Did Short Sellers Attack this Market? Could Be

So it seems that the Brits outlawed shorting bank shares and AG Cuomo may put some shorties in jail. I read somewhere that some shorties may have did some rumor mongering while shorting Morgan and Goldman stock at the same time as they were buying up the Investment Banks Credit Default Swaps.

If you think about it that trade it would be like profiting from a drop in the stock that you are causing yourself. CDSs seem to be like any other asset that is subject to supply and demand. So if you drive up the CDS prices then start to pull your money out of a highly leveraged investment bank like Morgan you create both the cause and reap the bonus from the effect at the same time. Many CDSs were going nuts in the last few days for both Morgan and Goldman.

Five-year credit default swaps on Morgan Stanley rose by 40 basis points to 796 basis points, or $796,000 a year to protect $10 million of debt, while Goldman's swaps rose by 16 basis points to 462 basis points, according to data from CMA DataVision.

As of late Tuesday, Morgan Stanley's credit default swaps were trading as though it were rated deep into junk territory at "B2," according to data from Moody's Investors Service's credit strategy group. That is 10 steps below its actual rating of "A1."

Goldman's swaps were rating as though it were rated "Ba3," a junk level that is nine steps below its actual rating of "Aa3," Moody's added.

How can Morgan's credit be trading at junk status when they have $77 billion in cash and having just had a quarter that beat the Street to the tune of $1.43 billion in earnings? No rating agencies were talking about downgrading their debt as far as I can tell. Even if they did downgrade their debt it wouldn't be by 10 steps from A1 to B2.

The Goldman news was even weirder to me. It is the top Investment Bank in the world with $98 billion in cash. How can their credit trade as if it dropped from Aa3 to Ba3 so quickly? I have to agree with Cramer with his take on Goldman.

"Goldman has no home equity loans and car loans. Goldman does not have exposure to the parts of the economy that are bad," he said. "No one's listening to me that I think Goldman is fine."

Goldman doesn't have billions in toxic debt on their books like Fannie and Freddie or billions in underwater commercial real estate like Lehman did. So there would be no real reason at all why their credit was suddenly 9 steps more expensive in like 2 days time.

So the cause and effect thing could have gone down like this. The hedge funds (or whomever) bought the CDS of Goldman and Morgan like mad. This drove the price of the CDSs up so high that the media starts saying things like "look, it costs $796,000 a year to protect $10 million of Morgan debt. They must be in big trouble."

Morgan has $447 billion in debt outstanding so they would need $35 billion in capital (If my math is right) to insure that amount of debt. That means that $77 billion in cash will only be enough for like 2 quarters. Don't think about the fact that Morgan can and has serviced this debt all this year when there was one crisis after another. They just could not at this moment because their CDSs were driven up to artificially high levels. So Morgan has to scramble fast for capital from a Wachovia merger or China or whomever just to keep afloat.

So then these funds get to go short the stock without having to borrow it or wait for an uptick. After that they pull their money out of Morgan thus causing a crisis of confidence. A mini-bank run if you will. Then they spread a few rumors that Morgan will go out of business just like Lehman since everyone is pulling their money out at the same time, they can't service their debt, $700K for each $10 million, pairing with Wachovia is a bad move, etc.

These funds know that the government will not bail out Morgan because they let Lehman die earlier in the week. So these funds are safe to continue to buy their CDSs while shorting the stock since no one will step in to save the company. They only risk losing the amount they paid for the CDSs (I'm not sure if they get that back in a liquidation) with the chance to wipe out all of the equity in the stock.

The hard evidence is that the market went up almost at the same time as pension funds stopped lending out the stock and these funds had to close the trades. I think the New York State Common Retirement Fund and Calpers both stopped in the same hour period.

So message to Congress, McCain, Bush, Obama, Paulson, and the Man-In-The-Moon: Regulate the CDS market before you bail anything else out. That is the key before Goldman and Morgan are both killed as well.