The Upside of Falling Bank Stocks

by: Felix Salmon posted on: July 15, 2008 | about stocks: FNM / FRE / NCC / WM    
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Financial stocks are plunging right now: If Fannie (FNM) and Freddie (FRE) can be brought to their knees, then no bank is safe. And falling bank stocks are systemically very worrying: The equity cushion is an important part of the way in which banks protect themselves from runs and ruin, which means that a falling share price can become self-fulfilling.

But I'm more sanguine about all this chaos. Indeed, it's entirely possible that the volatility we're seeing on the stock market right now is actually a good thing, systemically speaking.

Heidi Moore feels the poor shareholders' pain:

Shareholders bought shares of Fannie and Freddie precisely because they knew that if the two lenders ever fell in trouble, the government would step in. And now that the government has stepped in, it is determined not to help shareholders...

In the Bear Stearns bailout as well, Paulson was determined not to save shareholders, which was a classic case of blaming the victim of a run on the bank. With Fannie and Freddie, the shareholders may be victims again, which is likely to have an impact on the entire U.S. economy.

But what about the shorts? Won't anybody step up to defend them?

I'm serious. Mohamed El-Erian explains today why Paulson stepped in on a Sunday night to bail out the GSEs:

It reflects the understandable eagerness to minimise forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function.

It wasn't that long ago that El-Erian was saying that we were leaving the financial phase of the downturn behind, and moving into the second phase, where casualties started piling up in the real economy. Clearly that was a bit premature: The financial crisis is far from over yet, more than a year after it began. And there are many more shoes which could well drop: big banks like WaMu (WM) and National City (NCC) are trading at extremely distressed levels, and we mustn't forget the whole issue of counterparty risk, which if it ever starts to snowball would make everything thus far look like a walk in the park.

 

Clearly, we're in a world where the biggest risks to the economy remain financial. And it just so happens that there's an easy and reasonably effective way of hedging those risks: shorting financial stocks. Investors around the world who want to protect themselves against market-crisis risk are likely doing just that right now, helping to drive the price of those stocks downwards. Which means that as the stocks of big banks fall, quite a few sensible investors are actually making money. Not because they're betting on Armageddon, but just because they understand the big risks and are hedging them accordingly. Indeed, broad stock indices have been remarkably calm over the past few sessions, in the face of all the financial-sector craziness.

The share-price volatility in Fannie and Freddie over the past few sessions looks to me as though a hell of a lot of people are playing in those stocks, and that most of them are not buy-and-hold investors from years ago who are now finding themselves underwater.

Indeed, I'm almost reassured by all this stock-price volatility. Equity, sitting as it does at the top of the capital structure, is never going to be a safe place to be during a crisis. But it just might be the case that the crazier the rollercoaster ride suffered by shareholders in Freddie Mac, the safer the rest of us can feel, if that rollercoaster ride is partly a consequence of prudent risk management elsewhere in the system.

This article has 8 comments! Add yours below...
Felix Salmon

Felix Salmon

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This article has 8 comments:

  •  
    Ishortyou
    Jul 15 10:55 AM
    Well it looks like things are not getting better, so the government has no choice but to launch an aggressive plan to bump up the demand in the housing market to reduce inventories, either that or we all are going down to the dark ages.
  •  
    Research123
    Jul 15 11:19 AM
    My Website
    Our financial trading system is incredibly opaque. I wonder how you can tell that falling financial service equity prices is a sign of prudent hedging and not simply pile-on hedge funds and traders pushing prices down because they can, not neccessariy because they should be brought down?

    Frankly, except for the financial press telling us all (often and shrilly) how bad financial balance sheets really are, I'm not at all sure how any rational investor can tell what's really going on. Stock prices for most banlks are trading at a fraction of book value - either management is lying about what they think is going on, or market participants are clubbing all baby seals in reach simply because they have been able to make all seals look like babies, even if some of them in fact are still grown-ups.

    Shorting is never a pretty process, but between the elimination of the uptick rule and the lack of enforcement of the requirement to actually locate stock to borrow, the process has become downright ugly and threatens to bring down the entire system. Think about it - why save money when saved wealth invested in the markets can be destroyed by others at will without any apparent recourse? Maybe the low US savings rate is the only rational response to this brutal phenomenon.
  •  
    Raincheck
    Jul 15 05:41 PM
    What about the poor little guy who is watching his 401K and IRA investments evaporate - Tell him how easy it is to short some financial stocks to hedge his retirement savings. If the content of your article was intended to reach the 5% of the folks that can avail themselves of such a strategy - you're too late they were doing it months ago. If it was intended to inform the 95% who cannot avail themselves of the strategy then I am brought to my question -- what is the purpose or value of your article?
  •  
    moonbat1775
    Jul 15 08:10 PM
    "Think about it - why save money when saved wealth invested in the markets can be destroyed by others at will without any apparent recourse? Maybe the low US savings rate is the only rational response to this brutal phenomenon." Research123

    I have understood the low US savings rate to be a result of artificially low interest rates set by the Fed. Abolish the FED and fiat money laws and interest rates for savers would rise. Also, since the boom bust cycle would be tamed, their principle would be safer too.

    I am suspicious of a financial system so shaky that words can blow it over.

  •  
    inthemoney
    Jul 15 11:10 PM
    > Clearly, we're in a world where the biggest risks to the economy remain financial. And it just so happens that there's an easy and reasonably effective way of hedging those risks: shorting financial stocks. Investors around the world who want to protect themselves against market-crisis risk are likely doing just that right now, helping to drive the price of those stocks downwards
    ----------------------...

    The only problem is that 401K and IRA don't allow shorting and many so-called "investors" investing for retirement don't know how to short. They have been always told to "buy and hold".
    Of course, hedge funds, institutions and traders short financials left and right at the expense of "long only" categories, who don't know any better.
    401K is such a fraud, it will leave millions unable to retire. And that is really a scary prospect and it is not good for anybody in the long run. In comparision, day trading FRE and FNM to make some easy money is little consolation.
  •  
    Cruiseguy
    Jul 16 12:00 AM
    My Website
    you can short in your IRA by buying the ETFs. I bought calls of the QID and SDS which are 2 times the inverse of the QQQ and the S&P 500. You can buy puts as well in your IRA as well which is less risky than shorting.
  •  
    cuddles
    Jul 16 01:21 AM
    I can shot put my 401 k shorting my pants a ZZK and a JJL? G, thanks for the tip.
  •  
    Jimmy
    Lathrop
    Jul 16 07:55 AM
    My Website
    If your holdings are tanking in your company sponsored 401k then just liquidate them into cash or the money market segment. If they match funds its still a bargain. Why can't you buy SKF in your IRA?
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