chirping

By Francesco Guerrera in New York

Published: September 30 2008 10:34 | Last updated: September 30 2008 10:34


Thirteen months into a crisis that has forced millions of Americans to default on mortgages, caused half a trillion dollars of losses among financial companies and decimated the ranks of Wall Street banks, we finally have a culprit.

Ladies and gentlemen, I give you the “real” causes of the worst financial meltdown since the Great Depression: hedge funds.

That’s right. Not the greedy Wall Street banks that inflated the US housing bubble by creating ever more exotic ways of selling mortgages to unsuspecting investors. Not the unscrupulous real estate brokers who flogged home loans – with no strings attached – to people with no ability to repay. And not regulators and monetary authorities who did not know, or understand, large parts of the financial system contained the seeds of their own destruction.

No. It was all the fault of the geeks with the checkered shirts, the MIT degrees and a penchant for exploiting market inefficiencies.

That is the message emanating from the world’s capitals where watchdogs claim to have suddenly discovered the cure for the ills afflicting global finance.

Over the past few weeks, the rule of thumb for regulators such as the US Securities and Exchange Commission has been: when in doubt, ban short-selling on financial stocks.

In the space of four working days between September 17 and September 22, the normally sleepy SEC issued no fewer than seven press releases on its crusade.

The fact that the pivotal announcement on September 19 banning short-selling in 799 financial stocks until October 2 was followed by a litany of explanations, retractions and additions speaks volumes of how well the policy had been thought through.

If these were normal times, we could roll our eyes, make a couple of snide remarks and let the market take care of itself. Unfortunately, with markets paralysed, investors spooked and banks falling like extras in a battle scene, the invisible hand of the market is ... well, a little too invisible.

In the current panicky environment, regulators should exercise extra caution and make sure hurried actions do not put additional pressures on an already strained infrastructure.

Placing a blanket ban on short-selling in the financial sector does exactly that.

To be clear, I am no hedge fund lover. I don’t like the fact they are lightly regulated, largely secretive and virtually unaccountable.

But penalising knowledgeable investors for shorting banking stocks when the system is in meltdown is like blaming birds for chirping.

The slump in the share prices of the likes of Citigroup, Morgan Stanley, Goldman Sachs, and the late Bear Stearns, Lehman Brothers and Merrill Lynch, was caused by their own loss-making incompetence, not a bunch of whizzkids.

Look what happened to the stock market on September 22, when the anti-short selling rules were already in place. The S&P 500 index tumbled nearly 4 per cent, with financial stocks falling some 8 per cent purely as a result of “long selling”.

The much-trumpeted initiative has failed in its goal of stopping shares from collapsing. And it gets worse.

By forcing hedge funds to close their short positions in a hurry, the measures could exacerbate the problems of that section of the system.

The credit crunch has not been kind to hedge funds. The average fund is down nearly 5 per cent in the year to date according to Hedge Fund Research. However, those with a bias towards short selling are actually up 9.4 per cent.

So let’s recap: by acting in haste, US regulators have managed to shut down this year’s best performing hedge fund strategy while at the same failing to stem the rout in financial stocks.

One has to wonder whether intervention in these fraught markets should have such a damaging unintended consequence.

Even if you don’t care about hedge funds, their recent predicament underlines the peril of making up rules as a crisis rages.

Ever since they were called upon to rescue Bear (and Fannie Mae, and Freddie Mac, and AIG, and Lehman, and Merrill), the Federal Reserve and Treasury have been under incredible pressure to act quickly and creatively. And I am sure they feel they did their best to avert a total catastrophe in financial markets.

But this high-wire act, suspended between the perils of systemic failure and a Wall Street bail-out, has been plagued by inconsistency.

Regulators provided substantial aid to facilitate the takeover of Bear but only “encouraged” Merrill to merge with Bank of America. They let Lehman fail but stepped in with billion-dollar cheques to take over AIG and Fannie and Freddie.

The only constant has been their determination to punish equity holders in the troubled companies.

This commendable desire to avoid moral hazard had only one problem: by telling markets that the shares of ailing financial groups would be driven to nought, it encouraged short-sellers to target those stocks. That created a “reverse moral hazard” that gave hedge funds a green light to short the hell out of vulnerable companies.

The authorities’ decision to ban short-selling is an admission that their previous moves have backfired. Unfortunately, by hitting on one problem, they have unwittingly created another.

Even in times of extreme stress, financial regulation should not be a game of Whac-a-Mole.



Copyright The Financial Times Limited 2008






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