Ever since the markets started to destabilize in late 2007, regulators around the world have come up with new edicts to ban short selling, particularly of bank stocks. By squeezing out the shorts and making it tougher for new negative bets to be put on, the fervent hope of the regulators in the US and Europe was to buy the banks enough breathing space for the crisis to pass.

When it became obvious, in the darker hours of 2008, that the problem was not a short term one, Central Banks and Governments stepped around the equity markets and went directly to the source of the funding problem. The answer was to guarantee the liabilities of the banking system. In the US, this happens with depositors automatically through the FDIC but this was the first time such a massive, coordinated effort was undertaken to guarantee all bank creditors, even those with subordinate claims.

The gambit allowed most banking systems to start the rebuilding process although in countries like Ireland, it has landed the tax payer with a crushing new liability (estimated at nearly 40% of GDP). The financial authorities also recapitalized selected banks and in the case of the Federal Reserve, threw open the short term lending windows to push liquidity out on terms not seen in several generations.

This last week, we have now seen the advent of a new type of short squeeze, and most likely an unintended one at that. By changing the game for the CDS (Credit Default Swap) market (a voluntary writedown of Greek debt is not a default event), the EU has caused the issuers of CDS’s to change their view of the cover they need. Since CDS’s are unlikely to be triggered, the need for the CDS writer (typically an investment bank) to hedge is much diminished.

In the case of Euro sovereign debt, that means there is less need to hold short positions on the big banks that would get whacked by a sovereign default. The unwind of those shorts is part of the reason why the markets have greeted an otherwise unimpressive announcement from the EU with such enthusiasm.

How “Wall Street” really works

As we have argued in the past, the bulk of the professional financial world does not view the markets the way the mainstream financial press would have you believe. The trading floors are not populated with swaggering “Masters of the Universe” betting the balance sheet on single ideas.

Although there is the occasional story of tremendous profits (Soros breaking the British pound, Paulson betting against home mortgages), the bulk of financial firm profits derive from managing risk (and charging for the service). Firms take on liabilities (derivatives agreements, for example) and then try to match off the risks in correlated assets. If done correctly, the firm can profit by exploiting the different prices available in the market. At the bigger firms, a whole department is charged with adding up all these assets and liabilities on a real time basis so that managers can determine just how exposed the firm is at any one time.

The plan goes wrong from time to time in one of three ways: fraud, overconfidence and liquidity squeezes.

For fraud, we have an excellent recent example in the UBS case in September. A trader, Kweku Adoboli, managed to “fool” the system and blow a $2.3 billion hole in the bank’s finances (to say nothing of the reputational damage).

For overconfidence, the emerging story of how former Goldman Chairman, Jon Corzine has transformed MF Global from a profitable derivative broker into a flailing investment bank is a fresh take on an old problem.

But the most common pitfall is liquidity squeeze. Since the margins between the liabilities and assets which banks use are often very small (due to the competitive market forces), investment firms leverage their balance sheets to make their activities sufficiently profitable (on an equity basis). Leverage ratios of 20:1 are considered very prudent in most parts of the professional financial world (whereas individual experience is usually limited to an 80% Loan To Value mortgage which equates to a 5:1 ratio). Going into the Global Financial Crisis, many top tier names were sporting leverage ratios above 40:1. When markets are stable and funding is abundant, this is a formula for minting money. Indeed as late as 2006, financial firms accounted for over 40% of corporate profits in the US. However, when market values become volatile and funding dries up, leverage works against the system, losses pile up quickly and insolvency is a serious risk.

Why does this matter?

Since better than 80% of market transactions are initiated by financial intermediaries, it is important to understand what drives their behaviour. Listening to Financial “Captains of Industry” waffle on about capital raising and discovering tomorrow’s new opportunities will tell you as much about their firms’ trading plans as Coke’s latest ad campaign will tell you about the risk of getting fat. That doesn’t mean you should not invest any more than it means you cannot enjoy a sugary cola from time to time. It does mean that you need to make sure you tone out the marketing fluff and concentrate on the useful information available in the market.

That is why using objective tools to measure the market is so important. If we rely on emotions, which is what financial news writers get paid to stir up, we will end up most despondent at the bottom of the price range and most euphoric at the top.

Curbing your enthusiasm

If we look at the Fund King rankings, it is still evident that the “melt up” (yes, the mainstream financial media is working hard to peddle that as a legitimate term) is still looking very short term in nature. When you consider that the latest source of buying pressure is driven by trading desks rebalancing their risk exposure, one can see that this is not a typical building block for a multi-year bull market. We would expect a serious lack of follow through this week.

Two Fund King Portfolios to look at:

The Global ETF Portfolio would only have you positioned in Bonds, Gold and Japanese Yen.

Global ETF Ranking

The T Rowe Price portfolio, which boasts some top performing equity funds would have you all in cash.

T Rowe Price Rankings

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