Business Law Prof Blog

Prohibition on Short Selling Creates Problems

The SEC's bone-headed suspension of all short selling on 799 financial stocks has created havoc in the markets and the SEC is scrambling to create exemptions.  Options market markets cannot hedge positions; exchange traded funds that short the market cannot follow established trading programs; and long position traders (whom we are desperate to accommodate) may limit long positions because they cannot hedge.  Suspending trading has always been a very poor method of managing markets--even bailouts, which I abhor, are better.   Cox is lurching around like a drunken sailer in a wind storm.

Form For Bailout Requests from the Fed

To:  Hank Paulsen, Secretary of the Treasury

From:  [Fill in name of your company here]

Date:  [Before Nov. 4, 2008]

1)  Our company [...] needs an immediate cash infusion due to matters beyond our control.  Despite our fine employee, excellent managment, and wonderful [products or service], we cannot borrow enough money to keep operations going.  With a cash infusion we can survive the current economic credit crisis and continue to employ proudly [number] American workers. 

2)  If we do not get an immediate cash infusion we will have to declare bankruptcy by [day after "Date" inserted above].  If we declare bankruptcy, we will have to default on obligations to other American banks, International banks, and several foreign governments who all hold our debt. 

3) Our default will put several banks in jeopardy of not meeting their capital requirements.  In short, due to the interconnected nature of the global economy, our default will create capital market chaos.  Banks will fail; people will lose their homes; people will lose their jobs; people will lose the value in their pension plans.

4)  With our bankruptcy, unemployment rates will increase, the GDP will decrease, and the stock market will fall.  Senator Obama will decry your administration for its "failed policies"; argue that McCain only offers a continuation of the "failed policies" of your administration; and will win the election.

5) You will look bad.  Financial historians from the Ivy League will write about you "asleep at the switch"  and embarrass your grandchildren.

6) So please help us help you by loaning us [number] billion dollars.  We promise to pay it back; you have our word on it.

                                                                                     With You in Saving America,

                                                                                         [CEO, Company Name]

The "S" Word

Congress has lately been bludgeoning three "S" Words - Success, Speculators, and Short-Sellers.  Congress wants to tax any success, prohibit any speculation, and stop any short-selling.  Well, it got its wish today.  The SEC, after McCain came out in favor of firing its current Chairman, Chris Cox, suspended short sales on 799 financial stocks.  This came on the heels of Wednesday orders that prohibited "naked short" selling, which apparently were not enough, and came with the cooperation of the London markets (otherwise shorts could just go to London).  The prohibition will give an immediate lift to the market because the holders of in the money put options, many of which are due tomorrow, will force the writers of those options to buy the stop now so as to deliver the stock on the exercise of the option (the writers cannot go short to deliver).  But the lift will disappear as the put options unwind. 

This attack on short-selling is ill-conceived.  We are afraid of short-seller "rumors" that drive down stock but are not equally concerned with long-buyer "rumors" that drive stock up even though both "rumors" may be false.  If I were GM I would ask that short selling be extended to my company as well (financial people have dumping on GM lately why not protect GM as well?).  What's next, making selling financial shares or MBSs illegal?  Japan tried that in the early 90s in the Tokyo real estate market. 

By the way, Obama is shorting the market, and McCain is running to catch up -- on the short side as well. As the market fails, the value of Obama's criticisms rise and his empathy (I "feel your pain") rise and he gets more vote.  Obama's statements are just as much a bear raid as any trader's and with the intention of getting votes rather than cash (cash comes later).    

Private Equity Firms, Sitting on the Sidelines Loaded with Cash

How fast things change.  Just a year and a half ago, Congress and the pundits were riping private equity firms who had just completed a five year buyout binge -- in 2006 alone there were, in amount, one-third of the total buyouts in the last fifteen years.  The private equity firms were secretive and used leverage and we did not like them.  Now, our publicly traded investment and commercial banks, insurance companies and brokerage firms are in the crapper; the government is getting weekly requests to bail them out -- Bear Stearns, Lehman, Fannie and Freddie, and AIG.  On the eve of their government bailout denials or approvals, the parties appeal to, you guessed it, the private equity funds.  The PE funds are loaded with cash and waiting for the market to bottom so they can get in and buy at distressed prices.  A large part of what Paulsen is doing is attempting, with no success, to put "confidence" back in the market so as to attract the PE money.  His strategy is backward--the PE firms will get in when assets are valued and the market clears; government intervention muddies valuations and delays the creation of a true market clearing price at the bottom.

Does the Fed Have the Power to Buy AIG?

One or more of the twelve federal reserve banks, which are privately-owned companies chartered by the federal government with limited powers, and that are part of the Federal Reserve System, have loaned another privately held company, AIG, 85 million dollars under the banks "emergency" loan power.  The hitch is that, in return, the reserve bank will hold an in the money option for 79.9 percent of the stock of the company.  The bank then, for all practical purposes, owns and controls a privately held insurance company.  A federal reserve bank has no explicit power to do this and has not done this before.  In short, a federal reserve bank, at the request of the head of the Fed, Bernanke and the Secretary of the Treasury, has stretched its statutory power to, or even past its limit.  A suit challenging the Fed authority, brought by someone with standing, would have to be taken very, very seriously by the federal courts.

ESOP Employees Sue Zell in Tribune Takeover

Sam Zell bought the Tribune Company using a fancy ESOP plan structure.  The employees of the company technically own the company but cannot vote for the board and cannot sell their shares. Zell, with a cash payment and an option, controls the company.  The company, after the takeover, is struggling and, yes, it has fired employees and thinned out the pension plans.  Those employees are suing Zell for breach of a fiduciary duty.  Its a little late; they should have voted against the takeover at their union meetings, which could have blocked it at the time.

Monday's Legal Times: Soothed Waters Roiled

The following is a Legal Times article that I wrote on Friday for Monday's edition. You will note that by the time the article came out, the folly of the "soothe the waters" approach had already failed -- Lehman in bankruptcy, Merrill Lynch in a distress buyout out, and AIG knocking on the government's door for protection:

The big winners of last week’s mortgage-company seizures are foreign countries, foreign investors, and Republicans. The seizure would not have happened had it not been an election year.
In late July, President George W. Bush signed the Housing and Economic Recovery Act of 2008. The act gave the Treasury, the Federal Reserve, and a new agency, the Federal Housing Finance Agency, new authority over two struggling government-sponsored entities, Fannie Mae and Freddie Mac.
Together, these GSEs, which are federally chartered, publicly traded corporations, held or guaranteed close to 80 percent of the country’s residential mortgages.
The 2008 act gave Treasury and the Fed the power to pro­vide emergency funding to either GSE should it need funds to operate. At the time, we were told by Treasury Secretary Henry Paulson that he would not need to use the authority. (Remember his colorful “bazooka” language, that if you’ve got a bazooka in your pocket and people know it, you probably won’t have to take it out?)
We were told by the CEO of Fannie Mae and the director of its oversight agency, Jim Lockhart of the Office of Federal Housing Enterprise Oversight, that Fannie Mae had sufficient capital to meet the requirements of the agency, the FHFA’s predecessor. Both Paulson and Lockhart pointed to a success­ful sale in May by Fannie Mae of more than $7.4 billion in new notes.
In March, Congress had ordered the GSEs to pull out an additional $500 million to subsidize “affordable housing.” How sick could they be?
TAKEN OVER
Suddenly, on Sept. 7, a Sunday, we are told that the FHFA had seized the two companies. The FHFA had taken over total con­trol, removing management power from the companies’ boards of directors and voting power from their common shareholders. It is called a conservatorship; the FHFA is the conservator.
The two companies also had signed preferred stock purchase agreements with the Treasury. Treasury would buy $1 billion in senior preferred stock from each GSE immediately and, over time, could purchase another $99 billion apiece. With each pur­chase came a warrant to purchase 79.9 percent of the common stock for a nominal price. The senior preferred stock pays a 10 percent annual dividend, which will increase if not paid (which is likely). For additional cash needs, the Fed agreed to lend, short term, cash on “eligible collateral” and GSE mortgage-backed securities, and the Treasury agreed to purchase the GSEs’ mort­gage-backed securities at healthy prices.
The major effect of the seizure was to prop up the value of the GSEs’ existing senior and subordinated debt holders and the securities that the GSEs had guaranteed.
The seizure also encouraged new lenders to loan money to the GSEs at lower interest-rate spreads from U.S. Treasuries. Indeed, three days after the seizure, Fannie Mae floated $7 billion in new notes. Treasury hopes that with new cash, Fannie Mae and Freddie Mac can continue to buy and guarantee mortgages and that mortgage interest rates will drift down, stimulating a depressed housing market.
WINNERS AND LOSERS
The big winners were the GSE senior and subordinated debt holders and those who hold mortgage-backed securities guaran­teed by the GSEs.
The size of the GSE debt is staggering: The GSEs had floated $5.4 trillion in obligations—equal to the total amount of public debt floated by the entire federal government. With the seizure, the GSEs’ debts and guarantees were now backed by the full tax­ing power of the federal government.
The big losers were the GSE preferred and common share­holders, whose stock is hugely diluted and whose dividends have been suspended indefinitely. Their investments are therefore now worth a dollar or so a share, if that, down huge amounts from recent highs. Other losers probably include, and we do not weep for them, the well-paid, sharp-elbowed lobbyists who funneled $170 million a year into the hands of federal politicians.
Common shareholders are howling for two other groups to join their misery: (1) the GSE executives who took fat pay and severance checks home while running the companies into trouble; and (2) the politicians who took GSE cash and then pro­tected the executives from repeated calls over the last five years for GSE accountability (Sen. Christopher Dodd, any regrets?).
Unfortunately, it appears that their calls will go unheeded; soothing the waters is the order of the day.
Putting names on the winners and losers uncovers that appar­ently the biggest winners were foreign countries, either through their state banks or their sovereign wealth funds, and the world’s investment banks. China holds a whopping $400 billion in GSE debt and Japan $230 billion; several of the oil rich countries of the Middle East hold more than $50 billion or so apiece. The largest of the world’s investment banks hold substantial amounts of GSE debt in their portfolios, right along with their holdings of U.S. Treasuries. If you read Paulson’s announcement on Sept. 7, you will note his worried references to the world’s central banks and investment markets.
In short: U.S. taxpayers may be bailing out the governments of China, Japan, and Abu Dhabi, among others.
AN ODD PUNT
Why now? Why this way? Paulson’s Sept. 7 statement pro­vides the clues to an answer, and the answer is not pretty.
The public justification suggested that the GSEs’ balance sheets were worse than Paulson had suspected. On its face, that’s an odd public admission because it (1) discredits an administra­tion oversight agency and a sitting director (Lockhart), and (2) will stimulate a horde of private class actions against the com­pany (now government owned) for securities fraud. I wish I had a piece of the litigation.
To be sure, Paulson notes his dissatisfaction with a “flawed business model” that creates an “inherent conflict” between the GSEs’ public and private (profit) incentives, and he encourages policy-makers to “reform” the GSEs in accordance with recom­mendations to come.
But Paulson has put in place a stopgap structure that reforms nothing. He makes a weak effort to claim that the seized com­panies will “no longer [be] managed with a strategy to maxi­mize common shareholder returns, a strategy which historically encourages risk-taking.” He has it backward; shareholder returns were sacrificed to public-interest goals that justified excessive risk-taking. But, in fact, as he has otherwise admitted, he has punted the entire problem to the next administration.
But an odd punt it is. Why seize and then punt? Again, the clues are in his statement. Paulson worries that the GSEs are so “interwoven into our financial system” that a failure by either of them would “cause great turmoil in our financial markets here at home and around the globe”—there’s that reference to foreign investors again—and be “harmful to economic growth and job creation.”
Ah, there it is. Paulson is worried about the gross domestic product and unemployment numbers going into a highly con­tested election.
All those who are politically sophisticated know that as GDP goes down and unemployment numbers go up, Barack Obama’s chances to win the presidency go up. On the other hand, if those numbers go in the other directions, John McCain’s chances to win the presidency improve. Paulson wants to minimize finan­cial upheaval in an election year. Also important is an effort to minimize the anger our foreign trading partners may feel if they hold devaluing GSE securities.
Paulson is wrapping bailing wire and duct tape around our economy, hoping the temporary fix will hold until Nov. 5.
And now the big three automobile makers and Lehman Brothers are knocking. They too would like help—before Nov. 4.

Reprinted with permission from Legal Times. © 2008 ALM Properties, Inc. All rights reserved. Further duplication without permission is prohibited.
For information, call (800) 933-4317 or ltreprints@incisivemedia.com. ALM is now Incisive Media, www.incisivemedia.com.

Lehman Declares Bankruptcy

Lehman, minus some of its healthy units (its asset management group, for example) has filed for bankruptcy.  Paulsen refused to put federal money into a workout deal and potential buyers walked out.  Bear Stearns investors should view themselves very lucky. Why Bear and not Lehman?  Who knows.  Buyers will appear but it will be for Lehman assets in liquidation rather than for the company itself.  Bankruptcy is an inevitable part of our economic system, like forest fires in forests,  -- they cannot be managed out for long and when we try we make their effects worse. 

There is Cash Out There

I am less panicked than others this morning because I am informed that there is a healthy amount of cash on the sidelines.  The cash is waiting to get in the market.  At issue is how our government can encourage the private cash to get it.  Right now, private cash is waiting to see whether the federal government will intervene in the Lehman  insolvency or the Merrill Lynch buyout.  Past government interventions, a mistake, have led to current uncertainty.  Private investors cannot value the firms; they cannot value the effects of government action.  The Merrill Lynch buyout by Bank of American for $29 a share is evidence that there are still buyers in the market.  I wish Bank of American had competitors in the bidding; the think the Bank itself is getting too big, too fast.  My investment strategy, a modest success, has been to buy when my faculty colleagues are in a state of panic, using dire language of catastrophe to foster arguments for their pet political goals [which are left and lefter].  This morning the liberals when gnashing their teeth in the coffee line.  Soon it will be time to buy.

"Not Sure What Financial Companies [Lehman, e.g.] Are Worth"

The title is a quote from today's New York Times.  How can this be when the companies are publicly traded and liquid and deep stock and debt markets?  The government, that's how.  By dabbling in the financial markets the government has uncoupled companies stock and debt price from fundamentals.  How could you price Lehman shares and debt when you do not know what the government will do to bail out the company.  Private money stays on the sidelines and waits for the government to commit.   So the chief government financial officials are huddling around the clock to figure out what to do with Lehman.  Intervention begets intervention; It's not good folks.