Yesterday the SEC and UK’s Financial Services Authority made very drastic moves by disallowing traders from shorting financial stocks.  Selling short is the practice of selling shares of securities that are not owned by the seller.  Shares are borrowed on margin, sold, and then purchased at a later date.  If the price is lower when the shares are repurchased, then the short seller makes a profit.  If the price is higher, the short seller suffers a loss.  I think that banning short selling on financial stocks is a really bad idea for two reasons:

1. It will undoubtedly cause a short squeeze (as we began to see yesterday with the Dow rising 400 points). A short squeeze takes place when there is a lot of open short interest (a lot of people shorting a stock) and the stock begins to rise.  As the stock rises, many short sellers buy back the stock to prevent or cap their losses.  With many short sellers buying back the stock, it increases the demand for the stock and a snowball effect takes place as the stock skyrockets.  Many short sellers will receive margin calls and will either have to increase the value of the assets in their account or be forced to buy back short positions at a loss.
2. It does absolutely nothing to solve the problems that are causing financial stocks to drop in the first place. Financial firms have seen their market value falling because of the difficulty they are facing in finding sources of capital.  The cost of borrowing for lenders and banks has increased due to the credit crunch.  Banning short selling on financial stocks does absolutely nothing to resolve the fundamental issues that have caused the market value of financial firms to fall.

The action taken by the U.S. and U.K. regulatory agencies are likely to cause more problems than they will solve.  It will only increase the volatility in the stock market as a short squeeze takes place and after the ban is lifted.  After the ban is lifted, we will likely see the financial stocks drop once again.  Why?  Because the underlying issues still exist and the market will value the price of those financial institutions accordingly.  The day traders are going to really have a field day as they buy up shares of financial stocks and subsequently short them after the ban is lifted.

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The New York Times has a very interesting interactive graphic that depicts what has happened within the financial sector over the past year.  $4 trillion in market capitalization has been lost as the stock prices on financial firms have plummeted since last October.  I still believe that the worst is not yet behind us as the credit mess we are in continues to unravel.

Before

After

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In the wake of the turmoil in financial markets, the Federal Reserve met yesterday with representatives of the U.S. Treasury, financial services companies and state officials.  The Fed took steps to prevent a short-term cash crunch, as interbank rates jumped to more than triple the official rate.  They are also discussing measures to prevent a catastrophe from taking place at AIG, as the insurance company continues to try to shore up their balance sheet seeking sources of capital.

In addition to AIG seeking to resolve its problems, things were much worse for Lehman Brothers who is seeking chapter 11 bankruptcy protection.  LEH fell over 90% to 20 cents yesterday.  The other top story of the day was Bank of America’s buyout of Merril Lynch in an all-stock deal.  Bank of America shares were down over 20%.  The fed will continue to meet today and  a decision is expected around 2:15.

Through last week, there was no expectations of a rate cut.  However, yesterday sparked some hopes that the fed may decide to drop the federal funds rate to alleviate concerns surrounding the financial sector.  Interest rates may have to hit rock bottom to help those struggling to find capital.  I think that ultimately, the fed will have to allow some inflation to take place to help resolve many of the problems with credit and the economy.  If the fed doesn’t cut rates today, they may need to in the near future.  It has become exceedingly difficult for even large financial institutions to obtain capital, and without further reduction in interest rates these problems will continue.

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Freddie Mac and Fannie Mae were both originally established as government agencies. Years later, each agency became publicly owned corporations and remained that way until this weekend. Today, it was announced that the government will bail them out and the Treasury Department is seizing control of the companies. The financial markets reacted favorably to the news, as it is widely viewed as a positive move to help lower mortgage rates and improve the economy. As much as I am opposed to government intervention in private enterprise, I think this will indeed provide more benefit than problems.

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With the recent run-up in fuel prices, you have likely been seeing prices rise in your grocery store too. This weekend, I went with my wife to buy our produce. She first asked me to stop at the ATM to get $20. Going to the ATM is unusual for us in the first place, because we use cash back credit cards for everything and rarely carry cash at all. After picking up our yuppie food stamp (the ubiquitous $20 bills spewed out of ATMs everywhere, often used when trying to split the bill after a meal), we went to our local farmer’s market.

The farmer’s market is an unusual and wondrous place. There are customers and vendors from all over and you hear all sorts of different languages, not just Spanish and English (we live in Florida, so hearing folks speak Spanish is somewhat commonplace). Prices are rarely listed and normally customers just inquire or vendors will volunteer pricing information. It’s fascinating and rare to see such a pure and free market. You can even haggle if you so desire, although the prices are so low you really don’t need to.

Indeed we were able to purchase all our produce for a single $20 bill. The merchandise we walked away with would have easily cost us more than double at the grocery market. Not only are the prices much better, but everything is fresh too. The only drawback is that because everything is fresh, you won’t find items that are out of season (for instance, strawberries). Unfortunately, you will still have to purchase out-of-season items from your grocer. However, you should still be able to find the majority of your produce at the farmer’s market. If you like to save money and enjoy people watching, you should definitely try visiting your local farmer’s market.

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