"Those who cannot remember the past are condemned to fulfill it."
Tuesday’s blog ended with the above quote, but Europe’s actions today require the quote come first. Over the past couple years, policy makers pointed to rapidly rising financial markets as proof that the financial crisis was behind us. In trying to convince the public to move beyond the past, leaders appear to have erased their own memories of countless policy mistakes with unintended negative consequences. Unfortunately, Europe is embarking on the same flawed regulatory path circa 2008 and one would be foolish to expect any differing outcome.
For a moment let us look back upon the events of September 2008. On September 7th, Fannie Mae and Freddie Mac were effectively nationalized. A week later, Merrill Lynch sold itself to Bank of America. Over the next four days, Lehman Brothers filed for bankruptcy, the Reserve Primary fund broke the buck, the Federal Reserve bailed out AIG and Treasury Secretary Paulson laid out initial plans for TARP. With financial stocks under significant pressure, on September 19th, regulators responded:
“The Securities and Exchange Commission, acting in concert with the U.K. Financial Services Authority, took temporary emergency action to prohibit short selling in financial companies to protect the integrity and quality of the securities market and strengthen investor confidence.”
Stock markets responded positively that day, with the S&P 500 rising over three percent to close at 1255. The next day, markets opened flat before giving back the previous day’s gains. The sell off continued from there and that closing level of 1255 was not reclaimed until January 1st, 2011.
Over the past two weeks, Europe’s peripheral crisis has been morphing into a Euro-core crisis as Spanish and Italian sovereign yields rose, while France witnessed a proverbial run on its largest banks. Having apparently forgotten the lessons of 2008, this evening, France, Spain, Italy and Belgium banned short sales on numerous financial institutions (Greece and Turkey have already instituted this policy). Apart from the obvious previous failure of this policy, it’s important to understand why the policy failed and why it almost certainly will again.
Many policy failures are due to a fundamental misdiagnosis of the problem at hand. Recent weakness in bank shares stems from fear of significant asset write downs and potentially inadequate capital levels that could ultimately render the firms insolvent. Banning short selling implies these concerns are based on widespread rumors willingly accepted by millions of investors. The policy also fails to acknowledge that short selling is largely employed by financial institutions and investment funds as a means of hedging risk. Ignoring these factors has resulted in establishing a policy that reduces liquidity and discourages buying.
During normal times, potential stock buyers include investors wishing to acquire or increase long positions and others trying to cover short positions. On the opposing end, possible sellers consist of investors wanting to reduce or eliminate long positions and others initiating or adding to short positions. Although banning short selling is aimed at reducing sellers, in actuality it removes both buyers and sellers from the market. An initial consequence of reduced liquidity will probably be heightened volatility going forward.
By reducing selling pressure, the policy aims to strengthen investor confidence in European banks. Although I believe the ban actually signals desperation by policy makers aware of deteriorating fundamentals, I’ll ignore this point for a moment. Determining the future direction of bank stocks requires comparing the vantage points of remaining potential buyers and sellers.
Apart from rising sovereign yields across Europe, weakening economies have put pressure on bank earnings. Stress tests that were clearly rigged supported claims that banks were severely under-capitalized. Bank stocks have been falling rapidly back toward levels from the previous crisis. For investors, the question is, why buy now? Certainly some investors will believe the recent sell off is over done and that considerable value can be found in owning bank stocks. Even for these individuals, the risks run incredibly high.
As currently enacted, the short sell bans only last 15 days. Since few individual investors actively use short selling, outright short positions were likely held by sophisticated fund managers. It seems reasonable to expect these managers will continue shorting bank stocks after the ban ends. In that case, buyers may be well served to wait for even lower prices. Potential buyers may also fear that some rumors are true, as witnessed frequently over the past several years. Investors therefore must risk being almost entirely wiped out. With thousands of other stocks to potentially invest in, a strong desire by investors to purchase bank shares at this time is hard to fathom.
While potential buyers include current holders and investors starting new positions, possible sellers are now limited to investors with current positions. Having already experienced significant losses, these owners are confronted with the same concerns as the buyers mentioned above. However, if buyers prove to be scarce, sellers face an added fear of acting too slow. Within illiquid markets, a shortage of buyers means that sellers may frequently be forced to hit bids (selling at the current best bid, often a sign of weakness). Selling in this manner typically lowers prices and could cause buyers to withdraw or lower bids further. Sellers who act first will therefore receive the best prices. The biggest risk is that recognition of this process becomes widespread and sparks a surge of selling interest. In that case, prices could free fall as selling begets more selling and buyers retreat.
Yesterday’s equity market gains were probably the result of investors rushing to exit short positions before the ban was made effective. With those buyers now removed from the market, who will replace them in the days ahead? Investment funds and financial institutions that used short selling for hedges must now seek alternative measures or reduce long exposure. Shifting to other hedging strategies will result in prices of those short instruments being bid up significantly and further discouraging equity buying. Reducing long exposure will generate an imbalance favoring sellers and push markets lower.
Aside from failing to prevent further declines in bank stocks, banning short selling could very well directly reduce bank profits and lending. Banks earn profits from trading, both on their own account and through transaction fees from customers. Less liquidity means less transactions and lower profits. As mentioned earlier, financial institutions account for a significant portion of short sales. These positions are often used to hedge counterparty risk. Without an ability to hedge this risk, banks may become less willing to lend to other banks and in turn, consumers.
In September 2008, the U.S. and U.K. instituted widespread bans on short selling of financial institutions. Despite fiscal and monetary stimulus, liquidity declined in equity markets and practically vanished in interbank lending. Desperately attempting to raise capital, banks were forced to sell assets and accept bailouts. Deposit withdrawals pushed banks to the brink of bankruptcy and caused a contraction of credit. The rest of the story is history.
To be clear, the ban on short selling did not cause the financial crisis. Banks had lent recklessly and rung up massive amounts of leverage. Financial systems are built on confidence and once that falters it becomes increasingly difficult to reacquire. In my view, banning short selling in 2008 was an ill conceived sign of panic among regulators. Attempting to focus blame upon a few select short sellers, the policy discouraged buying and removed liquidity at a time it was desperately needed.
For the global economy’s sake, I hope this time is different. Maybe buyers will show up in droves to purchase bank stocks upon the removal of short sellers. Maybe 2 weeks will allow policy makers to create a plan of action for shoring up bank capital. Maybe the short sellers were just making up rumors on the fly. Sadly I have a hard time envisioning any of these scenarios taking place. My worst fear, that nothing would be learned from the Great Recession, appears to be coming true. Here’s to hoping the days ahead are not filled with more 2008 déjà vu.