Today In Silver

The SEC’s crusade against shorts is a joke
Paul R. La Monica (CNNMoney.com Editor)
October 2, 2008

In this piece, Mr. La Monica argues with facts that the SEC’s emergency ruling to ban all short sales of financial institutions has done nothing to stop the slide in their share prices. I would just add that the ban on short selling has actually made the prospects of a quick recovery in share prices much less likely. Here are some excerpts from Mr. La Monica with my responses:

In the latest head-scratching move from the Securities and Exchange Commission, the agency announced late Wednesday that it was extending the “temporary” ban on short-selling financial stocks, which was set to expire just before midnight tonight.

Actually, it isn’t a “head-scratching move” at all, it is a purely political ploy, a market intervention that for once has actually come from the Plunge Protection Team as opposed to all those supposed PPT interventions in the past that were nothing of the sort.

The SEC issued its edict against short-sellers, who borrow stock and sell it with the hopes of buying it back later at a lower price to pocket the difference, on September 19, just days after Lehman Brothers (LEHMQ) filed for bankruptcy and AIG (AIG, Fortune 500) essentially collapsed.

At the time, the SEC said that the action “calls a time-out to aggressive short selling in financial institution stocks, because of the essential link between their stock price and confidence in the institution.”

The SEC added that “unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation” and that “financial institutions are particularly vulnerable to this crisis of confidence and panic selling because they depend on the confidence of their trading counterparties in the conduct of their core business.”

But guess what? In the past two weeks, despite the ban on short-selling financial stocks, the crisis of confidence has deepened and shares of most financials have fallen even further.

The S&P Banking Index has plunged 11% since September 19, while the S&P Insurance Index has dropped 12%.

Clearly, the crisis of confidence did not originate with short sellers, nor did the short sellers do much (if anything) to make it worse.

The SEC, in its statement about the extension of the ban last night, explained its case for the ban even more clearly than it did two weeks ago.

“There are circumstances in which short selling can be used as a tool to mislead the market. For example, short selling can be used in a downward manipulation whereby a manipulator sells the shares of a company short and then spreads lies about a company’s negative prospects,” the SEC said.

“This kind of manipulative activity is particularly problematic in the midst of a loss in market confidence. For example, in the context of a credit crisis where financial institutions face liquidity challenges, but are otherwise solvent, a decrease in their share price induced by short selling may lead to further credit tightening for these entities, possibly resulting in loss of confidence in these institutions,” the SEC added.

This may be true. But shouldn’t the SEC more aggressively go after the short sellers that are actually committing fraud instead of banning the entire practice?

The fact that the SEC is resorting to an outright ban is just further proof of how ineffective it has been in dealing with the crisis. It can’t find the actual crooks so it’s going to just punish everyone that happens to be a short seller.

And it is the SEC that got rid of the uptick rule last year, making it easier for shorts to keep selling a stock while its on its way down. The uptick rule was first adopted in 1938 to prevent bear raids…exactly what the SEC is trying to stop from happening now. Why not bring back the uptick rule?

Finally, the SEC interestingly conceded that short sellers do play an important role in the financial markets by “increasing market liquidity, promoting capital formation, facilitating hedging and other risk management activities.”

That last comment is worth thinking about when you consider the mechanics of short selling. If someone shorts a stock, they do have to buy it back someday.

That purchase, in theory, should eventually help boost the price back up, especially if shorts get squeezed, i.e. if they rush to cover their positions and buy back stock they’ve shorted all at once.

In addition, many investment firms rely on short selling as a hedging technique. And if they no longer have the option to short financial stocks, they probably aren’t inclined to buy, or go long, on those stocks either.

So by banning short selling on financials, the SEC may have created an unintended consequence of reducing demand to buy shares.

Investors that might have been interested in purchasing financial stocks have instead decided to sit on the sidelines and wait for the ban to end before wading back in to the sector.

Bravo, SEC on a job well done.

Couldn’t have said it better myself.

silverax PM Comment Links

The Great Gold, Silver Conspiracy Explained
Mike Shedlock
August 27, 2008

Mike “Mish” Shedlock takes no prisoners in his blast at conspiracy theorizing in the gold and silver camp. While much of his logic is dead on, he does flippantly dismiss several factors that deserve more analysis. For example, the large short position by the two “U.S. Banks” constituting Ted Butler’s “naked gun” does not appear merely to be a matter of longs and shorts doing their thing in the futures markets (it could turn out to be that but right now it does not appear that way).

Similarly, what we recently saw in the silver market, where the price traded down dollars at a time in illiquid electronic markets yet market orders were filled with almost no slippage, does not appear to be merely a matter of longs and shorts doing their thing.

Furthermore, Mish states the following: “When a long sells his position, a short automatically covers.” This is either ignorance or gross oversimplification. A long, of course, may sell his position to another long. In fact, the only way to determine whether a long is selling to another long who is establishing a new position or to a short who is covering a short position is by looking at open interest. But since the open interest figure is only available on a daily basis, as an analysis tool it is more often a sledgehammer than a scalpel. Still, that doesn’t mean we should ignore it.

Also, Mish has no answer for why silver “lease” rates are negative, which clearly means he does not understand that these “lease” rates have nothing to do with actual leases at all. As most of my readers know by now, the gold and silver “lease” rates are simply the arithmetic difference between LIBOR (London Interbank Offered Rate) and the LBMA forward rate (the price at which metal can be purchased for delivery on the LBMA in 1, 2, 3, 6 or 12 months). The main reason the silver “lease” rate is negative today is because LIBOR has decreased faster than the forward rate on silver. This has several implications but perhaps the most obvious is that the balance between forward demand and supply of silver has shifted toward the demand side. In other words, there is currently less forward supply of silver to meet forward demand then there was a couple of years ago. That makes the silver forward rate very close to that of gold (whose own low “lease” rate is partially a reflection of gold producers not wishing to sell production forward).

Is the negative “lease” rate due to fraud or manipulation? Not in my opinion. There are a number of reasons that account for the recent shift. One is the reduction in the volume (supply) of silver being “leased”. Another is the buying of “silver streams” by Silver Wheaton which means that a growing number of base metal or gold miners no longer have the “need” to sell forward their by-product silver production. Notice this is a similar situation to the lack of forward selling by gold producers in the past couple of years.

This is rich subject and I can discuss it ad nauseum, but I’ve already done that in the past (see my exposition [PDF] on “leasing”) so I would prefer to answer only specific questions, which I will do in response to any comments on this post.

silverax PM Comment Links

A Fabrication Bottleneck or Something More
James Turk
August 17, 2008

Mr. Turk makes some very good points here. He confirms my recent observation about the huge disconnect between retail and wholesale bullion. He points out that leverage in the paper market is primarily responsible for the bloodbath. He shows us log price charts that indicate gold and silver are very close to long-term trend support. He wonders if the lack of supply at the retail level, not only in the U.S., Canada and Europe but in India as well, portends a sharp V recovery in PM prices, especially after the U.S. elections in early November.

His best idea, however, is that the rise in premiums on retail bullion can be viewed as a form of backwardation, as can the lack of availability. I hadn’t really thought about it this way before but he is absolutely right. If there was a price chart for silver Eagles or 100 oz. bars, it would show a growing gap between the price of futures and the price of retail bullion products.

Bear with me here. Actually calculating this type of basis is a bit different from the one we can directly derive from the spot and futures markets. Spot silver or gold does not have a manufacturing or dealer premium (unless bought from a dealer of course). Retail gold and silver does. Typically that premium is expressed as spot + X cents or dollars. Another way to look at fabrication and dealer premiums would be as a percentage of the spot price. Both have their advantages and disadvantages when making historical comparisons. It might be possible, however, to somehow combine the two and establish what the average gap between futures and retail bullion prices has been over time. Or perhaps more simply, we can look at just the gap between retail bullion prices and spot prices.

If wholesale backwardation can be defined as spot (wholesale) bullion prices rising over futures prices, then perhaps retail backwardation can be defined as retail bullion premiums rising over their highest historical average (throwing out the extremes like 1979-80 and 1999). I haven’t completed even a back of the envelope calculation using either cent/dollar or percentage premiums, so I can’t say for sure that, according to such a definition, we are now in retail backwardation. But let’s remember that a key feature of backwardation is a tightness, even lack, of available physical supply at a given price. Isn’t that effectively what’s happening here with retail bullion?

I’ve decided to go back and look very carefully at my spot-futures basis data over the past few days to see if there are any signs of abnormality. There has indeed been a decrease in the contango (the basis has fallen toward backwardation but is still in contango) but frankly not as much as I would expect if there was robust physical demand in the spot market while COMEX and other paper markets were being aggressively sold. It is not at all unusual for the basis to contract and expand right before and during major price moves. We are certainly seeing that now. But there is no official backwardation (yet) in gold or silver. We could see some interesting developments in the days ahead, though. I will try to keep my eyes on this (and a bunch of other things).

silverax PM Comment Links, Windbag Wisdom PM Comment, Turk, Windbag