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Freaky Friday Potpourri: Anatomy of a Short-Squeeze

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I came back home to raise crops, and God willing, a family. If I can live in peace, I will.

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Imagine a bearish rebel leading an uprising against bovine rulers at the end of the 13th century. He's standing on the battlefield, ax in hand, staring at thousands of angry soldiers of the establishment across the way.

His hungry, tired troops won many battles the past year against a superior army, no small feat given how outnumbered they were. They fight for their right to short, believing free markets are the cornerstone of capital structure.

"There's a difference between us," says Boo Wallace sitting on his trusted mount addressing the bovine leader, "You think the people of this country exist to provide you with positions. I think short-positions exist to provide those people with freedom."

The bovine were unimpressed, laughing to one another as they openly mocked the bears.

It was almost as if they knew something, almost as if they had a secret weapon.

Boo, wearing blue war paint across his face, returned to the beleaguered bears anxiously awaiting their marching orders. His eyes met theirs, the tension mounted. Some of them, bruised and bloodied the past few days, turned without talking and started to walk away.

"Ay, fight and you may die," he says as they turn back to face him, "Run, and you'll live… at least a while. And dying in your beds, many years from now, would you be willing to trade all the markets, from this day to that, for one chance, just one chance, to come back here and tell the establishment that they may take our shorts, but they'll never take… OUR FREEDOM!"

The bears cheered and pumped their sharp, homemade weapons in the air. After years of financial Prima Nocta, the time had come to make a historic stand. They looked from side to side at their bearish brethren, knowing some of them wouldn't make it.

They also knew that, no matter what, some of them must.

As they raced across the field towards their destiny, they heard a strange sound above.

They turned to see multiple Sikorsky UH-60 Black Hawk assault helicopters approaching on the horizon, firing high-grade missiles and shooting twin M60D 7.62mm machine guns.

"What the…?" Boo said to nobody in particular, "This is the thirteenth century. They haven't even made the Black Hawk yet!"

As the angry bovine mass approached, Boo realized he'd been trapped. The enemy of the state had too many weapons and shrewd, vicious resolve. They were desperate and desperate times called for desperate measures.

This was unfair, though--the establishment changed the rules in the midst of the battle!

He forged on, fighting for his right to trade two-sided.

Every bear dies, he knew, but not every bear lives.

A More Nuts and Guts Explanation

Forgive the metaphorical imagery-old habits are hard to shake. I offer it as the softer side of our current ride before diving into an insider's take.

I share the following fare without vice or virtue-I've been trading from the long side of late and, my small short position in Google aside, I'm flattish. I wanted to watch the reaction to news, which is always more important than the news itself.

Between Google (GOOG), Microsoft (MSFT), Merrill (MER), IBM (IBM) and Citigroup (C), there will certainly be a lot on our radar.

The following is offered by someone I have tremendous respect for, someone who has run major trading operations on both sides of the Street. If there's a smarter fellow in finance, I have yet to meet him. You may not agree with his view but as I've learned over the last twenty years, it should definitely be respected.

Two Plus Two Equals Four

Financial companies are desperate for capital but their stock prices are so low that any issuance would be dilution death for the companies. The government is desperately trying to keep the financial system together. Add that up and you get the possibility of a great manipulation.

How would the government engineer a rally in financial stocks so that these companies can sell stock to raise capital at a reasonable or at least palatable dilution level?

It might go something like this. Since financial stocks are in such trouble they have heavy short interest; this is natural and well known and can be used to their advantage. A clever "berry" might think to introduce confusing rules that raise the cost of borrowing short stock and temporarily confuse shorts into covering and not shorting more. And this is precisely what the SEC did.

It seems innocuous to most folks, but it put stock loan desks and dealers in complete disarray. New short sellers could find no stock to borrow and many existing short sellers were forced to cover as the technical rules forced allocation of loans at much higher costs.

For example, the rebate rate on Fannie Mae (FNM) the day before the SEC announcement was 1%; the day after it was -5%. Many who were short the stock were forced to cover, thus driving the stock price up.

But this alone would only drive stock prices up so much. The clever berry needs a catalyst, one that would force panic buying into now truncated supply.

It just so happened that the new SEC rules came conveniently the day before many of these financial companies were to report earnings. If just some how these earnings were really good the match would be lit on the kindling.

So far banks have miraculously come through on their end of things. Wells Fargo (WFC) and JPMorgan (JPM) reported better than expected beaten down earnings. Things must be getting better just as the companies need capital.

What a coincidence.

But if you look at how the banks "beat" their earnings the coincidence becomes clear. WFC took the unprecedented step of extending charge-off acknowledgment from 120 days to 160 days. This allowed the bank to move less capital to loan loss reserves and report better than expected horrible earnings. And JPM was even more aggressive. It actually lowered its loan loss reserves quarter to quarter.

The list of financial companies where shorting regulations are being enforced/enhanced is precisely the banks and dealers (and FNM/Freddie Mac (FRE)) that have access to the Fed's balance sheet (dealers through the PDCF and FNM/FRE through the recently-allowed access to the discount window). So we can speculate on the nature of the ''coincidence'': Perhaps the Fed is getting worried about the value of all that collateral these dealers have posted to the Fed balance sheet and must boost the capital of these companies to protect that value.

And now on cue FRE, a $5 billion market capitalization company wants/needs to issue $10 billion in new stock? Doesn't that sound a little crazy? Well get ready for others to do the same because the banking system needs capital desperately and the government is there to help.

But help at the expense of who?

Random Thoughts


R.P.

Positions in GOOG, FNM, WFC, JPM, FRE

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.

The information on this website solely reflects the analysis of or opinion about the performance of securities and financial markets by the writers whose articles appear on the site. The views expressed by the writers are not necessarily the views of Minyanville Media, Inc. or members of its management. Nothing contained on the website is intended to constitute a recommendation or advice addressed to an individual investor or category of investors to purchase, sell or hold any security, or to take any action with respect to the prospective movement of the securities markets or to solicit the purchase or sale of any security. Any investment decisions must be made by the reader either individually or in consultation with his or her investment professional. Minyanville writers and staff may trade or hold positions in securities that are discussed in articles appearing on the website. Writers of articles are required to disclose whether they have a position in any stock or fund discussed in an article, but are not permitted to disclose the size or direction of the position. Nothing on this website is intended to solicit business of any kind for a writer's business or fund. Minyanville management and staff as well as contributing writers will not respond to emails or other communications requesting investment advice.

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