“Attached is a recent Howard Marks/Oaktree note discussing markets and the financial crisis. Two points: 1) How dumb was the FDIC-R to sell IndyMac Bank (and other banks), at the peak of the 2008/2009 panic? and 2) Mr. Marks implies that the financial crisis short sellers (maybe watching the recently-released Big Short movie prompted his comments?) intentionally manipulated banks stocks, mortgage securities, and other financial assets…a “bear raid”, driving them well below their intrinsic value…
…I tend to agree, and have talked about it, more than once, on this blog. Billionaire speculator George Soros (a possible short seller), in his book on the crisis, lays out an economic/market theory he calls “Reflexivity.” The theory roughly says that “man, through active trading/investment, can significantly influence the outcome of financial events.” That sounds a lot like market manipulation, doesn’t it? Yet the S.E.C., the FED, other banking regulators, and our government have never seriously investigated short selling during the financial crisis and whether it was legal and/or appropriate. Why? I and others, who were at Ground Zero of the financial crisis and on the losing end of these speculators have a lot to share that could help our markets, financial system, and financial stability. P.S. Here are a couple of examples: Did you know that short seller Paulson paid the Center for Responsible Lending millions and they wrote negative reports about IndyMac (which I recall had false allegations/claims in it), Wells Fargo, and other banks? Also, there were lot’s of misleadingly derogatory names assigned to mortgage assets by the press (I believe some of these names were given to them by short sellers.): ”toxic”, “liar”, “garbage”, “worthless”, but think about it, backing all of these loans was an American home. So they were not close to being “worthless” and that’s why they recovered so much of their value post-crisis.”, Mike Perry, former Chairman and CEO, IndyMac Bank
Excerpt from Howard Marks Memo to Oaktree Clients: “What Does the Market Know?”, January 19, 2016:
“It seems clear to me: the market does not have above average insight, but it often is above average in emotionality. Thus we shouldn’t follow its dictates. In fact, contrarianism is built on the premise that we generally should do the opposite of what the crowd is doing, especially at the extremes, and I prefer it.
A Case in Point –The Crash of 2008
This year 2008 culminated in the greatest panic I’ve ever seen. The events that built up to it included:
- Massive subprime mortgage defaults and the failure of mortgage backed vehicles,
- Meltdowns at funds that had invested in those vehicles, notably two Bear Stearns funds,
- Rescues of Merrill Lynch by Bank of America; Wachovia by Wells Fargo; and Washington Mutual by JPMorgan (after it was first seized by the Office of Thrift Supervision),
- Decisions on the part of BofA and Barclays not to acquire Lehman Brothers, and on the part of the U.S. Treasury not to bail it out, leading to Lehman’s bankruptcy filing,
- The appearance that Morgan Stanley would be next if it couldn’t secure additional capital, and
- Widespread speculation regarding other firms that might follow.
A massive downward spiral ensued. Among the contributing factors were:
- Precipitous declines in the prices of bank stocks,
- Large-scale short selling of the stocks (the “uptick rule” previously mandated that a stock could only be sold short at a price above the last trade, meaning short selling couldn’t force the price down. But the rule was repealed in 2007, so there ceased to be limits on when stocks could be shorted. Thus short sellers could force stock prices down….whether intentionally, in what in the 1920s were called “bear raids,” or just because they thought the stocks were right to sell),
- Dramatic increases in the cost to insure the debt of banks through credit default swaps.
In the environment described above, the downward spiral in bank stocks was intensified by the follow factors (where they were intentionally manipulated, I can’t say for sure):
- It was easy to bet against the banks by buying credit default swaps (CDS) on their debt.
- It was easy to depress bank stocks by selling them short.
- The declining stock prices were taken as a sign the banks were weakening, causing the cost of buying CDS protection to rise.
- The rising cost of CDS protection was taken as a negative sign, causing the stocks to fall further.
I can tell you, it had the feel of an unstoppable vicious circle. Some compared it to the “China Syndrome”: a 1979 movie with Jane Fonda and Michael Douglas in which an out-of-control nuclear reaction threatens to propel reactor components through the earth’s core, from the U.S. to China. Thus the stock of panic-ridden Morgan Stanley (for example) fell 82%, to less than $10.
But it’s important to note that the negative feedback loop described above was able to continue without reference to….and not necessarily in reasonable relationship to….actual developments at the banks or changes in their intrinsic value. Eventually, however, the Treasury restricted short selling in the stocks of 19 financial institutions deemed “systemically important.” Morgan Stanley secured a $9 billion injection of convertible equity from Mitsubishi UJF Financial Group. The panic subsided. The economy and capital markets recovered. And Morgan Stanley’s stock traded at $33 a year later.
Do you wish you had taken the market’s instruction in 2008 and sold bank stocks? Or do you wish you had rejected its advice and bought instead? In short, did the market know anything?
There are three possible answers:
- The market was flat wrong in 2008 when it took Morgan Stanley’s stock so low.
- The market was right; it properly reflected the possibility of a meltdown that could have happened but didn’t.
- The market was wrong in the case of Morgan Stanley in 2008, but most of the time it isn’t.
I like the first, and the second is appealing as well. But while a meltdown certainly was possible, the below-$10 price probably assigned too high a likelihood. And, of course, I’m not persuaded by the third.”