Anatomy of Morgan Stanley Panic

Wall Street Journal (subscription) ^ | November 24, 2008 | SUSAN PULLIAM, LIZ RAPPAPORT, AARON LUCCHETTI, JENNY STRASBURG and TOM MCGINTY

[CutePuppy]

Two days after Lehman Brothers Holdings Inc. sought bankruptcy protection, an explosive rumor spread that another big Wall Street firm, Morgan Stanley, was on the brink of failure. The chatter on trading desks that Sept. 17 was that Deutsche Bank AG had yanked a $25 billion credit line to the firm

That wasn't true, but it helped trigger a cascade of bearish bets against Morgan Stanley. Chief Executive Officer John Mack complained bitterly that profit-hungry traders were sowing panic. Yet he lacked a critical piece of information: Who exactly was behind those damaging trades?

Trading records reviewed by The Wall Street Journal now provide a partial answer. It turns out that some of the biggest names on Wall Street -- Merrill Lynch & Co., Citigroup Inc., Deutsche Bank and UBS AG -- were placing large bets against Morgan Stanley, the records indicate. They did so using complicated financial instruments called credit-default swaps, a form of insurance against losses on loans and bonds.

A close examination by the Journal of that trading also reveals that the swaps played a critical role in magnifying bearish sentiment about Morgan Stanley, in turn prompting traders to bet against the firm's stock by selling it short. The interplay between swaps trading and short selling accelerated the firm's downward spiral.

This account was pieced together from the trading documents and more than six dozen interviews with Wall Street executives, traders, brokers, hedge-fund managers, regulators and investigators.

For years, sales of credit-default swaps were a profit gold mine for Wall Street. But ironically, during those tumultuous few days in mid-September, the swaps market turned on Morgan Stanley like a financial Frankenstein. The market became a highly visible barometer of the Panic of 2008, fueling the crisis that ultimately prompted the government to intervene.

.....

[CutePuppy]

Bear Stearns was brought down very similarly in February-March of this year. The timing of attacks on Lehman, Morgan Stanley and others - just before elections - which severly affected and froze the financial markets, and took down market and particularly financial stocks including some of the firms which participated in short-selling and CDS "insurance", is very interesting.

[snarks_when_bored]

The Wall Street pack members were turning on their own. There is no honor among jackals.

[tallyhoe]

this is what happens when you allow short selling! The short buyers buy huge amount of short stock with only about 10% capital. They then spread a rumor, stock prices plummet and then the short buyer makes millions! Bad for investors and causes extreme fear on the markets!

[CutePuppy]

The pattern, finally but slowly, is making its way into financial press.

Pressure also mounted on another front. There was a surge in "short sales" -- bets against the price of Morgan Stanley's stock -- by large hedge funds including Third Point LLC. By day's end, Morgan Stanley's shares were down 24%, fanning fears among regulators that predatory investors were targeting investment banks.

That pattern of trading, which previously had battered securities firms Bear Stearns Cos. and Lehman, now is dogging Citigroup, whose stock fell 60% last week to a 16-year low.

SEC launches probe of Third Point hedge fund - Aug. 20, 2008 - this was even before September Lehman's collapse and near-collapse of Merrill Lynch.

No wonder Citi was asking Chris Cox to reinstate short-selling ban. In wrong hands it can be a weapon of mass destruction of capital. Soros made a lot of his money exactly the same way destroying capital with short-selling, using rumors and insider government information.

[CutePuppy]

Bad for investors and causes extreme fear on the markets!

And fear is stronger than greed. Not only that, the selling itself, besides causing the fear and/or financial panic, often triggers the forced portfolio liquidations due to margin calls and "stop orders", thus rolling down the price like snowball from top of the mountain turns into avalanche. The margin calls, portfolio liquidations and market panic, in turn, affect the stocks that have nothing to do with initial issues or industry.

Capital destruction leads to economic contraction. Intended or unintended consequences? That is the question.

[Tom D.]

Short selling serves an important function. To make it illegal would be a mistake. What is bad is allowing naked short selling (selling stock short without officially “borrowing” the shares from an owner). Winking at naked short selling was the SEC’s biggest sin here.

Of course there is mischief that can be done with shorting, but there is mischief that can be done through making it illegal. It is sort of like fire: it can be dangerous, but the benefits outweigh the downside.

[raybbr]

Relying on cascading investments is what caused this mess. The reselling over and over of mortgages. It should have been illegal.

[ReleaseTheHounds]

Just what we need: make short-selling illegal! NOT!

What’s informative in this article is the description of the use of credit default swaps mixed with shorting. The CDS market is what scares me. While I’m not a great fan of regulation, allowing this unregulated market in these complex instruments has been the black hole of this market meltdown and it may go further, unfortunately.

[proxy_user]

I you’re leveraged 40-1, you’re trading on your good name.

If your good name goes, you go.

[StatenIsland]

“Short selling serves an important function. To make it illegal would be a mistake.”

Tom or anybody, this is a serious question. Why is short selling necessary to a healthy market? I fail to see its purpose beyond the obvious nefarious one: sowing panic by putting artificial downward pressure on a stock’s price.

And don’t even get me started on naked shorting - its like being in a casino where you’re playing with house money. Just sell till you wipe out all the longs, and KEEP selling till the average investor panics, the margin players get calls and all the stops are wiped out.

[nicola_tesla]

Oh bull. Short sellers are the only ones that put a floor under the market. Geez, get a clue and look at China. They’ve never allowed short selling and their indices are off 70%. They are just now talking about allowing short selling.

[nicola_tesla]

ARTIFICIAL downward pressure ? Why do you say artificial ?

A large short interest in a stock is usually a major tell that there is something wrong in the company books. Short sellers read balance sheets and 10Qs, something that most buy-and-hold or long-term investors do less of.

Short sellers put a floor under stock prices. As an example look at the DOW then lok at the Hang Seng. Which index is down more - bearing in ming that the US allows short selling and the Chinese do not. Would you rather your market down 40 or down 70 % ?

[slnk_rules]

this is a serious question. Why is short selling necessary to a healthy market? I fail to see its purpose beyond the obvious nefarious one: sowing panic by putting artificial downward pressure on a stock’s price.

Short-sellers, believe it or not, are usually "smart" money. Meaning, on average, an average short-seller is more sophisticated and knowledgeable than your average standard investor. If you find yourself in an argument with a short-seller over the future prospects of a company, you may want to listen closely to what they are saying, even if you disagree with them.

Also, some of the biggest scams have been discovered by short-sellers. Why? Because they are on the prowl for these overbloated issues, and will normally do extensive research on the company to support their decisions. Because your losses are potentially unlimited in a short position, you need to be pretty confident in your position if you are short. They will do extensive investigations on a stock and will normally know the balance sheet inside and out. Again, it would probably be to your benefit to listen to what they are saying. Some of the biggest scams (Enron, etc.) have been initially unearthed by short-sellers.

Also, short-sellers provide the stock market with liquidity. When you sell a stock, someone has to be on the other side of your trade. Short-sellers buy, or "cover", when you sell, and sell when you buy. If a stock gets completely crushed overnight after announcing bad news, they are the reason for most of the buying pressure off the open, as they are covering their positions. In the case of a bankrupt stock, short-sellers can often be the only reason that you can get ANYTHING back for your virtually worthless equity position.

Lastly, short-sellers can help to self-police the equity markets. The SEC can't investigate every company, but a short-seller can do extensive investigations on a company if they feel as though the company is not on the up and up. The short-seller can then publicize his findings, giving you a chance to exit the stock if what you hear alarms you. Contrary to what you might think, short-sellers do a great service for the ordinary Joe Average investor. >P> Of course, naked shorts are different altogehter. They are nothing short (no pun intended) of criminal. It is nothing more than electronic stock counterfeiting. The failure of the SEC to bring even ONE case to court for failure of regsho is enough reason to dismantle theat whole corrupt inefficient, phenomenally lazy excuse for a "regulatory" body.

[6SJ7]

Subprime explained.   ;-)

[Mouton]

Naked short selling is the biggest problem in this market followed closely by the removal of the uptick rule. Left to extremes, a company's stock issues can exceed more than double its authorized issuance. How can any market absorb that volume of stock?

Now then, the stock market collapse is not due to naked short selling BUT such selling has allowed for pools of short sellers to single out and drive out of business companies that would normally have withstood declines. That is not investing, that is simply bludgeoning companies out of business on a whim. Bankruptcy due to failed business models is how failed firms are supposed to go out of business. Naked shorting fails firms that rely upon confidence, not just product sales, i.e. banks and financial firms. It should be outlawed.

Vince

[StatenIsland]

Thank you, and tesla, for the informative replies.

[Tax Government]

TallyHoe,

Short selling is what happens when one individual, a stock owner, agrees to lend or rent the benefits of stock ownership to another person. The right of individuals to contract among themselves in this way is basic. Apartment rental is similar...one transfers the privileges of ownership to a different person for a period of time in exchange for compensation.

What is the compensation to a person who allows stock to be lent? It is access to a margin account, with features not available in a cash account. In a margin account one can trade more kinds of instrument and receive broker loans.

What is not basic, is fraudulent and should not be allowed, is naked short selling, where the original stock does not exist. Effectively, securities are being manufactured out of thin air on demand. This is nothing short of fraud.

[WashingtonSource]

bump

[raybbr]

Subprime explained. ;-)

Those guys are funny. I bet they will be funnier this evening. British humor is not easy to follow in the morning.

[Hostage]

Mack was protected by the SEC in an insider trading investigation brought on by a veteran SEC investigator.

Yes it seems there are more politics here than meets the eye and could be tied to the October surprise and market collapse. To tie it to the Election is a stretch though as it would be difficult to forecast what markets would do. But if there had been a lesson learned in the Bear Stearns takeover and then the Lehman bankruptcy, it is likely the hedge funds saw gold in buying default swaps and shorting the investment bank targets.

It would be interesting to know the party registrations of the executives involved and whether any Soros or Clinton related hedge funds were involved.