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THE MACAU METRO MONITOR

STANLEY HO HOSPITALIZED, STATE OF HEALTH UNCLEAR scmp.com

 

STANLEY HO HOSPITALIZED IN HONG KONG, SJM SHARES FALL Bloomberg.com

Casino magnate Stanley Ho has been hospitalized in Hong Kong, according to reports released on Tuesday.  The Chinese-language newspaper Apple Daily cited unnamed sources as saying that Mr. Ho had tripped and hit his head last week, resulting in him being rushed to hospital for surgery.  Apple Daily said that his condition had stabilized following the removal of a blood clot in his brain.  The long-term effects of the injury are not certain, according to the report.

 

JULY GAMING REVENUES UP 3.1% macaudailytimesnews.com

Gross gaming revenues in July came to MOP9.5 billion, a year-over-year increase of 3.1%, according to the LUSA news agency.  SJM continues to lead the way in terms of gross revenues, with 23.36% market share, followed by LVS with 21.63%, MPEL with 17.77%, WYNN with 14.85%, and MGM and Galaxy with approximately 12% and 10%, respectively. 

Of the MOP9.5 billion, MOP599 million originated from slot machines.

 

ADELSON AND WYNN CONFIDENT IN NEW CE macaudailytimesnews.com

Sheldon Adelson and Steve Wynn are both optimistic about the future political leadership of Macau.  The Chairmen of the Venetian and Wynn expressed confidence in newly elected Chief Executive Fernando Chui Sai On by touting his US-based education as a positive attribute. 

During a quarterly conference call last week, Wynn said, “in America, the creators of employment have a target on their back, that's not the case of Macau and the Peoples Republic of China. Maybe we could learn a lesson from what is going on there.”  Sheldon Adelson expressed hope that the gaming tax could be subject to “innovation” – specifically he seeks the removal of a 4% tax (on top of the 35% basic gaming tax) that goes to the Macau Foundation as well as an overall reduction to compete with emerging gaming markets like Singapore, Taiwan and the Philippines.

 

GENTING SINGAPORE RESORT MAY OPEN BY END-2009 btimes.com

CIMB Investment Bank has said that Genting may open its S$6.6 billion resort in Singapore before the end of 2009 and earn more than previously estimated in its first year of operation.  Construction has been progressing at a “quick pace” and Genting may announce the resort’s opening date next month.  The resort is now expected to generate S$690 million in EBITDA in its first year, more than double CIMB’s previous estimate. 

Genting’s Singapore project is one of two casino resorts the government has allowed to be built in the city-state in order to triple annual tourism revenue to S$30 billion by 2015.  LVS announced on July 8th that its Singapore casino resort would open on schedule in January or February of next year.


WMS: CONF CALL HIGHLIGHTS

We are bullish on the slot supplier segment, not so much based on 2010 but more so because there is a visible and developing domino effect with new markets, leading to neighboring jurisdictions needing to “keep up with the Joneses”.  It is fair to argue that WMS deserves a premium valuation given its stellar performance.  However, we believe that there are cheaper ways to play this trade, with stocks that have lower embedded expectations.

 

WMS 2Q09 EARNINGS CALL

  • 13th consecutive quarter of meeting or beating guidance
  • Over the last 3 years WMS’s net income tripled, despite the decline in industry shipments
  • Results were achieved in the midst of the worst replacement market and weak new openings
  • Capital investment is targeted towards high ROI initiatives
  • Activity in multiple new jurisdictions and eventual replacement cycle makes them optimistic
  • Increased share repurchase program
  • High performing games is helping their gaming operations through more units and higher win per days
    • WAP footprint grew 38%
    • 171MM of gross profit
  • Estimate ship share will be higher than 21% achieved last year
  • International new unit revenue grew 5% for the year
  • CFFO was 179MM
  • Bluebird 2 platform saw some success  - 62% of new shipments, with 25% being mechanical reels (22% for the year), 20% higher price
    • Same gross profit margin % achieved in BB2 as BB1
    • They expect to further increase margins with cost decreases and price increases
    • Can deliver units faster, saving money
    • Aria – 23% of floor will be blue bird 2 – highest flow share for Vegas strip opening
    • 23% in Rivers Pittsburg, and 24% in River City – PNK (shares)

Outlook/ new products:

  • Growth from new international jurisdictions
    • Already shipped first units into Mexico and expect to recognize revenue in New Wales by 1H2010
  • Growth from new platforms like Helios (value oriented cabinets for international markets)
  • Growth from networked gaming contribution
    • Log on feature- player recognition
    • Time machine game/ monopoly games – first participation game on BB cabinet
  • Higher selling prices, despite depressed unit shipments domestically
  • Higher install base and higher average daily win per day in 2010
  • Entry into centrally determined markets – WMS games are already in those markets (like Oklahoma) through 3rd party distributors. Already shipped first units to Washington
  • They have a monopoly license through 2016 (and extension available through 2019)
  • Opened new lab in Seattle – to demonstrate new network gaming products
    • Launch wage-net enable products over the next 6 months (Aria & other casinos)
      • Received approval in Mississippi to conduct trials for downloadable
  • WMS assumes lower Native American expansion opportunities in 2010
  • They aren’t including any new markets that still have a lot of uncertainty around them
  • Lower margin on game ops from higher mix of WAP units
  • Benefit from higher mix of BB2, hurt by higher mix of lower margin product sales like used games and lower # of conversion kits –resulting in lower gross product margins
  • R&D: will continue to grow – ~14% of revenues
  • SG&A:  (June reflected higher headcount from global growth)
  • D&A:  increase modestly and decline as a % of revenues
  • Effective tax rate will be 36-38% (after R&D tax credit expires this year)
  • Remain optimistic given:
    • 18 consecutive quarters of double digit EPS growth
    • 2 week customer order turn around
    • Innovative culture and pipeline = special sauce for boosting demand for products in challenging times
    • “Future ready” for networked gaming

Quarterly highlights:

  • Other product sales (used) created a small drag on margins
  • Operating cash flow in 2009 was same as 2008   
    • Provided financing for more customers in the quarter
  • Inventory turns improved 35% to 4.2x from 3.1x turns
  • Cash grew despite $27MM used in investing activities

Q&A:

  • What are they seeing with their install base, is there more price resistance?
    • No – they continue to see pricing leverage
    • Units – tremendous success with Wizard of Oz not sure that they can replicate that growth
    • “There could be some upside if games are success”
    • Expecting a decline the rate of growth for participation business to slow
  • Assumptions for domestic / international
    • International mix to remain constant next year
    • See first 6 months of 2010 to continue current trends and pick up in back half
  • Why are they comfortable that back half replacements will help them in 2H2010?
    • Had a number of dialogues pre G2E and see a resurgence in demand from some clients that haven’t bought in a while (big players)
    • “loosening of purse strings”
    • Some of it is because there was pent up demand
      • I’m sure that the refinancings are driving this
  • Used games?
    • Great demand for BB1 product – not a lot of inventory so great demand for them… may start to see the BB1 come back to them and go to 2nd tier markets (internationally) so when their customers upgrade to BB2 they get more BB1’s back
    • No used games in their inventory today
    • Used games vs conversions kits moving in the opposite direction
      • NO
      • They are to venues outside the US vs. conversions are to US
  • Is IGT’s increased WAP footprint (BYD/MGM) impacting their guidance –NO
  • Growing excess FCF – above R&D needs – where are the opportunities to deploy that
    • Scour the globe for new technologies/ IT
    • Acquiring a company…
    • Board increased the buyback program by $75MM have $150MM under the program
    • Reinvest in the same range as 09 into gaming operations
  • Backlog?
    •  “healthy”
    • Very comfortable with their guidance
  • Class 2 & Australia cheaper… than BB2 – hence lower ASP growth given higher BB mix
  • Think they had a mid-high 20’s share – mid 30s replacement share
  • Majority of replacement units are competitor units- particularly in mechanical product – fresh market share for them
  • Taking “Price is Right” brand from a competitor
    • Thought they could leverage the brand – not about stealing competitor brands – it came to them  - given server based capabilities
  • Outperformance in operating margins driven by the gaming operations business- that’s where the beat can come from in 2010. On the product sales side, could have upside from new markets.  Replacement cycle improvement would be huge too.
  • Expanding video poker platform
    • Exciting opportunity in IL – but it’s not going to be just video poker. Expect to participate and have a commensurate share of that market
  • Idea behind internal casino Seattle to help sell their server based games – hard to sell on paper –easier to demonstrate
  • Are they sandbagging win per day for 2010?
    • July was the best month ever (June & Sept are seasonally the strongest quarter) but hard to forecast super strong trends continuing
    • Wizard of Oz – new placements – unclear if win per days will hold
      •  typically participation games have falling off win per days as games on the floor age
  • Any chance they get same share of games for new openings as replacements?
    • People forget that existing floor share is in the teens so 30% is getting them closer to new opening share in the low to mid 20s
  • Regional operations have been aggressively  replacing their  machines, and Native American casinos are on a normal 5/6 year cycle… it’s really the multi-property/ strip players  that haven’t been holding up orders
  • Comparing Wizard of Oz to Wheel of Fortune is a stretch …
    • I don’t think people realize how many WoF games are out there… probably about 25,000… whole other league – not to take anything away from WMS
  • Long term – where can margins go:
    • 60% product margins (will depend on conversion kits and software success of “networked gaming”)
    • 25% operating margins

Reflation's Rotation: ISM Prices Paid

If there is one question I have been getting most consistently from investors as of late, its ‘why do you think we see inflation in Q4?’…

 

Generally speaking, until macro numbers are on the tape, “private forecasters” won’t believe they are possible. Maybe that’s because groupthink is so dominant right now. Maybe it’s because you can’t get these forecasts with in a “one on one” with your favorite economist. Otherwise, I have no idea. This call isn’t that complicated.

 

When I measure risk, I measure ranges, deltas, and spreads. One way to measure the risk of reflation rotating into inflation in Q4 is through the delta of the Prices Paid component of the ISM Manufacturing survey. Last month I called this out as an eye opener. This month’s number is a flat out moon-shot (see chart).

 

A lot of economists are calling for perpetual deflation because that’s what the lagging indicators (reported CPI and PPI) are telling them. Looking at the smack-down of this chart from July of 2008 until the end of Q408’ will give you a great summary of what’s in that rear-view mirror.

 

At a reading of 55 for July of 2009, this horse has already left the barn. If these price levels hold, year-over-year inflation accelerating in Q4 is as close to a mathematical certainty as I can find. People have to pay for things in US Dollars – the Buck is Burning.

 

And Reflation’s Rotation is finally underway…

KM

 

Keith R. McCullough
Chief Executive Officer

 

Reflation's Rotation: ISM Prices Paid - ISMCHART

 


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Obama Down, Market Up

As we were going through our weekend reading, the cover of the Economist jumped out at us.  For those of you who didn’t get a chance to read the Economist, the cover had a picture of President Obama with the title, “Crunch time”.  We typically consider the covers of most major financial publications as contrary indicators, or at least derivatives of such.  This cover actually seems to be an apt description of the President’s current predicament.

 

As the Economist notes:

 

“If the opinion polls are to be believed, Barack Obama is now, six months into his presidency, no more popular than George Bush or Richard Nixon were at the same stage in theirs.  His ratings are sagging particularly badly with electorally vital independent voters: two-thirds of them think he wants to spend too much of their money.”

 

We have previewed this shift of the middle moving away from President Obama, and it now seems to be occurring in a substantial way.  We have inserted a chart below of the Rasmussen Daily Presidential Tracking Index (difference between strongly approve and strongly disapprove), which shows the inverse relationship between President Obama’s approval rating and the stock market.  The internals of the Rasmussen highlight a number of key points in regards to President Obama:

 

  • Only 11% of voters believe taxes will go down under President Obama;
  • Only 29% of voters trust President Obama on the economic crisis; and
  • Almost 76% of voters believe President Obama is too liberal.

Rightly or wrongly, President Obama is very vigorously being categorized as a leftist President who will raise taxes and can’t handle the economy.  These characteristics are what seem to be directing Obama’s weak polling numbers as of late.  Two additional polls from Rasmussen offer evidence as to why this is the case:

 

  • 30% of voters believe that increases in government spending will help the economy and 50% believe that it will hurt the economy; and
  • 54% of voters believe tax cuts will help the economy and 19% believe they will hurt the economy.

Unfortunately, for his approval rating, President Obama is doing the one thing that voters broadly disapprove of, which is he is increasing government spending.  The implication of this increase in government spending is that taxes will likely have to go up.   According to Associated Press reports over the weekend:

 

“Treasury Secretary Timothy Geithner and National Economic Council Director Larry Summers both sidestepped questions on Obama's intentions about taxes. Geithner said the White House was not ready to rule out a tax hike to lower the federal deficit; Summers said Obama's proposed health care overhaul needs funding from somewhere.”

 

It doesn’t take a group of knucklehead hockey players from Yale to figure out the obvious here, taxes are going higher, which is what President Obama’s approval rating is starting to discount.

 

Perversely, the benefit of a declining Presidential approval rating is that it is positive for the stock market.  Ned Davis Research has done extensive work on this idea, and we conceptualize it in the chart below, but “in weeks when the presidential approval rating sagged below 50 percent, stocks rose at an annual rate of 9 percent -- versus only 2 ½ percent when the president in office sported a wildly popular 65 percent approval rating in the polls.”  No surprise, that when a President’s approvals declines too far, typically below 38%, stocks tend to fall on average 2% annually. This is not unlike our thesis on the dollar, which is that a weak US$ is positive for the stock market, to a point.

 

President Obama’s Chief of Staff Rahm Emmanuel famously said, “Never let a serious crisis go to waste.”  For investors, the rule may be more aptly characterized: never let a serious crisis in Presidential approval go to waste.

 

Daryl G. Jones
Managing Director

 

Obama Down, Market Up - djchart2

 


Chart of The Week: Volatility Breakdown

One of the main lessons from what is becoming as forceful an up move as we had on the way down is that Wall Street continues manages risk on a revisionist basis. This is not a proactive investment process. It’s reactive, and you should capitalize on its outputs.

 

Prior to Q2 of 2008, for most 30-year old hedge fund managers a VIX above 30 was unheard of. Although I’m using that age to be cute, the reality is that there are very few institutional managers who managed their portfolios in a 30-80 VIX environment prior to 2008. Today, there are equally as many PM’s who are being told to manage their exposures towards a 30-80 environment AFTER the fact.

 

The probabilities of seeing a VIX over 30 anytime in the immediate term are very slim. That, of course, makes the 30-80 range a tail risk that we should perpetually consider. But it also means that you’ll get crushed on 97% of the days in this current trading environment by hedging towards that tail risk scenario. Tail risk is exactly that – not in the heart of the bell curve of daily price distributions.

 

Across all three of our key durations, the VIX remains broken. While it’s nowhere near as nasty as the US Dollar chart, this is one of the most bearish charts in all of global macro right now.

 

The long term TAIL line = $41.29 and the intermediate term TREND line = $30.57. Until you see these lines penetrated to the upside, you’ll be paid to buy low and sell high.

 

Trade the range confidently, rather than in fear. The days of calling for crashes and squeezes are behind us… for now…  simply because everyone continues to look for them.

KM

 

Keith R. McCullough
Chief Executive Officer

Chart of The Week: Volatility Breakdown - kmchart1


Slouching Towards Wall Street… Notes for the Week Ending Friday, July 31, 2009

A Flash In The Pan

 

An appeaser is one who feeds a crocodile, hoping it will eat him last.

                             - Winston Churchill

 

Senator Chuck Schumer has warned the SEC that, if the Commission does not act to halt the new “flash orders”, he will introduce legislation to ban the practice.  The New York Times obligingly ran a front-page story (23 July, “Stock Traders Find Speed Pays, In Milliseconds”) and followed up with stories about Senator Schumer’s assault.

 

Flash trading takes to a new level the algorithm-driven model known as “High Frequency / Low Latency” trading.  Traders with the most powerful computers and the most sophisticated algorithms – “algos” in trader-ese – capture significant advantage by identifying patterns of buying and selling literally as they emerge, and in many cases before trades are even printed.

 

Free markets are predicated on the notion that those who are smarter, faster and more diligent than the rest also get to make more money, even at the expense of the rest.  No one compels us to trade stocks, and we do so with eyes open to the risks.  Including especially the risk of trading against someone smarter than ourselves.

 

But the flash order double-dips the advantage already enjoyed by the smart guys.  First, the market venue where you enter your trade attempts to fill your order by sweeping available inside bids or offers – preferencing its own members – then they flash the unfilled portion to their biggest customers.  Only then does it get routed out to the broad market.  We always knew that money talks.  Now we learn that it also front runs your order.

 

The Times reports that on July 15, trading in the shares of Broadcom surged.  The Times story indicates that buy orders in Broadcom were flashed to the Star Wars crowd for 30 milliseconds.  This 0.03 of a second was enough for the algos to determine out not only the direction of interest, but the upper and lower price limits, and to scale their orders accordingly.  The times reports “the slower-moving investors paid $1.4 million for about 56,000 shares, or $7,800 more than if they had been able to move as quickly as the high-frequency traders.”

 

A profit of $7,800 on transactions valued at $1.4 million may not seem like a lot of money, especially when factored over all the High Frequency / Low Latency guys in the flash realm.  It is a return of 0.0056, or a little over one-half of one percent of the total amount that changed hands.

 

Multiply that by the billions of shares that trade in the markets every day, factor in the news stories, rumors or just plain market momentum that drives trading swells, and you see this can add up.

 

As a random example, for trade date 30 June of this year, NYSE Group daily dollar volume was reported as $45.6 billion.  One-half of one percent of numbers of that magnitude – $228 million – adds up quickly.  How quickly?  The Times article cites a report indicating the high frequency traders as a group took in $21 billion in profits in 2008. 

 

At the time of this writing, the SEC is looking at flash orders and it looks like the kibosh will soon be applied.

 

Buried in the Times story, almost as a throwaway, is the following:

 

“High-frequency traders also benefit from competition among the various exchanges, which pay small fees that are often collected by the biggest and most active traders — typically a quarter of a cent per share to whoever arrives first. Those small payments, spread over millions of shares, help high-speed investors profit simply by trading enormous numbers of shares, even if they buy or sell at a modest loss.”

 

The exchanges, in an attempt to attract business, pay incentive fees to traders who execute on their facilities.  Everyone in the business acknowledges this practice. It even has crept into trader-ese, where they call it “incenting.”  For those of you who have forgotten, this practice – Payment For Order Flow – is how Bernie Madoff built his business.  It worked for him, and it has certainly worked for the exchanges.  NYSE average daily volume is up some 164% since 2005, even as other exchanges and trading venues have proliferated.  By some estimates the Star Wars guys account for over half of all trading volume on all exchanges.

 

This is touted as being good for everybody.  Markets need depth.  All other things being equal, the more volume on an exchange, the more robust that market should be.  But by paying for order flow the exchanges induce firms to place orders in trading venues, regardless of the quality of execution.  Exchanges are supposed to offer depth, liquidity, transparency, and protection of customer orders.  Firms should trade based on the robustness of that venue – not on the basis of who pays them for their business.  By “incenting”, exchanges create a false impression of market activity – the activity is real; what is false is the underlying reason for that activity.

 

When this type of activity occurs in individual securities, it is called Painting the Tape.  Traders buy and sell the same securities repeatedly, artificially pumping the trading volume in order to create public interest in a security.  When individuals do it, it is a criminal activity.  When an exchange does it, it is called promoting liquidity and market depth.  Now, even incentive fees are not enough to hold onto the Star Wars traders, but they need an early peek into the order book to top it off.  The bigger they are, the more clout they have, and the more the exchanges have to offer them to stay.  Some traders even have algos that calculate maximum loss scenarios, then enter losing orders as long as the incentive fee will be more than the loss on the trades themselves.

 

In a reversal that should take no one by surprise, the NASDAQ Stock market, which introduced Flash Orders on 3 June, now characterizes these types of orders as “order types that do not support price formation” (Reuters, 28 July, “Nasdaq Backs Ban On “Flash” Trading: Schumer”).  For the lay person: we tried to give an excess unfair advantage to our biggest players, because try as we might, we couldn’t incent them enough, but too many people figured it out too quickly.

 

So it looks as though the flash order will end up as a flash in the pan.  This looks like the regulators once again giving away the store, then making a big fuss about taking back a little, while still leaving the big boys free rein to dominate the marketplace. 

 

The Star Wars world of high frequency trading is here to stay.  Anyone doubting this need only look at the Wall Street Journal report (WSJ, 31 July, “”NYSE’s Fast-Trade Hub Rises Up In New Jersey”).  The NYSE is creating a 400,000 square foot mega trading starship at a secret (we’re not making this up) location in Mahwah, NJ, to house Star Wars traders.  The physical proximity to the NYSE trading floor, we are told, will make a difference in time of order transmissions, as traders are now executing not in milliseconds – thousandths of a second – but in microseconds – millionths of a second.

 

Winston Churchill once observed that no government in history has ever gone to the vast logistical trouble and financial expense of a broad military mobilization without subsequently going to war.  Once the armies are massed on the border, too much money has been spent – and too much political capital – to ask that they stand down.

 

The NYSE is betting on the future of Star Wars, and it looks a safe bet – though whether the NYSE’s Starship Frequency will be the fleet’s flagship is anybody’s guess.  The article says the NYSE hopes to attract certain established players in the high frequency world.  “Worries about high-frequency trading aren’t focused on” Goldman or hedge fund Citadel.  No surprise there.  Indeed, the only thing the NYSE is worried about is whether Goldman and citadel will actually book aboard their starship, or if they will be off on someone else’s DeathStar.  Count on the NYSE to offer free rent – otherwise known as “soft dollars” – as another way to “incent” the big boys, at the risk of undermining the integrity of the marketplace.

 

As Senator Schumer leads the charge, the flash order may look like a dead issue.  But have no fear: the Empire will strike back.

 

 

 

Got Them By The Shorts

 

If you’re gonna set somebody up, it’s gotta be a surprise, you got that?

-         Chili Palmer, “Get Shorty”

 

What a surprise!

 

It isn’t every day we get to praise securities regulators, so let us not let pass this opportunity to congratulate SEC Chair Mary Schapiro on the announcement of new initiatives on short selling.  The high points of SEC Release 2009-172 (27 July, “SEC Takes Steps To Curtail Abusive Short Sales And Increase Market Transparency”) are: a requirement to deliver stock, and enhanced transparency by making short interest data more widely available. 

 

In addition, there are significant political offerings.  These include “a public roundtable… to discuss securities lending, pre-borrowing, and possible additional short sale disclosures…”, and assurance that the Commission is “continuing to actively consider proposals on short sale price test and circuit breaker restrictions.”

 

The SEC’s brief is market integrity, and investor protection.  Anyone who ever earned their living selling anything to anybody will tell you that the incidence of truly informed consumers is statistically insignificant.  Therefore, the best any market regulator can possibly do is require maximum market transparency.  Added to that, it would be helpful if every brokerage account statement came with a warning similar to those displayed on Canadian cigarette packages, which feature large full-color photographs of gangrenous limbs and active cancer tumors.

 

Chairman Schapiro has not always contented herself with hoping for the best.  She has acted affirmatively in the public interest before.  While at the NASD she oversaw the creation of the Investor Education program – you may remember the silly photos from the NASD website, like the pudgy gent wearing a tiny hat under the caption “Small Cap”.  The pictures were goofy but memorable, and they were right there on the NASD’s home page under a header that shouted INVESTOR EDUCATION.  If you got as far as typing in NASDR.COM you couldn’t miss it.

 

Of course, even Mary Schapiro could not force you to read the material – but until she came along, no one else had even bothered to publicize it.

 

We now get to watch Chairman Schapiro as she joins the cast of Get Shorty, where people who are harder working, more focused, and better informed than average investors get punished for being… well… harder working, more focused, and better informed.  This has been true of hedge funds, and its latest targets are the High Frequency / Low Latency traders.  But there has always been a special place in the hearts of the American public – and legislators – for the Shorts.

 

Chairman Schapiro, herself no stranger to the Politics of Politics – to coin a phrase – has neatly thrown the short sellers into the briar patch by calling for a roundtable and promising “ongoing” and “active” consideration of other proposals.  With any luck, the political process – the septic interface where Hill and Street meet – will slow this debate down to a 16 RPM screaming match that will drag on until nature takes its course: either speculative frenzy will overtake the markets and no one will care about silly things like short sellers and hedge funds, or we will forget about short sales as we queue up to swap our dollars for Yuan, meanwhile hoarding water, bread and bullets.

 

It would be nonsensical to make a type of transaction illegal.  Cocaine is illegal and is distributed through a sales network.  Would it be a stretch to think the way to halt the widespread use of cocaine was to introduce legislation making it a crime to buy something?  (We may regret suggesting that – please don’t forward this to anyone in Washington!)

 

No politician will defend short selling against all the nonsense coming down the pike – that would make them look like they were in the pocket of the hedge funds.  But we note the issues Chairman Schapiro chooses to avoid. 

 

It is well and good to make delivery mandatory.  We expect there to be a few high-visibility and hard-hitting cases brought in short order, where firms will be punished for not making timely delivery.  Thus will the SEC show the press it Means Business.

 

Our market, large and complex as it is, runs on certain presuppositions.  At any given time, there is not enough stock available for borrowing in the marketplace to support all the short sales that are done on any given day.  Active traders in a volatile market may recycle a short multiple times in one day, shorting, covering and re-shorting stock against the same locate.  Would a “hard borrow” require them to make multiple deliveries, even if their position is flat at the close of business?  (Don’t send that to Washington either…)

 

We all know that the Easy To Borrow lists make unrealistic quantities of stock available for shorting, and that at any given moment there are phantom shares in the marketplace as a result of aggregate short sales that exceed prime broker Easy To Borrow lists.  But the probability is that not all these shares will be required for delivery at the same time.  To introduce a hard locate, or pre-borrow and deliver requirement would be to clamp down on volume and liquidity in the market so drastically, the US would no longer be the marketplace of choice for equity traders.  Talk about reneging on your handshake.

 

This aspect of the market appears to be here to stay.  If you had any doubts, footnote 29 of the Release quotes several Exchange Act Releases regarding issuers’ attempts to protect their shares from naked shorting.  Issuers have tried issuing shares that are only available in physical certificate and can not be “held” electronically, or simply withdrawing from the industry-wide DTC clearinghouse, making their securities no longer available for book-entry transfer.  “Withdrawing securities from DTC or requiring custody-only transfers would undermine the goal of a national clearance and settlement system designed to reduce the physical movement of certificates in the trading markets.”  Translation: self-help is not available to issuers.  Liquidity of the markets is more important than the woes of individual issuers; short selling is here to stay.

 

Even the absolute delivery requirement, which reads great in the press, is not absolutely absolute.  We note that the expression “ex clearing” does not appear in the SEC document.  What does appear is an immediate close-out and deliver position “if a participant of a registered clearing agency has a fail to deliver position at a registered clearing agency…”

 

Outside of the registered clearinghouses, there appears to be no record of how many trades remain uncompared at any given time.  Thus, there seems to be no clear way to challenge those corporate executives who rant in public about collusion between firms to run up and maintain invisible short positions in their stock.  If the SEC were serious about rooting out naked shorting and other abuses, they would require firms to record ex clearing contracts, to mark them to market, and charge them against regulatory capital. 

 

Thus, the new short selling release accomplishes a measurable increase in transparency – a good thing.  Outside of that, it makes permanent a prohibition against naked short selling – no one will argue there.  For the rest, as one market participant said, this monumental exercise appears to be “a fix in search of a problem.”

 

Or, to put it another way: this is the way the markets work.  You got a problem with that?

 

 

 

The Congressional Meddle Of Honor

 

Politics are very much like war.  We may even need to use poison gas at times.

- Winston Churchill

 

He’s Baaaaack!  Barney Frank, who once said it was worth taking on unknown risks in order to spur growth in the housing market, has now said it is advisable “to err on the side of caution” in imposing regulation and restrictions on the commodities, futures and derivatives markets.

 

The ban on naked trading of Credit Default Swaps (CDS) now under consideration may have the incidental effect of dramatically increasing the costs of borrowing.  To the extent the overblown CS markets represent an aberration – and even dramatically increased costs going forward would therefore be merely reversion to the mean – this is almost a a non-event.  For those who earn their living pushing these things around, though, it is big, big news.

 

As frightened as we are of as yet undiscovered abuses in the markets, we are far more scared of Washington.

 

Consider: our colleague, Andrew Barber, points out that, unlike securities regulations, “once you allow the camel’s nose into the tent on commodities, it gets international and global real fast.”  It is bad enough watching as Washington sinks its meathooks into the securities markets.  As anecdotal evidence that those charged with making our markets function properly do not understand those markets, we offer the latest news reports of Fed Chairman Bernanke’s net worth, which has fallen to perhaps under a million, from a reported range up to $2.5 million in 2007.  This is along the lines of our CEO Keith McCullough’s observation this morning (3 August) highlighting Nouriel Roubini now going bullish on commodities – copper is up over 90% year to date.

 

If Ben Bernanke can not parlay his market smarts into a substantial seven-figure portfolio – or if he can not parlay his banking and Wall Street connections into eight, or even nine figures – then why are we entrusting the world’s money supply to him and contemplating handing him an unprecedented level of control over the nation’s financial system?  Hank Paulson, now there was a guy who understood how money and markets function.  Why should a tyro be entrusted with the keys to the vault?

 

Following up on Andrew’s “nose of the camel” metaphor, it is now zero hour – midnight at the oasis.  We may want to instruct Sheikh Barney to send his camel to bed before it’s too late.

 

We watched Venezuela nationalize oil.  Will Chairman Frank give Chavez the opportunity to nationalize oil futures as well?  One thing we are comfortable predicting: once the Capitol Hill Pitchfork Brigade forces standardization and exchange trading of derivatives contracts, these contracts will become the next big product.  Watch for billions of dollars of issuance of derivative contracts aimed at the retail investor.  You were uncomfortable with Grandma buying oil and gas ETFs?  Wait until her broker puts her into CDS based on commercial mortgages. 

 

FINRA finally came forward with a timidly worded warning that certain ETFs are fiendishly complicated and possibly not appropriate for private investors.  They better start sharpening their pencils against the day when Series 7 registered stockbrokers start pitching CDS.  Many an average customer does not understand how a margin account works – alas, many an average broker either never bothered to explain, or can not explain to their customers.  Hands up, how many of you want these guys pitching derivatives to the public?

 

 

 

Gotcha?

 

For the record, since January we have been raising questions about ETFs.  In addition, our conspiracy theorist paranoia has led us into speculation tying these sometimes complex critters to the political tension – between, say, the US and Switzerland, which was not playing ball.  We don’t mean that Switzerland was not playing ball about tax cheats – that’s old news, and we wonder whether some lawmakers have had to scramble to shift their accounts to Liechtenstein or Vanuatu in advance of the assault on bank secrecy.

 

If you recall, our theory was that the US was leaning on Switzerland because they were dramatically under-invested in US Treasurys, at a time when our debt needed all the bolstering it could get.  Once launched, we speculate the tax inquiry took on a life of its own.  The announcement this week that UBS reached a settlement with the IRS came on the heels of the announcement that UBS was discontinuing the marketing of leveraged and inverse ETFs.

 

Not a moment too soon, as Massachusetts state regulators have started issuing subpoenas requesting (Wall Street Journal, 1-2  August, “Subpoenas Put Pressure On ETFs With A Twist”) “requesting information on sales of products, the revenues generated from those sales, and broker training and marketing materials.”  Followers of this Screed will recall, this is exactly what we have been warning about.

 

Tough break, UBS.  If only we could convince Barney Frank that these things are a good idea…

 

Moshe Silver

Chief Compliance Officer

 


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