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Paddy Whacks Wrong Target

Posted on: September 22nd, 2008

Bravo, Paddy. A scapegoat has been found. But I have news for poor Paddy the Regulator: Short sellers are good guys.

Last Friday morning we all awoke to the news that a small group of stock market traders had been vilified.

Paddy Neary, the boss at the financial regulator, had fingered short sellers. They were banned from dealing in bank stocks. The implication was clear: behold the bad guys who had sent Irish banking shares into a tailspin.

Perhaps they had, but they had called the shares right. And they were good for the market.

It was Paddy’s third attempt at calming the banks and reassuring customers. On Wednesday night, he had chosen an Institute of Directors event to tell the media that Irish banks were “resilient”. Such a weedy little adjective failed to reassure worried depositors. Nor did his later limp language of how “vigilant” his regulator was. He even expressed the opinion that global market turbulence was “significant”, that it had “widened and deepened”. It was banality by the bucketful.

No one was impressed. On Thursday morning AIB and Bof I shares lost six per cent. Two fingers to the regulator. So, after another day of mayhem, he hit RTE’s nine o’clock news with the same weak message. Finally, in the early hours, he actually acted. A pity he hit the wrong target.

Short sellers are not the problem, but they make wonderful scapegoats.

Irish banking shares have been grossly overvalued for years. Short sellers spotted the weaknesses and sold stock they did not own. They were sitting on healthy profits when Paddy moved last Thursday night. On Friday, Irish banking shares rocketed in anticipation of a cull of the short sellers.

The RTE news joined in the scapegoating. Taking a lead from the regulator’s spin the news described short sellers as “speculators” who ” bet” that stocks will fall. RTE, of all stations, should not insert perjorative words into news items. Such branding, dressed up as news, is more commonly known as propaganda.

RTE calls those who buy stock “investors”. They brand short sellers as “speculators” who “bet”.

Buyers are speculators too. One man’s cheap stock is another man’s horror story. And everyone likes a quick buck.

The attempt to blame short sellers is a diversion. The reason why bank shares have tumbled is because bankers have been behaving badly. They have run their banks into trouble because of gross overlending to the property sector. And, in particular, to their developer friends. They have made fundamental mistakes, in some cases threatening the future of the bank and its depositors.

Canny market observers from home and overseas spotted the bankers lunatic behaviour, saw the danger and pressed the “sell” button. They usually borrowed stock from a long-term holder in advance of the sale. This enabled them to deliver the shares when they were due for delivery.

The financial regulator rode to the rescue of investors last week. But that is not his job. His job is to protect depositors, not investors.

The effect of his intervention was to give some banking shares a bounce of as much as 60 per cent. Bof I shareholders breathed a selfish sigh of relief, but the move was a mistake.

After the knee-jerk euphoria, bank shares paused. The market knows that the short sellers will be back whenever the ban is lifted. Which it will be. The fundamentals remain woeful.

The regulator has, as usual, missed the point. Short sellers are good for the market. Nobody ever remembers that a short sale contains within it a commitment to buy shares in the future. While the immediate effect of short selling is to depress shares, equally, the mandatory repurchase of shares actually supports the price. The stock must be bought back.

More importantly, short sellers take far greater risks than buyers. Some short sellers are “naked”, meaning that they do not even bother to borrow the stock. Their potential loss is unlimited. If the shares quadruple, they will lose four times their original capital sum. Buyers only lose the sum that they put into the market. They often take short sellers to the cleaners.

And our chosen culprits are frequently cleaned out. Such activity is often known as a “bear squeeze”, when markets push ahead, forcing short sellers to buy back while nursing heavy losses.

The regulator’s ban will be bypassed anyway. It only extends to financial shares. On Friday morning traders were already selling baskets f Irish shares, through an instrument known as ETFs. As 40 per cent of the Irish market is made up of banking shares, the sale of a weighted basket of shares is, in fact, a back- door way of selling the banks.

And no doubt such active traders can still buy complicated derivatives, like ‘put’ options, giving them the right to sell banking shares which they do not own at a future date. Over to you, Paddy.

The regulator’s move was cosmetic. It will work for about a week. Some short sellers will now be forced to buy back at high levels. A few long- term holders will gratefully sell to them at artificially high prices, but the move is unlikely to make any long-term difference. If the Irish banks fail to put their house in order, their share prices will tank again. Long term holders will sell out.

The move was forced on the regulator by the Financial Services Authority in the UK, which banned short sellers earlier in the day. Not for the first time, our regulator was simply trotting behind its neighbour.

Far more important was the leak of Anglo Irish Bank’s’ interest in the Irish Nationwide Building Society. Small banks are under pressure. A friend of mine, with an account in Anglo Irish, told me that he had never seen so many people in Anglo’s St Stephen’s Green headquarters as were milling around on Thursday. The last sight Anglo wanted was the appearance of clients in their office.

The masses were withdrawing funds to transfer to the Post Office — with its government guarantee — or even Rabobank, with its tip top credit rating.

Such unwelcome attention from its customers concentrates the mind of management. Anglo has endured a torrid time, much of its own making. It needs a partner. Irish Nationwide, with its countrywide network of branches, could fit well, but perhaps a stronger third party, with more blue chip credentials, would consolidate the takeover.

Anglo and Nationwide have the same problems as all the Irish banks. They all overlent to real property “speculators”.

Which brings me back to Paddy the Regulator. Where was the regulator during all those years when the banks –under his supervision — were recklessly lashing out buckets of money to builders, developers and housebuyers? Why did he not call a halt to the madness of local bankers?

At the time, we could have done with some short sellers in the property market. They would have kept prices at more realistic levels. They have done us a service in the stock market.

Good public relations, Paddy. Wrong target, wrong time.