Saturday, September 20, 2008

The Problem of Falling Share Prices

Readers Question: Due to recent events, the concept of short selling has been explained here and elsewhere, however, one thing that I don't understand is why driving the share price down necessitates an immediate bail-out or a merger of a bank.

Surely unless the bank has an immediate need to raise capital by issuing shares, it could just sit out the period of short-selling? I understand that low share price makes a takeover more attractive, but many such takeovers appear to be more a result of encouragement by government.

For many firms this would be true. The problem is the banks being 'shorted' actually needed to raise finance on the stock markets or in the money markets. For example, HBOS was so short of cash in the summer it is issued a share issue - trying to raise money by selling more shares; this was only partially successful, because people doubted its long term financial health.

The problem is that the bank's have balance sheets which rely on being able to raise funds on the money markets. In other words, they financed their loans and mortgages by borrowing on the money markets. When money markets froze they were in a pickle. The problem Northern Rock had was that it was simply unable to raise enough funds on the money markets (interbank lending) to meet its immediate need.

Also, the problem is that the short positions encourage people to sell who otherwise wouldn't. If people are betting the share goes down, who will want to hold onto them? Then, if a share price falls by 80%, financers feel that this bank is not a safe investment, therefore, no one will want to lend it money and then it will have further difficulties raising funds on the money markets.

It was hoped that Lehman Brothers would be able to raise enough finance to deal with its shortage of funds. However, at the last minute Korean investors pulled out not wanting to commit to a bank on the verge of going under. Maybe, if there hadn't been short selling and an aggressive decline in their share price they would have lent the money Lehman Brothers needed and just possibly, they would have been able to ride out the storm.

Some may say, they would have gone bankrupt even without short selling driving their share price down, and this is probably true. But, if HBOS share prices were driven down to 10p, it starts a panic to sell shares and no one wants to lend to the company. This only increases the chance it will become insolvent.

This is my understanding; although it is not my area of expertise.

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