"But this turns out to be dangerous hysteria, disconnected from the trading facts. "

Peston on BBC:

"When the ban on short-selling( ASININE ) was introduced last year, the chancellor basked in the general approbation of this crackdown on financial speculation that was supposedly destroying confidence in our banks.

The impression was created that the Treasury was in part responsible for the prohibition on the practice of borrowing bank shares to sell them (with the speculator hoping to buy them back later at a lower price to trouser the difference).

Which now puts the government in something of a pickle. Because it's very unhappy that the City watchdog, the Financial Services Authority, lifted the ban last Friday on these transactions that generate profits from falling share prices.

But ministers can't easily express their disapproval in public - to do so would imply that they didn't really have much say in the imposition of the ban in the first place.

The thing is that the FSA is an independent regulatory body. And at least part of its role is to promote liquid markets that set prices in an efficient way.( YES )

The FSA believes that short-selling enhances the process of setting prices, by capturing the available supply and demand for securities and also relevant information.( I AGREE )

As we surely must now appreciate, as we live with the bitter consequences of the popping of the debt bubble, the euphoric buying of assets by manic investors is highly dangerous - so it can be very helpful that the market contains short-sellers expressing a contrary, negative view.( YES )

So the FSA would only ban short-selling, or any other similar orthodox and longstanding trading practice, when it detected palpable, significant damage to companies or to the economy that outweighed the market benefits.

There was evidence of such damage last spring and summer. A vicious interaction of malicious rumour and speculative sales was devastating bank share prices, and this in turn affected the confidence of banks' creditors and depositors.

When these creditors and depositors withdrew their funds, banks came perilously close to collapse, which transformed the rumours into self-fulfilling propositions.( BUT THE CALLING RUN WAS ENTIRELY SEPARATE )

The ban on short-selling was therefore a circuit-breaker between rumour and the undermining of banks' ability to fund themselves in the wholesale money markets and from retail deposits.

However, since the ban was imposed last autumn, the funding of banks - their borrowing - has become much more stable, thanks to the forced largesse of taxpayers.( YES )

The Treasury has committed around £800bn of taxpayers' money to underpin banks' ability to borrow what they need. A run on a bank that would bring it down is almost impossible today, because banks can secure what they need from us, the taxpayers.( YES )

Which is why the FSA felt comfortable about allowing short-selling to re-commence.

To put it in stark terms, thanks to taxpayers' largesse, short-selling bank stocks is no longer a potentially lethal activity.

Even so, many - including ministers - argue that the FSA was crackers to allow short-selling to start again.

They point to the collapse in the share prices of Royal Bank of Scotland, Lloyds Banking Group and Barclays as evidence that hedge funds and other short-sellers are up to their old tricks of destroying the infrastructure of the British economy for private profit.

There's only one problem with this thesis: it's not supported by the facts.( TRUE )

Since the ban was lifted, there has been a negligible amount of short selling.

And although some will be revolted by the disclosure in this morning's Guardian that Landsdowne has made a few millions in profit from shorting Barclays, it's laughable to think that Landsdowne's miniscule short position could have contributed to the billions wiped off Barclays' value since last Friday.( SILLY )

Most of the share price movements in the big banks have been caused by conventional selling of shares by the normal gamut of investment institutions.( YES )

Some of these investors may have sold because of their conviction that the shorts were selling the stock down to zero. In fact a number have told me precisely that. But this turns out to be dangerous hysteria( YES ), disconnected from the trading facts.

There is an argument that the FSA should have anticipated this irrational depression( TRUE ) on the part of pension funds and others - and should have delayed the lifting of the ban until a bit more common-sense( MAYBE ) returned to the market.

But the main cause of the recent falls in bank shares was the Treasury's massive new package to stimulate lending - which spooked the City for reasons discussed in earlier notes - and a worldwide escalation in fears about the health of banks.( YES )

The short-sellers are the convenient whipping boys, not the prime malefactors (if you think it's a crime that the share prices have fallen, which is moot).

As of now, no irredeemable damage appears to have been done. And although it may jar to say so, shares can rise as well as fall - even bank shares. "

I think that the short selling ban was a mistake, which might have helped calcify the market.

"Short sellers are known by many names": Like, "Shorty"

I don't understand the problem with short selling. Felix Salmon visits the issue:

"Jim Surowiecki says, quite rightly, that short selling can cause viciously self-fulfilling downward spirals, especially in financial stocks. But reading the WSJ's long and alarmist tale of what happened to Morgan Stanley in September, I'm more convinced than ever that short-sellers, be they in the stock market or the CDS market, are not the cause of current problems.

I'm with Jim Chanos on the subject of the WSJ story: he writes that

The WSJ piece, despite its sensationalist headlines, actually confirms what we have been telling Washington for some time now. That is, that most of the "short activity" in the banks/brokerages, was to hedge embedded long exposure to these institutions, often by other banks/brokerages! These were NOT "bear raids", but prudent fiduciary-related decisions made by these entities to protect their capital/investors. An important story to the Financial Crisis narrative so far."

Read the rest. Here's my comment:

Posted: Nov 25 2008 12:09pm ET

Felix, I'm not sure how betting on the market going down can cause harm. After all, if an index can go up and down, surely it's sensible to take financial advantage of the index going down, which it's going to do sometimes, being an index,if you can.

This whole worry has the whiff of a jinx. It's as if people are saying, "Look, we want the index to go up. That's when everything gets better. If you bet on the index going down, you're basically cheering on calamity, and making money on it. How dare you!"

What am I missing? After all, do we ban people who are naturally ebullient from trading, since they might cause the index to go up too much?

By DonthelibertarianDemocrat

What's A Hedge Fund?

A good explanation of Hedge Funds by Timothy P. Carney on Heckanomics:

"But what the heck is a hedge fund? Who owns them? Are they really unregulated? Are they really undertaxed?

The meaning of “hedge fund” is broad and fluid, and they don’t necessarily involve hedging. The two closest things to defining traits would probably be: (1) by law, they are not open to the general public; (2) the manager of the fund is compensated mostly by claiming a portion of the fund’s profits. Also, hedge funds typically multiply their gains by borrowing heavily (also known as leveraging). Another common trait is that they often employ short-selling (positioning the fund to benefit from a downturn in a stock, commodity, etc.) or creative investments that move in ways uncorrelated to the stock market."

Okay:
1) Not open to general public
2) Manager paid from profits
3) They borrow a lot ( Leveraging )
4) They short sell a lot ( Bet on stock, etc. going down )
5) Use assorted ways of not moving with the market

"Hedging is an investment practice whereby you protect yourself against risk, often by betting on both sides, so to speak. For example, if you’re a business that is vulnerable to increases in the price of gasoline — say, a trucking company — you might hedge your exposure to oil prices by investing in oil futures. If oil goes up and your costs increase, at least you can cover some of the cost with the increased value of your oil futures.

There are hundreds of ways to hedge an investment or hedge against a vulnerability. Hedging reduces both risk and potential reward — an unhedged trucking company might suffer more when oil prices climb, but they also are better off when oil prices drop. It’s kind of like an insurance policy: you pay to ward off uncertainty."

This is kind of like hedging your bets.

"The first hedge fund was all about hedging. Its creator, Alfred Winslow, called it a hedged fund. The fund took a long position on some stocks (betting on their going up), and a short position on others (betting on their going down). This strategy meant his fund lagged the market when the market was climbing, but it also meant his fund climbed when the market sagged. But by leveraging — investing mostly borrowed money — you can turn steady, but earthly growth into huge returns.

(If you invest $2 million of your own money, borrow $20 million and invest it all, earn 10%, and pay 5% interest, you just made more than a million dollars with only $2 million in seed money. A 50% return, by some measures.)"

The same thing. The details will vary, but you're investing on going up and going down at the same time. The trick is to make this counter investment make you money.

"Today, some people think of hedge funds not as being hedged, but as being a hedge against other investments. In other words, because they often get more creative in their investing, a hedge fund is a way to hedge against more traditional investments."

It's actually the same thing, you're trying to counter invest.

"But neither hedging or short-selling are not at the heart of hedge funds — those are investment strategies that one can engage in outside of a hedge fund. A hedge fund, at its heart, is a business model. It is a limited partnership in which the manager is rewarded proportional to the fund’s performance — a model crafted largely to avoid the regulations and taxes that constrain other forms of investment."

Main Objective: Manager paid for performance
To avoid regulations and taxes of other investments

This is why people invested in CDSs and CDOs in my opinion. In other words, to avoid capital requirements.

"Eager congressmen and much of the media describe the hedge fund industry as “unregulated.” This, of course, is an exaggeration, but at the heart of the “unregulated” claim is an important truth: hedge funds do not operate under the jurisdiction of the Securities and the Exchange Commission, they are not subject to Sarbanes-Oxley or the slew of reporting regulations the SEC imposes on publicly traded companies or mutual funds. Also — and this is key — they are not limited in how much they can leverage their position."

Now, I'm saying that CDOs and CDSs answer the same question: namely, how can we invest using less capital= increase our leverage. ( I should say that one can use them otherwise. One could simply keep more capital, and yet write a CDS. Whether it would be worth it is another question )

"Well, consider the purpose of SEC regulation of publicly traded companies and funds. It’s not as if the SEC polices these companies in order to make sure nobody’s getting too rich — or losing too much money. The SEC’s stated goal is to erect protections for investors, thus making Joe the Plumber believe he is less likely to be ripped off by whichever corporation, brokerage, or mutual fund is asking for his business.

But Joe the Plumber can’t invest in a hedge fund. If the hedge fund were to let Joe invest, they would therefore be subject to SEC regulation. And so, hedge funds evade most SEC regulation by making themselves open only to “accredited investors.”

Hedge Funds allow only Accredited Investors.

How does one become “accredited”? Basically, you have to be rich.

"A corporation or charity can be an accredited if it has more than $5 million in assets. An individual is “accredited” if he has net worth of more than $1 million, or has earned more than $200,000 each of the last two years (or if he and his wife combined for $300,000 each of the last two years).

The idea is, these people don’t need the protection of the SEC. If rich people want to blow their money on some dumb investment, or in some shady scheme, why should the taxpayers pay to protect them from their own errors?"

Accredited Investor= A wealthy investor who can afford to lose money and not be indigent

"A hedge fund, then, is a limited partnership, in which every partner must be an accredited investor. Most partners in hedge funds are investment banks or non-profit institutions such as foundations or pension plans. A minority are wealthy individuals.

When Alfred Winslow Jones wanted to launch his hedged fund, he didn’t want limits on how much he could leverage himself, and he didn’t want to run his every move past the SEC. So, he couldn’t just launch a mutual fund. He had to make a limited partnership, and that was the first half of making the modern hedge fund.'

This is financial innovation.

"If you have heard complaints about how filthy-rich fund managers are under-taxed, well, that’s kind of the point.

Before we get to the taxation of hedge fund managers, it’s important to explain the business model of hedge funds. The manager of a fund gets most of his compensation based on the performance of the fund. That gives investors bit more faith in the fund manager — both of them have their wealth riding on the fund’s growing. But just how the fund’s growth translates into the manager’s wealth is at the heart of the current debates over hedge-fund manager-taxation.

You may know that the top tax rate on capital gains is 15%, while the top income tax rate is 25%. That means the money you make when you sell your stocks for a profit is taxed less than the paycheck you bring home. You can imagine why a trader, possibly earning millions each year, would try to find a way to replace all his “income” with “capital gains.”

This is the other essential aspect of a hedge fund. The fund manager may receive some compensation in the form of straight-up fees, but the managers are compensated mostly through what’s called “carried interest.”

“Carried interest” is not interest like the interest you pay on your mortgage or collect on your savings account. It’s an interest in the fund — as in, a stake in the fund. In the business, they call it the carry.

As the fund increases in value, the manager, who very well may not have invested a single dime, gains an interest in the fund. If the fund stays stagnant or shrinks, the manager gets paid only the nominal fees. Sometimes there is an agreed-upon rate of return (for example, inflation, or the gains in the stock market) before which the manager gets no carried interest. Once that threshold is crossed, though, 20% of all gains are credited to the manager."

The manager gets paid with part ownership of the fund.

So, if all the investors combined put in $50 million, the manager might collect $500,000 in fees (much of which goes to expenses), and then he will gain a 20% interest in all earnings over 2% per year. If, after one year, the fund is worth $75 million, $4.8 million of that money is the manager’s stake, while the rest is divided among the partners proportional to their investment."

Fine. He can sell the interest or proceedings at a lower tax rate.

"Hedge funds, then, are the fancier versions of the mutual funds or investment schemes you and I get to play with. Because their managers have the opportunity to make huge gains, hedge funds attract much of the best talent. Because they are not regulated as tightly as stocks and mutual funds, they have opportunities to correlate their profits to things other than the stock market.

From one way of looking at it, it’s odd that Congress should want to impose SEC-style regulation on hedge funds. Why should our government pay to protect rich people from losing money? Shouldn’t folks with millions of dollars to invest be left to their own as far as deciding who is a worthy trustee of their wealth?"

Good question.

"One factor advancing hedge fund regulation: existing hedge funds will benefit from any regulations that make it harder to enter the business."

Raising the entry fee. If they're lucky, they'll become a cartel like Ratings Agencies.

"Another: all this talk by politicians of regulating and increasing taxes on hedge funds has driven a huge a boom in hedge funds’ contributing to these politicians’ campaigns — and hiring the politicians up as lobbyists."

They're citizens just like everybody else. Why shouldn't they.

To be honest, I think that they should pay regular tax rates on carried interest. To the extent that certain investments are regulated, the Hedge Funds should play by those rules. But the basic lesson to be learned out of all this is that financial innovation means taking or adding risk by avoiding laws and regulations.

If you want to keep track of this, you're going to have to have broad principles that can funnel all risky investments, say ones that extend leverage, or involve third parties, or magnify risk, to an agency that can look them over. Whether or not to regulate should be secondary to making sure that they're following basic sound rules of investing.