Bear squeeze blues: How to destroy a bank

Set phasers to 'short sell'

Comment With the banks apparently unable to cope with the markets anymore, the poor dears, short selling has been banned to protect them. HBOS is being taken over cheaply, even compared to what a mortgage bank is worth in this rotten market. Allegedly, "spivs" conducted a whispering campaign, and used short selling to make money out of misery. It is nearly true.

If you had known in advance that Northern Rock was doomed, you could have made real money. But insider dealing wouldn't have helped you since the "insiders" didn't seem to know what was going on until it was too late. The Lehman collapse seems to have been partly caused by executives refusing to take a catastrophic write-down in their personal wealth, betting that they were too big to fail. So inside information here would have been hard to use.

Of course, if you cause the bank to go down, then you have the most perfect of insider information - so how would you do that?

Short selling is just a bet that the price will decline; you sell stock you don't yet own, and hope that when the time comes to deliver, the price will be lower. Outside the markets it has few friends, although it is a critical component in getting better returns on money for lower risk. A traditional bet on a horse does not make it run faster, at least in an honest race, but every part of a company's financial profile interacts with the others.

Hedge funds have made respectable money shorting financial stocks and using the proceeds to go long on energy shares, at lower risk than simply buying shares in oil companies. The greater risk efficiency of HFs is the reason that on average they have grossly outperformed "long only" traditional fund managers - and as any student of finance will tell you, the only consistent performance is under-performance. And yes, before you ask, that is where a large chunk pension of funds are invested.

As banks don't sell beer...

Every company has a set of credit ratings; how likely it is to default on its debts in a given range of time. The longer you lend money, the more exposed you are to a default, and so there is often an extra premium for lending for the longer term than for shorter periods. The core job of any bank is to do just this. Banks borrow in the shorter term, sometimes literally overnight, and lend over years. Without this we could not have mortgages, or finance infrastructure projects where there is no revenue from the investment for as much as ten years.

The greater the difference in time between how long you lend for and borrow, the more money you make, on average. However, with this greater return comes greater risk, which Northern Rock simply ignored.

When an individual lends money to a bank in a deposit account, they enjoy government guarantees, which commercial lending usually did not, so the NR debacle started when became clear that if you lent money to NR, the chances of getting it back were dropping sharply. NR was exploiting the short term money markets, and although even the FSA spotted the high risks involved early, it didn't want to annoy them - so the banks ignored it until this hit them in the face. Short-term markets are of course a bad place to be when you suddenly find yourself without enough cash to pay what you owe in the longer term.

If you happened to have a short position in NR early enough, you did pretty well - but few did. Still, the idea was clear enough - if a bank is perceived to be on the slide, the next dip in the stock can actually be caused by the most recent downtick.

The next villains in this mess are the ratings agencies. Their job is guessing the odds of a debtor not paying back debts, whether that is bonds, or payments to suppliers. This is an eclectic mix of accountancy and PhD-level mathematics, though of course it is mostly done by MSc-level people at ratings agencies, trying to vet the maths of PhDs. Guess how well that ends? The MScs are not only cheaper than PhD Quants, they ask fewer awkward questions. The agencies are paid by the issuers of debt instruments to give them a rating which is critical to the value when they are sold. Yes, you read that correctly.