Hanky Panky

By Todd Harrison  JUL 30, 2008 7:45 AM

Paulson's just playing the hand he was dealt.

 


“Sometimes nothing can be a pretty cool hand.”
--Cool Hand Luke


They say the friction between opinions is where true education lies. If that’s true, we’ve officially entered the realm of higher learning.

As both sides of the societal chasm haggle over how the market—and, by extension, the economy—is being handled, Treasury Secretary Hank Paulson has found himself in the center of the storm.

Perhaps that’s a fitting role for the former chairman of Goldman Sachs (GS), a man who deftly sold his equity holdings tax-free when he took the position in 2006. If anyone knows how the game is played, it’s Hammering Hank.

When pressed on policy, he recently responded “I’m playing the hand I’ve been dealt.”

Fair enough and truth be told, there isn’t a realistic solution other than the inevitable, and unenviable, elixir of time and price. It just so happens that we’ve all got chips on this particular table as he draws his next card.

Sucker’s Bet

We can wag our finger that the writing was on the wall since the sub-prime simmer of last summer.

We can point at Alan Greenspan, who sowed the seeds of cumulative imbalances during the Asian contagion and tilled them anew after the technology bubble burst.

Wall Street, repackaging risk and masking the disease with years of financial engineering, deserves a dishonorable mention as we dissect the discussion.

And we, the people, must shoulder some of the blame. Questions were rarely asked as we collectively consumed beyond our means and pushed our obligations into the future. The bar tab has been building for quite some time and now that it’s due, our pockets are bare.

To appreciate where we are we must understand how we got here. Once we have—and not many people do—we’re left with the naked truth that few, if any, viable alternatives exist.

Government officials must choose the lesser of two evils: massive intervention that will burden future generations or chaotic unwinding of risk that will bury our current one.

Counter-party Risk

You always want to know what the party on the other side of your trade is thinking. When that party is the United States of America, the stakes rise in kind.

You may not agree with the socialization efforts but you must certainly respect them. With the election less than four months away, the eyes of the world are upon our capital markets. That lens isn’t lost on policy makers who seemingly have two separate initiatives.

First, they want to break the bearish credit bets currently being made by global macro hedge funds. Their attempting to do this by squeezing stocks higher through the enforcement of the short-sale rule, an initiative aimed at 19 select financial institutions but widely expected to soon include a broader swatch of equities.

While stocks are the world’s largest thermometer, the credit markets are the backbone of our system. Therein lies the true agenda of the government, to navigate prices to levels that would allow corporate America to issue secondary offerings. Do that, they hope, and the credit markets will scramble.

The second component of their master plan is crude oil, with an eye towards $100/barrel by the election. While empirical evidence shows little if any historical relationship between the price of oil and equities—the 10-year correlation between crude and airlines is negative .246 (very mild)—psychology surrounding lower oil could conceivably shift sentiment.

Those are the ingredients for near-term reversal and while the script is still being written, you now know the motivation of the policy makers. They are playing the hand of socialization in an attempt to stem risk gone awry.

Nothing Comes for Free

The government is trying to buy time with hopes that a legitimate economic recovery will take root and reverse the contagion that crippled our finance based economy.

This is nothing new. In fact, that is precisely the mindset that got us into this mess in the first place.

Ironically, the effort to artificially squeeze stocks higher, if successful, would have dangerous repercussions for global financial markets. The eradication of shorts, while facilitating the short-term agenda, would remove important and necessary layers of demand.

Once and if that ban is lifted, the conditional elements of a crash would officially be in place.

Sir Isaac Newton wrote of three physical laws which provide relationships between the forces acting on a body and the motion of the body.

The first law is that a particle will stay at rest or continue at a constant velocity unless acted upon by an external, unbalanced force.

The second law is that the net force on an object is equal to the mass of the object multiplied by its acceleration.

The third law is that every action has an equal and opposite reaction.

Hank Paulson and the boys on the beltway are powerful forces indeed.

But unless they want to rewrite the basic covenants by which our universe is based, they would be wise to let markets do what free markets do.

The sooner we’re allowed to go through it, the quicker we’ll all get through it.

R.P.
No positions in stocks mentioned.

Todd Harrison is the founder and Chief Executive Officer of Minyanville. Prior to his current role, Mr. Harrison was President and head trader at a $400 million dollar New York-based hedge fund. Todd welcomes your comments and/or feedback at todd@minyanville.com.

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