Monday, November 24, 2008

A Strange Duality: Government Bailout of Banks Which Shorted Each Other's Equities

Rick Santelli of CNBC raised a very interesting point this morning regarding today's Wall Street Journal front page piece on the bear raid on Morgan Stanley in September.

Without trying to recount all the detail in the very long and well-written story, suffice to say that it has now been shown that Morgan Stanley's equity price was, indeed, affected by a sort of squeeze created by hedge funds and other investment banks buying credit default swaps, CDSs, on Morgan Stanley debt, along with shorting or buying puts on the firm's equity.

This activity pre-dated the TARP, and Treasury investments. However, Santelli noted the parallel of Morgan Stanley's troubles with those of Citigroup's recent problems, and wondered aloud how much taxpayer money was engaged in far-from-transparent speculation and similar squeezes on Citigroup's shares.

Upon being challenged by Squawkbox's Joe Kernen for suddenly being for more regulation, Santelli sensibly replied, to paraphase him (since I can't recall his exact words),

'Free and fair market capitalism doesn't mean no regulation. You need some regulation to keep things fair, and avoid insider and crony capitalism. We read today about the goings-on regarding Morgan Stanley's CDSs and equity in September. How about some transparency for today's activity in Citgroup instruments?'

As I wrote here last Thursday, in reference to AIG's troubles, the swaps market needs to become far more transparent, via a regulated, explicit exchange. Santelli raises an equally-valid reason for such an exchange.

As tools for squeezing and manipulating markets have multiplied, the old regulatory model of the 1930s is hopelessly, laughably outdated. The Journal piece indicated how a small purchase of CDSs to drive their prices up would yield outsized gains on short positions or puts of the same company's equity. Yet the former markets is completely opaque, consisting of phone calls and even IMs as its method of operating.

Santelli's concluding point was that, with taxpayer money in practically every large, remaining commercial bank, we can no longer risk having these institutions use 'our' money to engage in the activities which nearly triggered Morgan Stanley's demise and, certainly, forced its conversion to a Federally chartered commercial bank.

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