Europe Revives Failed Policies of 2008...Again

Following a weekend that saw many regional governments in Spain and across Europe come close to requesting sovereign bailouts, both Italy and Spain have once again implemented bans on short-selling. Italy’s ban is limited to the financial sector, while Spain’s ban encompasses all stocks. Both stock markets had been down several percent again this morning following major losses on Friday. Although the Spanish market rebounded following the ban to close well off its lows, the slight increase in optimism is likely to be short lived.

Since I’m still in Charlotte (on a golf trip with some old friends from high school) and have previously covered this topic (when similar failed policies were enacted last year), the following is my thoughts from last year:

Europe Revives Failed Policies of 2008

"Those who cannot remember the past are condemned to fulfill it."

-George Santayana

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.

Stock Market Pessimism Rises But Actions Speak Louder Than Words

Reading through countless blogs each day, the general tone regarding global economic growth and stock markets is highly pessimistic. In fact, many investors and market watchers have recently been arguing that the extreme pessimism could be a bullish contrarian signal. This week’s report from AAII (courtesy of Pragmatic Capitalism) provides support for this thesis:

Bullish sentiment, expectations that stock prices will rise over the next six months, plunged 8.0 percentage points to 22.2%. This is the lowest that optimism has been since August 26, 2010. It is also the 68th lowest bullish sentiment reading out of more than 1,300 weekly readings in the survey’s history. Optimism has now been below its historical average of 39% for 16 consecutive weeks.

Although I normally enjoy taking a contrarian perspective, history has also taught me that actions often speak louder than words. Here’s a look at the S&P 500 over the past year:
Source: Yahoo Finance

This market is up nearly 10% year-to-date and almost 8% from its recent low less than two months ago. Are the pessimists hiding out in options? Here’s a look at the VIX over the past year:
Source: Yahoo Finance

The VIX is down approximately 40% in the past couple months and approaching its lowest level in the past few years.

These two charts tell a very different story than the one currently being portrayed by mainstream media. While sentiment surveys are turning overly bearish, investors with money on the line are clearly willing to buy and/or hold stocks at higher prices. Further, the rapidly declining VIX suggests a minimal desire for protection. As the actions of investors have diverged from their words, the former likely offers better insight in to actual market sentiment. Over the years, corporations have clearly learned how to game earnings in order to consistently beat expectations by a significant margin. Maybe investors have finally learned how to game sentiment indicators to bait others in to following the trend.    

Ray Dalio - Disorderly Outcome in Europe "A Significant Possibility"

Ray Dalio and Bridgewater have been among the top performing hedge funds for many years. More importantly, Dalio is probably one of the best minds in understanding and explaining business cycles with a focus on credit. In his most recent letter (courtesy of Zero Hedge), Dalio paints a dour picture of global growth with a strong chance of further weakening as the deleveraging cycle continues to play out. As for Europe:

The unresolved European imbalances and the differences in their impacts on each country have produced widening differences in the self-interests of these countries, which have led to political divergences that have magnified the risks. Unlike a year ago, Germany and France no longer stand in solidarity as backstops behind the euro system, but have been divided in their self-interest by divergent financial conditions which are leading to conflicting rather than unified political orientations. France's deteriorating finances and economy have shifted its self-interest toward alliances with "recipient" (lower credit rated) countries like Italy and Spain and away from "contributor" (higher credit rated) countries like Germany and the Netherlands, leaving Germany more isolated as a guarantor of the risks in the euro system and in its views about how to manage the imbalances. Given these shifts in the alliances between contributor and recipient countries we think that the popular assumption that the Germans and the ECB (which requires agreement of the key factions within it) will come through with money to make all of these debts good should not be taken for granted. Said differently, we think that there are good reasons to doubt that European bank and sovereign deleveragings will be prevented from progressing to the next stage in a disorderly way, without a viable Plan B in place. This fat tail event must be considered a significant possibility.

Is the Return of Auto Subprime Lending and GM "Channel Stuffing" Connected?

Cardiff Garcia over at FT Alphaville has a recent post up on the return of auto subprime lending. Apparently lending standards are being increasingly relaxed, leading to an increase in lending activity. Garcia questions whether this news is good or bad, coming to the conclusion (my emphasis):

Whatever the case, we noted in May that while the pace of car sales in the US has picked up this year, it’s still much slower than for most of the past decade. More and more it’s clear that this is an ongoing rebound following the end of a depreciation cycle. (The pickup in lending activity is at least a sign of expected sustained demand in this sector, so there’s that.)

This sounds plausible enough but my nature involves being skeptical. Let's consider a different thesis on the rise in subprime lending. 


Over the past couple years auto manufacturers, namely GM, have been loading up dealer inventories to falsely promote higher sales. What many people may not realize, is that sales are booked when the cars are “sold” to dealers regardless of whether the dealers are able to sell the vehicle to end users. Here is a chart from Zero Hedge depicting the rise in GM dealer inventory:

This practice, known as “channel stuffing”, is actually part of a recent class action lawsuit filed against GM by investors. As the dealers are left with increasing unsold inventory, costs of storage are certainly rising. If sales to end users are not keeping pace with the desire of GM to unload inventory (clearly the case), one way to spur increasing end sales would clearly be lowering lending standards. The pickup in lending is therefore not a sign of expected demand but rather a means to increase demand. Is it possible the decline in credit quality of auto loans is a means to cover-up “channel stuffing” practices? If so, when subprime defaults eventually rise, who will be left with the losses?

Do Business School Ethics Lead to Financial Industry Scandals?

The financial sector has had a difficult time getting any positive press recently following the LIBOR scandal, loss of customer funds at PFG, hidden losses at JPM and money-laundering at HSBC. As we wait to see what criminal activity pops up next week, one has to question why so many of these illegal actions seem centered around business and finance. Luigi Zingales, a professor at the University of Chicago Booth School of Business poses the related question, Do Business Schools Incubate Criminals? In his view, the manner by which ethics are taught might suggest these actions are reasonable. Acknowledging this deficiency, Zingales provides a potential solution:

The way to teach these ethics is not to set up a separate class in which a typically low-ranking professor preaches to students who would rather be somewhere else. This approach, common at business schools, serves only to perpetuate the idea that ethics are only for those students who aren’t smart enough to avoid getting caught.

Rather, ethics should become an integral part of the so- called core classes -- such as accounting, corporate finance, macroeconomics and microeconomics -- that tend to be taught by the most respected professors. These teachers should make their students aware of the reputational (and often legal) costs of violating ethical norms in real business settings, as well as the broader social downsides of acting solely in one’s individual best interest.

Of course, no amount of instruction can prevent some people from engaging in bad behavior. It can, however, contribute to a social consensus that would discourage diffuse fraud, like the widespread misreporting of Libor rates or the willful self- delusion and dishonest dealing that helped turn the subprime crisis into a global financial disaster. The daily scandals that expose corruption and deception in business are not merely the doing of isolated crooks. They are the result of an amoral culture that we -- business-school professors -- helped foster. The solution should start in our classrooms.