Saturday, September 20, 2008

Markets Soar, but New Rules Upset Traders

Published: September 18, 2008

After a week of escalating panic in the markets, stocks soared for the second consecutive day on Friday, and many investors rejoiced. But below the surface, a new sense of turmoil set in. When Washington changed the rules of Wall Street, winners were turned into losers and losers were turned into winners, and both camps were left fearful about what would come next.

In a day of chaotic trading, the currents in the financial world changed course on Friday morning after the Bush administration moved to prop up faltering financial institutions.

Stocks that had been beaten down soared. Treasuries and gold, where investors had sought safety in recent days, plunged. Junk bonds shot up.

“Clients and advisers are almost giddy,” said Sallie L. Krawcheck, the head of Citigroup’s Global Wealth Management division. “It’s a sense of massive relief. Everyone feels like they looked over the edge and saw the abyss, and have been pulled back.”

The Standard & Poor’s 500-stock index soared 4 percent to 1,255.08, while financial shares rose 11 percent, in the busiest day of trading in the New York Stock Exchange’s history. The American International Group, which the government essentially took over, jumped 43 percent. Big banks like Bank of America and the Wachovia Corporationrose more than 20 percent.

But across Wall Street, many of the basic mechanisms of the marketplace broke down after the Securities and Exchange Commission announced on Friday morning that it would ban short selling in nearly 800 financial stocks, making it harder for people to bet against those securities, and that it also would force investors to disclose those trades. When investors sell short, they borrow shares and sell them, hoping to buy them back at lower prices and profit from the difference. Short sellers had come under fire for contributing to the sharp decline in financial shares this year.

Computers that automatically buy and sell for big investors hit snags because they were not programmed for such a restriction. Securities firms and money managers that routinely sell short to hedge against possible losses wondered how they would cope. In certain stocks and funds traded on New York Stock Exchange, some prices and trades were “erroneous,” a spokesman said.

The surge in financial shares was driven at least in part by traders who were forced to buy those stocks to cover earlier short sales, raising doubts about whether the rally will last.

Hedge fund managers who made vast profits betting against the nation’s financial titans called the ban unfair, and said the move would only prolong the financial crisis. Some traders said they were no longer betting on the intrinsic health of companies, but rather on what the government might do next. Others simply withdrew from the market.

“Some of my clients are literally closing their books and going on their vacation for two weeks — they can’t operate in this environment,” said Meredith A. Whitney, a financial services analyst. “You pack up and come back and play the game when you know what the rules are.”

One hedge fund manager, who declined to be named, likened the changes to “turning a football game into badminton.”

Many players warned that the government’s sweeping actions might have unintended consequences. The ban on short selling raised questions about how certain parts of the capital markets would function. Companies may have a harder time raising money by selling instruments like convertible bonds, which can be exchanged for shares, because many investors short stocks to hedge against the risks of owning these instruments.

Byron Wien, chief investment strategist at Pequot Capital Management, the big hedge fund, said that forcing big investors to disclose short positions could create a run on stocks. It might not be immediately apparent whether investors with short positions were using it to hedge another position or bet against stocks.

In the market for options — instruments that give holders the right to buy or sell shares at certain prices — traders reported frantic trading in Chicago and New York. Many big options traders, or market makers, must frequently sell shares short to hedge other trades.

“It was the most difficult day we have ever seen in the market,” said Peter Bottini, an executive vice president at optionsXpress, a brokerage. “We have had a very volatile day.”

William J. Brodsky, the chief executive of the nation’s largest options exchange, Chicago Board Options Exchange, lashed out at the S.E.C. “The need for the policy intervention notwithstanding, it is difficult to comprehend the merits of a draconian measure that will result in the sudden and severe removal of liquidity from the marketplace at the same time that the government is taking unprecedented steps to preserve it,” he said in a statement.

Later in the day, the S.E.C. said its staff had recommended that the commission exempt options market makers from the short-sale trading restrictions.

“People have definitely been saying that this is no longer an investor’s market, nor even really a trader’s market — it’s all entirely speculation on what the government is going to be doing next,” said a broker at a Wall Street firm, who was not authorized to talk to the press. “Anyone who thinks they have a handle on where things are going is deluding themselves.”

The immediate targets of the S.E.C.’s actions were short sellers, who have been blamed for the plunges in the stock prices of large investment banks like Morgan Stanley andGoldman Sachs. To many observers, shorts were to blame for the collapse of Bear Stearnsand the bankruptcy of Lehman Brothers; the government takeover of Fannie Mae andFreddie Mac, the mortgage finance giants; and the $85 billion bailout of A.I.G.

The world of deal-making was turned upside-down by the stock market rally, as mergers like Merrill Lynch’s $50 billion sale to Bank of America, struck as Lehman Brothers slid toward bankruptcy last weekend, could unwind. Arbitrageurs, investors who bet on the outcome of deals by buying shares in the target company while shorting those in the seller, were unable to play one side of that trade.

Some hedge fund managers complained bitterly that they had been singled out, even as they were among the few to properly manage risk. Those whom the government had propped up were the investment banks, whose hundreds of billions of dollars in losses arose from reckless risks undertaken to raise profits to hedge-fund-like levels.

“Bailing out the banks should not be done,” said Carl C. Icahn, the activist investor. He suggested that the government should have extended those firms a loan, instead of buying their toxic mortgage-backed securities.

In the end, the market closed on Friday at nearly the same price it did last week before all the mayhem. An e-mail message circulating around Wall Street on Friday carried the subject line: “If you took the week off ... you didn’t miss anything.”