Opinion: Horror story - A trillion dollars in equity borrowing says the US market will fall

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Short selling is a fundamental force of the market, which doesn’t like losing money, either way the stock prices move.

What’s interesting is that there’s now a lot of money being invested in short sales on the US market. Meaning, obviously, that the people investing are expecting the market to fall.

The Sydney Morning Herald has this Bloomberg piece, which I couldn’t see on Bloomberg itself.

Managers from William Ackman to Jim Rogers made a total of at least $US1.4 billion in July with wagers against US mortgage financiers Fannie Mae and Freddie Mac, according to data compiled by Bloomberg. Harbinger Capital Partners staked $US665 million that UK mortgage lender HBOS would drop and Sao Paulo-based hedge-fund manager Francisco Meirelles de Andrade's short selling of Cia. Vale do Rio Doce is also paying off.

Cute, huh? Fannie Mae and Freddie Mac went down like bricks.

Just to explain a bit further: If you borrowed 1000 of Freddie Mac, a year ago, you’d have been borrowing $60,000 worth of equity. You sell the stock at that price. If you “paid back” those shares now, you’d be paying back $6000. You don’t have to pay back the money, just the shares you borrowed.

Who gets hurt?

The poor bastards who bought the stocks retail, obviously, but not in the way you might think they get hurt.

What happens is that these stocks, safely resting with doting family-values type brokers, are borrowed from the brokers. The brokers, in turn, borrow them from their clients. It’s quite legal, and the brokers do in fact incur liability for their borrowings, so somebody does take that $60,000 seriously, in terms of those 1000 Freddie Mac shares.

What’s supposed to happen is that the broker gets fees and commissions, the borrower makes money, and the world is a better place… for the borrower and the broker, anyway.

However, if the stock falls, the retail buyer gets hurt, obviously. The borrower makes a lot of money, and the broker can pick up the fees.

Short selling doesn’t always work. Sometimes, thoughtless people drive up the stock prices, and the reverse scenario happens. The borrower, if he’d borrowed at $6000 and had to buy at $60,000 would have been losing out badly, obviously.

Now, if you’ll all please raise your barf bags to the ready position:

More than $US1.4 trillion of equities worldwide are now on loan, about a third higher than at the start of 2007, data compiled by Spitalfields Advisors, the London-based firm specializing in securities lending, show. Almost all of that is being used to speculate that shares will fall, according to James Angel, a finance professor at Georgetown University who studies short selling. The global economic slowdown, $US447 billion in bank losses and an explosion of funds that can profit from stock declines spurred the increase in short selling, helping send 22 of 23 countries in the MSCI World Index into bear markets.

In other words, that trillion dollar plus borrowing spree means that a trillion dollars plus worth of stock is expected to be worth a lot less than a trillion plus, at some point in time.

Short selling isn’t illegal. It’s a hedging methodology, and anyone who’s ever tried day trading can tell you that for traders, it makes sense. Just buying and selling can wipe people out, quickly and permanently.

But-

Anyone happen to get the impression that the world’s short sellers now have a lot to gain out of a catastrophic drop in the markets? 2007 wasn't anyone's idea of a good year for the markets, when it ended.

The trillion or so being bandied about happens to represent the face value of the equities.

Now, what would be a nice return rate, that would bring smiles to all those dear little borrowers, and stop them crying?

20%, 30%, how about 50%?

Yep, that sounds about right. That’d cheer up anyone. Can’t help but have a bit of a giggle, if you’ve just parlayed $500 billion of someone else’s money into a nice little windfall, now can you?

Well, not unless you happen to know what you’re doing.

That sort of crash, and it would make 1929 look like a falling snowflake, would also hit the cross exposures of every equity investor on Earth.

Brokers who borrowed from their clients are up for face value. The drop means they’re up for less, but if a real crash happens, that’s an awful lot of money, all at once, because people will want to get their money out.

The brokers in 1929 weren’t jumping out of windows because they wanted some fresh air.

Borrowers, alas, also tend to hold market related assets, like credit cards and cell phones with irritating people on the other end of them. These, while diving brick-like, are worth a lot less in terms of covering their own dues.

Then there’s the little matter of someone having any money left to buy anything on the market. Runs on banks are caused by market panics, and in the middle of a credit crunch, cash and credit aren’t that easy to find to begin with. The banks are weak at the moment, and this huge amount of equity borrowing has just added a very large possible straw to the scenario.

Meanwhile, the retail investors have gone to the wall, the floor, and the sewer in that order. They’re out of the picture.

With them go the funds, the 401ks, and the rest of the Middle American Investor Patsy Factory, into some well-audited oblivion, yet again.

Now I’d like to get a bit cynical, if possible, under the circumstances.

We’ve just had a nice little market kamikaze mission from global markets, over the last 9 months. Since September 2007, if you look at all this as a short selling exercise, someone’s been doing very nicely out of it.

Add oil futures, and things must be great, for someone. Tom Johansmeyer has a very interesting DJ article on money pouring in to private equity investments. Any guesses where all that money's coming from?

Because nobody's ever going to be entirely sure.

If this is market manipulation, it’s on a colossal scale, and it’s trashing the entire US economy in the process.

If it’s not market manipulation, it’s one hell of a coincidence that all this equity borrowing has happened in a bear market. It’d be money for jam, literally.

Only problem is that done like this, it won’t work. In a real major crash scenario, paper value will be worthless.

You might make a lot on paper, but where’s the hard cash going to come from? Offshore? They’ll be in Swan Dive mode, too. Interest rates will go through the roof.

Can you short sell to someone who’s just jumped out a window, and left his business affairs in an indecipherable, complex, incomprehensible, mess?

Can you get money out of a bank which has just run out of the stuff, and is loaded with debts?

Can you duck bullets from annoyed depositors and investors?

Sorry, guys, I don’t see this as a short selling Nirvana.

This looks like more trouble than anyone but a coroner can handle.

If half of that trillion or so evaporates in a crash, it won’t be alone. The Dow would be looking at 7000-8000, because of automatic selling, and panic selling compounding the face value effect. Funds will be crippled, and you can forget buying stamps for the Christmas cards for 2012.

You might want to try scratching messages on rocks.

I hope I’m wrong, but my instincts say when the vultures pick up $1.4 trillion worth of dead meat, something’s not right.