Wednesday, April 02, 2008

The Uptick Rule & Recent Market Volatility

Yesterday's Wall Street Journal piece on the effects of the removal of the 'uptick rule' provided some fascinating information on recent changes in the securities markets.

As background, the article began with the passage,

"With the stock market posting its worst quarter in six years, an obscure change in how stocks are traded is the subject of a nasty debate on Wall Street, with one side blaming the switch for everything from increased volatility to the collapse of Bear Stearns and the other side dismissing those critics as fools and worse.
The subject of this rancor is the "uptick" rule. Until July, investors typically had to wait until a stock was rising before they could wager on its decline. Under this rule, adopted in response to the stock market's crash in 1929 to inhibit bearish traders, there had to be an "uptick" in a stock's price before traders could short the shares. In other words, investors could borrow shares and sell them, hoping for the price to fall, only after a trade that pushed up the stock's price.

After years of academic research suggested that the rule was hindering trading without protecting prices, regulators eliminated the rule last summer, giving a green light to those eager to sell a stock short, even as it was falling."

So last summer, just as the Bear Stearns mortgage-backed mutual funds were experiencing losses, the uptick rule disappeared. Accordingly, the article notes,

"Some argue that the move unleashed a new era of volatility. Consider the drastic drop in Bear Stearns stock, which tumbled to $4.81 a share March 17 from $57 just two days earlier. When groups of traders short a stock they effectively flood the market with shares they are selling -- even though they don't actually own them -- which can drive down prices and sometimes even cause a panic, critics say. Some investors maintain that groups of hedge funds and others conspired to knock down Bear's stock price, hoping to profit by forcing the big brokerage to seek bankruptcy protection.

"Traders are in hog heaven -- they keep banging and banging a stock [down] -- but investors find it hideous," argues Mario Gabelli, chairman of Gamco Investors, who wants the rule re-instated. "The increased volatility causes investors to want higher returns, so there will be a higher cost of capital for companies, putting our markets at a competitive disadvantage."

Adds Martin J. Whitman, founder and co-chief investment officer of Third Avenue Management: "In my 58 years in the market, it's never been easier to conduct bear raids." His funds sustained losses when shares of companies such as CIT Group and bond-insurance companies, such as MBIA and Ambac Financial Group, fell significantly, declines he blames on short-sellers.

And, just over a week ago, CNBC's James Cramer encouraged his viewers to contact the Securities and Exchange Commission and Congress to complain about the change, saying that "tens of billions of dollars" have been lost because of the change, and that SEC officials "are total morons" about the issue.

Thus we have a number of industry pundits complaining that the sky is falling, and all because of this one minor change. But there are other views, as well. For example, as the Journal piece continues,

Hogwash, say others. They argue that a debt crisis and economic weakness are at the root of the market's problem.

"Anyone who thinks the removal of this rule is somehow causing havoc in the financial markets is hopelessly lost in the bark of one tree and may never be able to see the forest," says James Bianco, who runs Bianco Research in Chicago. He notes that there were ways around the uptick rule, such as using options strategies and exchange-traded funds, or simply violating it and paying a small fine. "To suggest that the removal of this rule is causing the markets to go down is to loudly announce 'I don't understand the credit crisis, and I am incapable of ever understanding it.'"

I love Bianco's comment. And the Journal article clearly set up the sequence in order to imply that Bianco thinks anyone who thinks and behaves like Cramer is 'incapable of ever understanding' the credit crisis.

Which I think is pretty much true, in Cramer's case. He railed for lower Fed rates and bailouts for his hedge fund and trading desk friends. But the credit crisis, as I've since written, has always been more about counterparty risk than it has about a need for lower costs of funds.

The article goes on to describe some of the other, confounding changes in the markets which occurred with the disappearance of the uptick rule. To wit,

"But lots of bad things have gone on in the market since July, making it difficult to isolate the impact of the dissolution of the uptick rule. And volatility eased when the market rebounded in October, though it remained somewhat above pre-July levels.

A representative of the SEC, which made the rule change, notes that since 2001, stocks have traded in decimals, rather than fractions. So even before the July change, a bearish-minded investor easily could have pushed a stock even just a penny higher with a little buying and then come back with a big short sale, effectively skirting the intent of the rule. He notes that some foreign markets also have seen a volatility spike, even though there were no similar changes in how stocks can be shorted."

Decimalization alone is very important. So, of course, is the usage of puts to do what shorting does, without any uptick complications.

I think it's pretty hard to view the relevant market changes since last summer and lay all of the damage on one rule involving upticks.

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