Regulators betray a sense of panic

Tue Aug 26, 2008

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By Neil Wilson

Was it ever thus? Perhaps it is simply human nature to seek a scapegoat. Certainly, it seems that whenever the markets are in freefall and losses are leaving blood on the Street, there is a scramble to find somebody to blame. And who are the usual suspects? The hedge funds, of course - those bad guys mercilessly shorting the hell out of stocks.

Such was the case the last time markets plunged - in the wake of the tech bust, when equities fell more than 40% from 2000 to early 2003. During that period, many listed companies and long-only investors complained loudly about hedge fund behavior, and some institutions even withdrew from the stock-lending market to try to frustrate the short sellers.

And it is the case again, this time around, in the wake of the credit crunch. Only this time, the regulators seem to have gotten caught up in the hysteria, too - with counter-productive and potentially damaging consequences.

In the United States, the Securities and Exchange Commission imposed emergency rules this summer to restrict naked short sales in certain financial stocks and issued subpoenas to a long list of firms requiring information on short-selling activity. And in Britain, the Financial Services Authority made two moves - requiring disclosure of short positions on stocks undertaking a rights issue, and requiring disclosure of "synthetic" long positions held via contracts for differences (CFDs).

There was arguably nothing wrong with either of the FSA's actions. Sizable short positions should quite rightly be disclosed just as much as sizable long positions - though the FSA requiring disclosure when a manager holds only 0.25% or more on the short side does not seem quite equivalent to the long side (where disclosure is required only at 3% or more). Arguably, it is also right that large positions held in CFDs - often held simply for reasons of tax efficiency (so that a fund avoids paying the stamp duty transaction tax) but also sometimes perhaps for sheer anonymity - should be just as reportable as outright stock positions.

But what was wrong, certainly with the rule change on disclosure of short positions, was the way it was pushed through in such a hurried way. Normally, if a regulator is contemplating a rule change, there is a process. Once a proposed new rule is published, comments are sought from the industry during a consultation period, amendments are usually then made, and finally the new rule is implemented.

Britain's rule change on shorts did not adhere to this process; instead, the proposed change was announced and enforced within a matter of days - allowing no chance for the industry to make considered comments or lobby for amendments. And why was that? One reason the regulator gave was that in a highly stressed market, the FSA had to guard against greater potential for market abuse.

But it seems to me hard to escape the conclusion that the perilous conditions in the markets had driven the regulator into a state of panic. As the head of one leading hedge fund group in London put it to me, with a strong note of indignation: "What market abuse? What evidence of market abuse is there?" No evidence of market abuse has come to light so far.

And what has been the effect of the change? Perhaps the ends would have justified the means - if the FSA's move had indeed calmed the turbulent markets.

But instead, the results appear to have been contrary to intentions. In the case of the recent rights issue by HBOS, Britain's biggest mortgage bank, forced disclosure by major short-sellers only served to confirm that strongly performing hedge fund groups, such as Harbinger and Lansdowne, were indeed short HBOS during its battle to raise roughly $8 billion in new equity. And the market seems to have concluded that, if smart guys like them were short, maybe it wasn't worth backing.

In any event, HBOS stock continued to languish below the offer price after the disclosure rules came into force, and the rights issue was a massive flop. Less than 10% of the offer was taken up.

In a short space of time, therefore, the FSA appears to have put in jeopardy its hard-won reputation as a sophisticated regulator that understands hedge funds. After all, markets require buyers and sellers in order to function smoothly; active traders, as many (if by no means all) hedge funds are, make markets a lot more liquid; and markets benefit in particular from natural buyers when prices are falling - which is the way short sellers take profits.

ISSN: 2151-1845 / CDC10004H

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