Send To Printer Email to Friend

Hooverism, Horse Hockey and Happy Talk:
The Aggressive Progressive
Looks at Economic Policy

By Stirling Newberry

The Next S&L Scandal (First in a Series)

New York is being over run.

Not by Arab terrorists, nor by drug dealers - but by short sellers hammering the stock market into the ground. For the second year in a row, the man of the year should be an animal.

A Bear.

In itself a down stock market is nothing to panic about overly much, stock market slides are the house of the casino that is finance collecting the losing bets when the wheel stops. That there are losers is part of the nature of the game. But that is not what is happening here. Instead, there is a belief among many traders, with money to back that belief, that the major indexes on the New York Stock Exchange are overvalued, and ripe for attack. Against them, others who are trying to hold the line have been, for the past few months, fighting a desperate battle to prop up the Dow and S&P.

What does this mean? And how does it work?

Imagine something smaller - a neighborhood with 10 houses. If one goes up for sale then it will fetch a certain price - if 2 do, then there there is a slightly lower price. If everyone is desperate to sell, and all 10 are up, then they will sell for a much, much lower price. Simple supply and demand.

Now, what happens when you go to get a home equity loan? The price of your house is calculated by the sale prices of other similar homes in your area. If you think that both can sell at a high price, there is no problem. But what if you know they won't both sell? Then you know the value of your home, and thus what you can get for a loan is about to go down.

A defense then would be to go to all the other home owners and say "let's chip in, make the down payment on the house, rent it out, and then sell it later." The cost of the down payment is 5% of the house, and if two houses would hurt everyone, then you might be able to do it. This, in essence, is what happens when a bank "intervenes" to buy a currency - it reduces the amount of supply, and thus increases price.

An attack against an index or a currency - as with Soros' celebrated attack on the pound, and the attack on the Argentine peso earlier this year - is a bet that by shorting - borrowing a stock, selling the borrowed stock and buying it later - will dramatically reduce the price. In other words, it is a bet that there are no more buyers out there than have lined up, and there are other people who will sell if they lose too much money.

This line up - where those who have money borrowed against the value of the market line up against those who think the price of the market is artificially high by constricted supply - is what makes an attack possible. Usually the attackers lose, badly. What is worse is that the defenders in a successful defense profit, and can therefore defend better later.

However, when the attackers win, the result is spectacular. This year the Argentine Peso and Tyco stock have been the target of bear attacks, and both have broken.

- - -

So how does this apply to the New York Stock Exchange. Well, you can't spend stock. If you sell it, you reduce the value of your other stock - which could cost you more than the money you get. It is also taxable. So what do you do? Well, you borrow against the value of your stock. This means that while there is wealth in the NYSE - some of that is actually not there, but has been borrowed, the way a homeowner gets a home equity loan. He doesn't want to sell his house to buy a new bathroom for it, which makes no sense.

This means that those people who have borrowed against some asset have a reason to defend it. And therein lies the art of it: if no one has money borrowed against something, an attack is unlikely to work, because no one has to sell. The way an attack works is when people who are not interested in the asset dropping in price are forced to sell to raise cash. If they have money borrowed against the stock to buy more of the stock as an example. The attacker thinks he can set off a chain reaction - the price drops, people who have borrowed against the stock sell, depressing the price, forcing other people to sell.

So what is an owner to do? Intervene. The brute force way is to simply buy the shorted asset, and sell it later. However, this is expensive. Instead, the more successful intervention tries to find a key point in the attack and make it difficult to execute. To go back to our house example - suppose you know that the house that is to be sold needs to have its sewage fixed - and the new line has to run across a small strip of land. You buy that small strip of land, and then tell the homeowner who wants to sell that he can't fix the sewage, so he can't sell. Or you tell prospective buyers that they will have to go around your land. The cost to buy the little strip is small, and it ties down much more value.

That is what has been happening on the markets. In order to short the market, the bear needs some protection in case he is wrong. He buys contracts on the S&P. The defender, knowing this, buys lots of these contracts - drastically increasing both the price to the Bear, and also increasing his risk - because he can't stop the losses at the same low level.

The huge surges in the market that have been seen were not lots of small investors getting back in, not lots of people - but a few people with lots of dollars to lose. Each time they poured money into S&P futures - which shot up - and then tried to force the bears to "cover" or buy back the shares that they had sold short earlier. They hoped that the bears were overextended and would have to retreat. But instead, each cycle has helped the bears - they have made money on each attack, the defenders have lost money, and the market has retreated.

Why is this? Because people are pulling money out of the market at an accelerating pace. The expansion in the dollars going into investments has stopped and turned to retreat. The force of gravity is on the side of the bears.

What we are also finding out is that some of the money to finance this came from the defenders selling puts well below the market. In essence, they were making a bet with the Bears that the Bears wouldn't win. If they could hold the line, they would finance the defense with the bear's own money. However, if they failed, they would have to pay the bear back, and then some, and sell stock to raise the cash.

- - -

So why does this matter to you? Because you, my fellow American and reader of Democrats.com, are going to pay for this mess. This is the sickness of our current system - a small fraction of the people who have money control much more money - money that belongs to other people. They aren't gambling with their fortunes, they are gambling with your money. Money that you will have to pay back if it fails.

How does this work? As most people who follow stocks know, 1/3 of all of the money in equities - stocks - is from pension funds. It is the pension funds that are running the defense, and making the attempt to hold on. But, if the defense fails, guess who backs the pension funds? You, the US Taxpayer.

That's right. You.

Now if the pension funds were really trying to defend your pension, you'd be rooting for them – after all, you don't want to lose your pension. But they aren't acting in your best interest, and haven't been. You see, companies claim that money over and above what is minimum to "fully fund" the pension fund belongs to them. They have reported that money as profits. Worse, they have reported what they thought they might get as profits. They are, effectively, borrowing money from your pension fund - at 0% interest.

Let's put some hard numbers on this to give an example.

Suppose there are 100 dollars in a pension fund. The government grinds its numbers and says, "Next year, you will need 105 dollars to be fully funded." If the next year there is 110 dollars, the company books 5 dollars as profit - from your pension fund - and leaves 105 dollars.

It gets worse. By using an accounting rule known as historical expectation - the company says historically the stock market returns 10%. So we will have 110 dollars next year, and we will book 5 dollars as profit. Next year the stock market goes down by 20%, and instead of 110 dollars, there is 80 dollars. Does the company have to pay back the money? Not yet, not until they are audited and can't juggle numbers to keep things in line. How to juggle? Why, by loaning the pension fund enough of the company's own stock of course. Effectively they have sold the pension fund 25 dollars of their own stock - without paying taxes, and without the pension fund manager having any say over it. And you the pension fund beneficiary? The guy who has paid in? A say? Fughetaboutit. If it is a short decline, or small, this kind of activity will not be noticed. For example, lets say there is a bad year on the market - the pension fund as 104 dollars, gets loaned a little bit of the company stock, and the year after, the market bounces back and the pension fund is fully funded. The company merely doesn't book any pension fund profits that next year.

But the market is now down for over 2 1/2 years. Stock sales, which made up chunks of the profits, were really loans from the future. The future is now, and it wants to be paid.

Which gets us back to the real problem. Let's say that the company goes bust - and when the dust clears the pension fund only has 80 dollars in it to meet 105 dollars of expectations. Why then you, the taxpayer, have to pay that money.

With the recent declines, this situation is getting near at hand. According to several sources - collected in the business press by the Wall Street Journal and CNBC - 5% of the "revenues" of the S&P 500 - the five hundred largest US companies - consists of fake pension fund profits that will have to be repaid. And that number is growing.

What would the Aggressive Progressive demand? Swift action to prop up the system and get the money paid back in due course:

First, require that government back debts be first in line at bankruptcy.

Second allow government regulators to vote any shares that are "loaned" to the pension fund on reorganization plans.

Third require the pension fund manager to be responsible, personally, for acting in the beneficiaries interest.

Fourth: Congress must act with legislation to end the raiding of pension funds, and it must end the historical expectation rule for investment income.

Fifth: require a 5-year write off of pension profits. Provide government backed loans to ease the transition and prevent an orgy of selling.

This may seem like a simple set of steps, but time is running out.

Next on Hooverism, Horse Hockey and Happy Talk:
Oversold and overvalued - Why there is a danger of a historic stock market crash.