Original URL: http://www.theregister.co.uk/2008/09/29/destroying_banks/

Bear squeeze blues: How to destroy a bank

Set phasers to 'short sell'

By Dominic Connor

Posted in Financial News, 29th September 2008 10:52 GMT

Comment With the banks apparently unable to cope with the markets anymore, the poor dears, short selling has been banned to protect them. HBOS is being taken over cheaply, even compared to what a mortgage bank is worth in this rotten market. Allegedly, "spivs" conducted a whispering campaign, and used short selling to make money out of misery. It is nearly true.

If you had known in advance that Northern Rock was doomed, you could have made real money. But insider dealing wouldn't have helped you since the "insiders" didn't seem to know what was going on until it was too late. The Lehman collapse seems to have been partly caused by executives refusing to take a catastrophic write-down in their personal wealth, betting that they were too big to fail. So inside information here would have been hard to use.

Of course, if you cause the bank to go down, then you have the most perfect of insider information - so how would you do that?

Short selling is just a bet that the price will decline; you sell stock you don't yet own, and hope that when the time comes to deliver, the price will be lower. Outside the markets it has few friends, although it is a critical component in getting better returns on money for lower risk. A traditional bet on a horse does not make it run faster, at least in an honest race, but every part of a company's financial profile interacts with the others.

Hedge funds have made respectable money shorting financial stocks and using the proceeds to go long on energy shares, at lower risk than simply buying shares in oil companies. The greater risk efficiency of HFs is the reason that on average they have grossly outperformed "long only" traditional fund managers - and as any student of finance will tell you, the only consistent performance is under-performance. And yes, before you ask, that is where a large chunk pension of funds are invested.

As banks don't sell beer...

Every company has a set of credit ratings; how likely it is to default on its debts in a given range of time. The longer you lend money, the more exposed you are to a default, and so there is often an extra premium for lending for the longer term than for shorter periods. The core job of any bank is to do just this. Banks borrow in the shorter term, sometimes literally overnight, and lend over years. Without this we could not have mortgages, or finance infrastructure projects where there is no revenue from the investment for as much as ten years.

The greater the difference in time between how long you lend for and borrow, the more money you make, on average. However, with this greater return comes greater risk, which Northern Rock simply ignored.

When an individual lends money to a bank in a deposit account, they enjoy government guarantees, which commercial lending usually did not, so the NR debacle started when became clear that if you lent money to NR, the chances of getting it back were dropping sharply. NR was exploiting the short term money markets, and although even the FSA spotted the high risks involved early, it didn't want to annoy them - so the banks ignored it until this hit them in the face. Short-term markets are of course a bad place to be when you suddenly find yourself without enough cash to pay what you owe in the longer term.

If you happened to have a short position in NR early enough, you did pretty well - but few did. Still, the idea was clear enough - if a bank is perceived to be on the slide, the next dip in the stock can actually be caused by the most recent downtick.

The next villains in this mess are the ratings agencies. Their job is guessing the odds of a debtor not paying back debts, whether that is bonds, or payments to suppliers. This is an eclectic mix of accountancy and PhD-level mathematics, though of course it is mostly done by MSc-level people at ratings agencies, trying to vet the maths of PhDs. Guess how well that ends? The MScs are not only cheaper than PhD Quants, they ask fewer awkward questions. The agencies are paid by the issuers of debt instruments to give them a rating which is critical to the value when they are sold. Yes, you read that correctly.

It is thus convenient that the smart quants at the banks can outclass the MSc and often BSc-level agency employees. Ironically the agencies have the harder job, since they are trying to work out the value of an instrument whose real value is often intentionally obscured.

As a reaction to how their performance is perceived the agencies have been hiring some "names", but the actual workers are much the same. To make it more fun, these instruments are traded, which means you want some idea of how likely the firm is to default on a daily basis. But accountancy is not a real time profession, so a lot of traders use models that partly rely on the stock price, since there is an obvious correlation between the expectation of future profits and the chances of it not paying its debts. There are other factors in the model of course - each firm has a sensitivity to interest rates, energy prices, exchange rates, and of course the general economic conditions.

So the ideal victim for this hypothetical operation is a firm that needs to borrow regularly in the short term markets, and has not been hurt too badly by current conditions. You don't want your target to be too feeble, because naturally the stock price will already reflect that. Thus the fact that HBOS was actually run relatively well seems to have helped it become a target.

How to plot a shareprice collapse

As a headhunter I get to hear a lot of things, such as the impending collapse of Goldman Sachs, which I know to be true because I hear it so often - on average every couple of months for the last 15 years. So one gets used to this sort of nonsense, and I guess I'm seen as a good person to feed this gossip to, since I might spread it around. So to get past the normal scepticism, one has to have a good story, and the credit crunch makes for a suitably dramatic backdrop.

Although there is no requirement to report your short position, it's not possible to do it on a large scale without the market noticing. Normally one tries to avoid being conspicuous, since the more you buy or sell the more the market learns about you, and moves the prices against you. There are people whose main role is to keep this effect to a minimum. A big role of a market is the aggregation of information, and sellers give the information that some people believe the stock is worth less than it appears to be.

It is tempting to believe that a cabal of well-financed operators worked together on HBOS. JP Morgan has a "Control Index" for concentrated short selling, on which they flatly refused to give me details. If I had it, I could tell you it implies how they know to a useful extent who was doing the short selling. I would have read that this index showed a dramatic and sustained increase in short selling in the last year. If I could look at it, I'd have seen something close to doubling during the recent crises, and know that the regulators have this data on their desks. Shame, really - that would have been a good part of this piece.

Given that the bank can be hurt by a stock price slide, if your "story" is believed by enough people you can trigger an avalanche. It's hard for any regulator to stop this. Phones are of course recorded, and banks try to ban the use of mobiles, store email, and restrict use of sites like Gmail and Hotmail where your communications can't be monitored or retrieved.

But of course many sites now have forum, comment and chat facilities, and short of cutting off all web access, chatter simply can't be prevented. Even if it could, then personal phones are not recorded, even if you do get the log of who has called who from the telco. The reality is of course rather low tech - there are a lot of bars where one can meet up, casually drop in gossip and note that the market seems to support your idea. Before long it hits the financial press, and even the BBC, which adds to what you are trying to achieve.

If this was a plot, it was very risky. If your pressure on the price stops too early, you can be caught in a "Bear Squeeze". The stock price acts like a stretched rubber band, and to make it worse, stock has to be bought, which adds to the snapback.

So plotters would have to be very well funded, and have complete confidence that higher management would not lose its nerve. That is a very small set, perhaps too small to exist - or too smart to be spotted. ®

Dominic Connor was an occasionally competent CIO developing trading systems, before he wised up and became a headhunter.