Ignoring SKF Tipping-Point, SEC Slams Free Market
September 29th, 2008
By Max Rottersman

HANOVER, NH (ETFguide.com) - In nine short months, investors rushed $3.3 billion into UltraShort Financials ProShares (AMEX: SKF).   Any reader of the best-selling non-fiction book The Tipping Point would have come to a natural conclusion.  Investors saw trouble.

But not the SEC. They so badly regulated the financials that rumors sent volatility off a cliff.  Injuring long-term confidence in free markets, the SEC banned the short-selling of 799 stocks.  The government decided who would win and who would lose on September 19th.   

Unforseen effects began to ripple through the ETF market. There were failures to maintain a small spread between ETF prices and NAVs.  There were liquidity problems; shares could be redeemed by APs, but not created.  Counter-party risk raised its ugly head. 

Below we can re-live, for that period, the market-price to NAV relationship for SKF.  As a quick refresher, the NAV, or net asset value, is what a valuation service expects an ETF to cost if you added up the prices of its holdings.  

By the 17th the market for financials was becoming unhinged.  

Christopher COX of the SEC said, "The Commission is committed to using every weapon in its arsenal to combat market manipulation that threatens investors and capital markets."  

Yet if the problem was market manipulation, doesn't the SEC have rules and methods to prevent it?  

Could it be that the root cause of the market volatility was not the mythical short-selling market manipulator, but the SEC's itself?  Why didn't the SEC confront the troubled financials about their balance sheets?  If, months ago, the SEC had moved Bear and Lehman into voluntary, PR-frendly bankruptcy, wouldn't the markets have remained calm?  We can understand a guy like Richard Fuld wanting to hold onto their job to the last possible second, but was it in the public interest to let these companies continually say everything was okay when we now know they weren't?  Either Sarbanes-Oxley should have put someone in prison or the SEC should explain how a company can go bankrupt in a week. (I'm not arguing that executives should go to prison).

Once again, in a repetition of the Enron fiasco, the SEC adhered to its unofficial policy that it will work on big frauds at small companies, little frauds at big companies, but never big frauds at big companies.  Former SEC investigator Gary Aguirre was fired in 2005  because he wanted to depose Morgan Stanley big-wig John Mack.  Not that anyone was surprised.  SEC executives move back and forth from high paid jobs on Wall Street.  Their world view is grossly distorted, if not corrupt.  After reading the Inspector General's Audit from September 26th, about SEC lapses with Bear Stearns, the Chairman of the SEC said, "The last six months have made it abundantly clear that voluntary regulation does not work."  Did he sleep all the way through Enron, Worldcom and Global Crossing?

An executive at a Financial company has nothing to gain and everything to lose through bankruptcy.  Richard Fuld earns about $3 million a month.  Why would he admit bankruptcy if he didn't have to?  Why would anyone in his shoes voluntarily give up that kind of money?  What one can't understand is why the SEC allowed him to bet his pay-check against our economic health.  By letting things get so bad that the SEC would have to ban short-selling, the SEC allowed Fuld, and many others, to walk away with maximum compensation.  But the short-seller who bets with their pocket book goes away empty handed.  How can capitilism succeed if the guys who are right don't get paid and the guys who are wrong do?

Blind-sided by the abrupt SEC action, Amex had to suspend trading on SKF while they sorted through the implications.  Though trading resumed in the afternoon the NAV ended at a market-stressed value of $85.95, which put the share price about a 17% above the NAV. 

The SEC had created panic among ETF investors. A sample of trader chatter on the Elitetrader forum, "I just spoke with my firm's tech support. SKF was halted....and whether they break or not the trade after the halt is all up to NASD. I hope it breaks... what do they usually do in circumstances like this?...ProShares telephones are off the hook...won't this paralyze the derivatives market?...Yep, and it will undoubtedly raise the cost of 'hedging'...The SKF folks use counter-parties with swaps in order to construct the SKF...These swaps just went WAY UP in price ( with the counter-party ) because of the inability to short the financials and this is what the freaking Govt. has no clue about."

The bottom line is that through SKF the ETF investors have been right from the beginning.  The SEC brutishly silenced the shorts, but history will show that is was the SEC, not the short-sellers, that created fear in the markets.  If the SEC had stood up to those large companies last year we'd be in a mess, but not a panic. 

The Emergency Economic Stabilization Act of 2008 is similarly rushed.  In the future look to ETFs for the expected outcome of that.

Max Rottersman is a partner of Hanover Technology Group, LLC. His opinions don’t necessarily represent the views of ETFguide.com or Yahoo Finance.