Editor's Note: This is the second of a 3-part series. Part 1 can be found here.

How do we know which companies are important to the Federal Reserve and Treasury? I've always been proud of the American financial system and how free-market and democratic it's "supposed" to be.

Note that I say "supposed to be," because regulators have become more and more involved in the daily operation of American financial markets dating back to 1998, with the demise and assisted unwinding of Long Term Capital Management.

In August 1998, then Fed Chairman Alan Greenspan helped bail out LTCM’s disaster, one created by a bunch of quant-jocks that had built a ‘black box model’ hedge fund with leverage employed of over 100 times capital.

It was expected by the Fed that if LTCM freely failed, it would create systemic financial risk. So a consortium of investment banks (the ones that were counter-parties and loaned LTCM the money in the first place) helped create a bailout plane which feels a lot like the shotgun marriage in March of J.P. Morgan (JPM) and Bear Stearns. (Note that the JPM/BSC deal was important as they had a lot of risk to each other as well.)

‘Surprise’ intra-day interest rate cuts began in August 1998 and then again in early 2001 and again in mid-2001, when we were already into the throes of a secular bear market.

What I find interesting is that the timing of the rate cuts have been thought to attack sellers of out-of-the-money call options that were to expire that week. I was subject to this once on each side, but these moves were intended to "get Shorty."

If you are going to surprise the market, you may as well get as much bang for the buck as you can, right? Greenspan and company were rather good market technicians and many traders were hurt by these surprise attacks. Longer term, of course, it is highly negative because short sellers are removed from the market, who are usually a source of important two-sided market liquidity and remove demand on a longer-term basis.

In addition, I feel that it takes many speculators out of the game as the rules are suddenly changed from what we are all accustomed to and makes people change their behavior.

Recently, other "Get Shorty" moves have appeared in the market. Short interest data is released every two weeks or so and there is a lot of evidence that many short-sellers piled on into the low prices of financial stocks. They were correct all the way down, and most likely pressed the bets too hard by "shorting into the hole."

I have a feeling that the SEC, Secretary Paulsen, etc, knew it. Let’s face it, financial institutions are starved for much needed capital, and there are only four viable financing opportunities:

1. Debt Offerings: The credit market, for many, is closed.
2. Hybrid Offerings (fixed to floating Tier 1 Capital): S&P has said it feels that financial institutions are at their limit on hybrids.
3. Preferred Stock: Rates are too high to be economic.
4. Equity Offerings

Since 1, 2 and 3 are not economic, equity seems to make the most sense, despite the fact that it is highly dilutive as companies have shrunken their revenue and profit opportunities while increasing their share base. For example, Merrill Lynch (MER) alone has doubled their share base in the past year so earnings per share will likely stagnate for many years at very low levels. So on July 15, 2008, "Get Shorty" really got rolling with the following SEC announcement:

The Securities and Exchange Commission announced an emergency action aimed at reducing short-selling aimed at Wall Street brokerage firms, Fannie Mae (FNM) and Freddie Mac (FRE), and will immediately begin considering new rules to extend new requirements to the rest of the market.

SEC Chairman Christopher Cox said at a Senate Banking Committee hearing that the SEC would institute an emergency order requiring any traders to pre-borrow stock before shorting Fannie Mae and Freddie Mac, the embattled government-sponsored entities that own more than half the nation's mortgages.

Why would the SEC target just 19 companies (Freddie, Fannie and 17 "Primary Dealers")? My guess is that they can read a chart and short ratios just like the rest of us. What resulted was a remarkable move in many important financial stocks with companies like Bank of America (BAC) rising nearly 80% in the span of a mere 5 days. The KBW Banking Index, while admittedly wildly oversold, rallied nearly 50% in the span of a week. Yes, a week.

Logarithmic Chart of KBW Banking Index

Click to enlarge

The SEC and other regulators know that these Primary Dealers desperately need capital, and my hunch is that the attack on short-sellers was intentional to open the window for a rampage of dilutive equity/convertible equity transactions that could take place at any time. All because the credit markets are closed in a classic sense: More on that in the next section.

With this kind of manipulative intervention in the market, we can't rule out hardly anything at this point. The Fed has recently brought us more surprise intra-meeting rate cuts, and introduced all sorts of desperate funding vehicles to bail out broker/dealers that loaded their balance sheets with an alphabet soup of esoteric investment vehicles. These esoteric securities now reside on the Fed’s balance sheet, having been exchanged for the Treasury securities that they used to own. While the Fed is not federal, but privately owned, I wonder why a private, not-for-profit institution would favor the same Primary Dealers whose stocks were bailed out with the change in short-selling rules.

Part 3 can be found here.