Thursday, September 18, 2008

Shorting will be banned

It is almost official shorting will be curbed in short order.

Of course commentary falls on both sides of the coin with regulators accusing hedge funds of bringing down solvent institutions like Lehman to its knees in matters of days (and next Morgan Stanley and Goldman?) and them replying that it wasn't them that created the mess in the first place and don't shoot the executioner.

Shorts as feedback loop on trend: emergence of non-linear failures

After some thinking I am more on the side of curbing short selling in this period. Short selling should be allowed during "calm storm" as they reflect analytical views on a company. During panic, they add to the fire.

I understand the current situation through the analytical framework of "monetary delevering", that is what I mean when I talk of M4 going down, monetary mass going down.

That trend is almost inevitable, see discussions on inflation/deflation/US Treasuries for a counterpoint in this blog. But the problem is not the trend, it is the feedback loops on the trend, what is commonly known as "death spirals". In mathematical terms a linear decline is tough enough, but it is be manageable, the time frame is known, usually mid-term, people have time to liquidate their assets raise cash etc. But a feedback loop leads to non-linear behavior (usually exponential) with rapid dynamics. Time phases contract and you do not have time to respond, you get caught off guard.

In physics, phase changes for example are catastrophic events. By catastrophic, physics means one-way, out of equilibrium, rapidly accelerating dynamic events. Many of these are well understood and documented.

In finance, during good times a feedback loop pushed to its extreme means "bubble", or momentum investing, in bad times a feedback loop going on in earnest can mean "death". Here is how it works with Shorts. Naked shorts is a financial trade where you borrow a security from a long term holder, typically a investment fund, you SELL it on the open market (keep that part in mind), collect the cash. When the stock goes down you buy the stock back give back the security and you pocket the difference. You have made money on the stock going down.

The problem with this scheme is the SELLING part. A down trend is re-enforced by the selling. That is a feedback loop. In fact, given enough size or coordination, it is not hard to do market manipulation this way. By betting on a downtrend and selling the stock you fullfil you add pressure to the downtrend. This feedback is what brought a Lehman or an AIG to its knees in less than a week.

Clearly what is going on right now is not good, but should we allow rapid liquidation of a Lehman, whom according to many reports was not insolvent but temporarily illiquid and saw its equity wiped out in less than 3 days??? When regulation takes equity as a variable for debt ratios and said equity is volatile and can be wiped out in bad times in short order, you have bred instability. Something has got to give, and something is giving: equity.

Therefore I see the rational for cutting out feedback loops in desperate times. There is a middle ground between the Japanese head in the sand approach where write-downs were drowned out for 10 years and the current bazooka-UZI violence in the street treatment of US corporate institutions like Lehman and AIG.

Buy puts, sell calls

There are many ways to play a down market that do not create such a violent feedback loop. Buying puts if you own the stock, means you can keep the stock (no selling) and protect your position. This does not add to the stock pressure. Selling calls, is another way of creating a synthetic dividend on the way down as you get the premium up front and don't get called if the stock goes down. You can even do both, sell calls to buy puts and create what is known as a "no cost collar".

Derivatives are in fact a lot more safe as they do not participate in first order to the movement of the stock. There is no first order feedback loop.

Blame the shorts
In short, no pun intended, the shorts cannot be blamed for the trend, as they correctly point out. The trend is the trend, but they can be blamed for accelerating the trend. Just like the govt turned the 1929 recession into the great depression, are the shorts creating more harm than good? I do believe so.

7 comments:

Jean-Luc van Hulst said...

I liked this article http://money.cnn.com/2008/06/27/news/economy/The_onion_conundrum_Birger.fortune/?postversion=2008062713

even though everyone agrees that the 'onion market' is very different and probably most any way. Still food (haha) for thought..

Marcf said...

Great story!

Daniel Brum said...

This is the best article i've seen yet on the whole mess: http://freakonomics.blogs.nytimes.com/2008/09/18/diamond-and-kashyap-on-the-recent-financial-upheavals/

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