Dissecting The Short Squeeze

Bank of America's (BAC) up 72% in five days. That's beyond ludicrous. So my first point is obvious: These are not normal times.

The second point is the rapidity of the move. What happened? Yes, the company reported better-than-terrible earnings, but discerning people know how they managed it: Assuming the worst was over, they lowered reserve requirements.

But even this would be met by buying in a more intelligent way. Certainly sellers would disagree with buyers, given the evidence, so any rise in the stock would be much more moderate if driven by purely fundamental forces.

But the bottom in the stock coincided with an arcane rule change by the SEC. The change seems so innocuous to a normal investor that it's beneath most people's radar. But for those borrowing the stock to short it, the rule change has been a nightmare - and it was orchestrated to be one.

Short selling's still possible, but 3 things have changed: First, there was a temporary shortage of borrowing, thus forcing a fair amount of shorts to cover. Second, the cost of borrowing has risen, such that the marginal short seller has left the market. Finally, sellers' psychology has changed: They ask, “Will the SEC make the rules even more onerous, so that I maybe shouldn’t short at all?” The objective has been accomplished: A vacuum of selling on the upside.

The situation's getting worse, not better, for credit markets and for the consumers they're lending to. The American Express (AXP) report showed that plainly: Amex was down $4 yesterday, when the rest of the financials went screaming higher. Bank of America, which has significant credit card exposure, rose 7% in an hour and a half.

So much for truth tellers.

And now the Feds are close to bailing out Fannie Mae (FNM) and Freddie Mac (FRE). At the same time, our foreign lenders (China alone owns about $400 billion in GSE debt) have undoubtedly been calling Mr. Paulson at home. Does it instill confidence in our capital markets, as Mr. Paulson gives the "raison de jour" to bailout these companies? As the list of companies bailed out grows, I would think it does the opposite.

As the price of these stocks rise, we'll start to see secondary stock offerings. The companies caught in one of the most massive short squeezes in history are in desperate need of capital. The Fed needs them to raise capital, because it's lending directly to them.

The shuffle game continues. But the game does nothing to change the reality: The system has a massive need for capital.

When buying these stocks, remember that a vacuum has been created on the downside. Short sellers produce demand for stocks as they go down. If there's no short interest (and something bad happens), this source of buying is gone.

Risk is very high.