Fractional reserve speculation

Fractional reserve lending, as "Sonus" explains so clearly here, became possible when people accepted receipts for gold as payment, instead of insisting on having the gold itself. This opened up an exciting opportunity for the guardians of gold and silver; they could issue receipts for which there was no gold or silver at all, and get other people to accept them as payment. Then we ended up with a world in which you could borrow money that didn't exist, but when the scam burst, you'd have to pay it back with the roof over your head. Now there are voices calling for the return to money actually backed by something that might limit its growth; this will pass.

In much the same way, speculation in shares has changed. Once, investor A bought a share in a company from B, held it and received dividends. But the financial market exploded when it became possible to trade in shares without actually having the certificates.

Speculator C can "short" a share - agree to sell it to A (without yet having ownership) for $1, later buy it from B at 5oc (he fervently hopes), then when settlement time comes, A ends up with the share and C pockets the profit less trading expenses. (C can also "go long": agree to buy a share from B at 50c, sell it to A for $1 later, then comes settlement time when the share ownership is officially transferred).

C can multiply his bet if he trades "on margin", in effect making only a small down payment on his share speculation. If the margin is 10%, then he can (promise to) buy or sell 10 times as many shares, and (if his judgment is right), make 10 times the profit when settlement is made.

C experiences success in conditions of a bull market and expanding money supply. C is now trading in big, big quantities, with shares he doesn't own for most of the time, and cash he mostly doesn't have. C has gone beyond mere shares, and is simply betting on movements in the market. C has become a trader in derivatives; in effect, a high-rolling gambler. What a wonderful world! So much nicer than the school he went to! C has an abundance of worldly goods, worldly girlfriends and envious colleagues who laugh at his jokes. C has taken to introducing himself on the phone as "Nick with the big swinging d*ck". C is young, and has never known things to be different. C is complacent; C has become reckless.

But oh dear, if some of his enormous bets go wrong. C has losses, multiplied by the inverse of his margin, plus his trading expenses. Maybe C doesn't have enough money in his account to cover his losses. Maybe C has been trading with another gambler, D, and now can't pay him. Suddenly D is in trouble, too. And both have also been playing around the green baize with traders E, F and G; maybe with the whole alphabet of gamblers, maybe with the Greek and Cyrillic alphabets too.

But before he busts himself (and possibly his employer into the bargain), C has influence (since it is known that he never gets it wrong - until the day he does): news of his bets affect the market, especially when the market is nervous. When C shorts a share big-time, he can start a run - even if the company was basically OK before then.

Which is why Denninger is now calling for a return to the custom of getting the stock certificate when you buy the stock.

Good luck with that; and with ending fractional reserve banking. Denninger argues against the latter here, and prefers a system of minimum cash margins; perhaps it would be more logically consistent if he advocated the same for short-selling.

Personally, I'd go for whipping the money-changers out of the temple; but they always return.

Paulson gets super-rich on short-selling

It's an ill wind... No relation to Hank, I suppose.

Worrying signs

Knowing that debt creates extra money and so boosts inflation, The Mogambo Guru notes that the Chinese now have 1.58 billion credit cards! For some reason, TMG thinks we should look at gold and silver.

Karl Denninger points out that short-selling actually acts as a kind of price support in the market, since ultimately the short seller has to buy the shares he's sold to someone else; and so the new ban on short-selling selected financials has removed the floor beneath them. Jim in San Marcos found he couldn't do any short-selling in that sector for three hours yesterday, and doesn't know whether that means we're looking at free-fall or a sudden rally. Either way, it seems to prove the point that banning short-selling increases volatility, the sensible investor's enemy and the gambler's fatal siren.

If two views make a market, does silencing one leave the other free to become a whimsical dictator?

Blaming the prophets

In this week's Spectator, Christopher Fildes discusses the way short-sellers get blamed for market falls, although they take hair-raising risks in doing so. He paraphrases Fred Schwed on the unfairness of such criticism: "In good times, he said, nobody minded the short sellers except their families, who minded going bankrupt. In bad times they were a receptacle for blame." I'd go back further:

But who wants to be foretold the weather? It is bad enough when it comes, without our having the misery of knowing about it beforehand. The prophet we like is the old man who, on the particularly gloomy-looking morning of some day when we particularly want it to be fine, looks round the horizon with a particularly knowing eye, and says:

"Oh no, sir, I think it will clear up all right. It will break all right enough, sir."

"Ah, he knows", we say, as we wish him good-morning, and start off; "wonderful how these old fellows can tell!"

And we feel an affection for that man which is not at all lessened by the circumstances of its NOT clearing up, but continuing to rain steadily all day.

"Ah, well," we feel, "he did his best."

For the man that prophesies us bad weather, on the contrary, we entertain only bitter and revengeful thoughts.

"Going to clear up, d'ye think?" we shout, cheerily, as we pass.

"Well, no, sir; I'm afraid it's settled down for the day," he replies, shaking his head.

"Stupid old fool!" we mutter, "what's HE know about it?" And, if his portent proves correct, we come back feeling still more angry against him, and with a vague notion that, somehow or other, he has had something to do with it.

Jerome K Jerome: "Three Men In A Boat", Chapter 5

So, don't blame me, please, but I still think investors won't be out of the woods until 2010.