Originally posted on 03/9/2010 by Judd Bagley
Nearly one year after its original date of publication, my video, Hedge funds and the global economic meltdown has finally received its first bit of serious criticism, and I can’t express how pleased I am about it.
So far, at least as far as bloggers and YouTube commenters are concerned, response to the video has come in five flavors:
2.Nutty approval (“This makes me so angry I want to take to the streets in bloody revolution! It’s all [insert political party or current/past president]’s fault! ”).
3.Tentative approval (“You’ve got part of the story right, but the real problem is…”)
4.Random and unaware (“I’ve got a puppy named Patches. He has a wet nose.”)
5.Nutty disapproval (“[Insert anything Gary Weiss would say]”)
What’s been missing is educated criticism based on the hard facts presented in the video. And believe it or not, this has bothered me, because it suggests that not enough smart people are paying attention.
As I mentioned, that changed this week when Mike “Mish” Shedlock of SitkaPacific Capital Management analyzed the video on his blog and managed to make a compelling contrary case. Though compelling, Mike misses the mark on a few key points and his analysis requires a rebuttal, which I’ve decided to offer here as it would probably be of interest to DeepCapture.com readers. I’ve also invited Mike to respond, and will print whatever he offers at the end of this post.
(If you’ve not seen the video yet, I encourage you to watch at least the first five minutes now, otherwise nothing that follows will make much sense.)
Shedlock frames his criticism of the video in terms of what he identifies as three assumptions (printed verbatim in black, with my response in italics).
1. That whoever bought way out of the money Bear Stearns PUTs “knew” something and illegally acted on it. I agree with this.
2. The same institution that bought the PUTs was illegally shorting shares. I think this is a safe assumption.
3. There is a conspiracy to protect those evil doers. I do not agree that there is a conspiracy to protect the short sellers who attacked Bear Stearns any more than there was a conspiracy to protect Bernard Madoff before his scheme blew up. What “protects” them is Wall Street culture, and it’s no conspiracy…it’s common knowledge.
Shedlock then attempts to explain how the market really works via four statements of fact which he expects will undo my arguments, but which in reality only support them.
Here again, I present Shedlock’s facts verbatim, followed by the information he apparently did not have when he originally wrote them, in italics.
Fact #1: When someone buys PUTs the market maker or counterparty who sold them is short those PUTs. This is a mathematical statement of fact. This is 100% truth.
Fact #2: The market maker who sold the PUTs, shorts stocks as a hedge against those short PUTs.
This is also 100% truth, and an indispensible component of illegal naked short selling, which requires the options market maker to sell the stock naked short to the fund buying the puts. This is part of the married put strategy we’ve claimed from early on facilitates illegal short selling. As far back as 2003, the SEC expressed concern about married put strategies as a means of circumventing multiple market regulations. In this 2007 paper, an economist explains how a combined strategy of married puts and reverse conversions provided the engine that powered the naked shorting epidemic that grew unabated until changes were finally made in the wake of Lehman’s demise.
Fact #3: The lower the share price, the more shares the market maker has to short to stay delta neutral. Also true.
Fact #4: Market Makers are not governed by naked shorting rules. Again, Shedlock steals my line. Prior to the repeal of the options market maker (OMM) exception of Regulation SHO, OMMs were not bound by the locate and delivery requirements of that rule. So, it’s entirely predictable that options trading would play a key role in any effort to circumvent Reg SHO.
The existence – and illegality – of these kinds of tactics are documented in this November 2009 administrative action brought by the SEC against Rhino Trading and Fat Squirrel Trading (one of only two enforcement actions specifically alleging naked short selling filed in the Commission’s history). In it, you’ll learn how reverse conversions and “resets” (the call-based alternative to the married put) were used to illegally manipulate other stocks down.
At this point, Shedlock has spelled out the entire philosophical foundation for his disagreement with me, and yet we’re apparently in the awkward position of not disagreeing about any of the parts that really matter. The actual disagreement seems to be based on our interpretations of the implications of these facts, in my case informed by a slightly more detailed (though not very broadly-applicable) knowledge of the tactics used by illegal stock manipulators. That Shedlock is not familiar with these tactics speaks very well of him as an investment manager, in my opinion.
So, while Shedlock claims, “the [options] market makers shorting Bear Stearns did so for purely mathematical reasons, to remain delta neutral” I assert that this necessity, combined with their exemption from Regulation SHO’s locate and delivery requirements in place at the time, made them the perfect counterparty to a short-selling hedge fund seeking to warp the market for Bear Stearns stock through the generation of artificial supply.
Shedlock further asserts that Bear’s demise was the inevitable product of its own greed and toxic balance sheet. I respond by agreeing that Bear probably was destined to go under, and in capitalism, that’s ok. However I further point out that Bear had $18-billion in cash on hand when the assault began, and so the process should not have taken just one week. In a civilized world, even when someone is on their deathbed, it’s not ok to hasten death through forceful application of the pillow; and particularly not when the incentive for doing so is pecuniary.
As promised, the space to follow is reserved for Mr. Shedlock to offer his rebuttal.