Bank of America (BAC) update #2—SEC Halts Short Selling of Financial Stocks

Wow, what a difference a week makes.

Bank of America (BAC) shares closed at $37.48 Friday, up 23% on the day and up 50% from Tuesday’s $25 close. The surge is attributable to optimism that the government’s plant to create a fund to purchase toxic assets will be approved by Congress and save the bacon of the (probably) insolvent banks combined with the effects of the SEC’s announcement on Friday that short-selling of financial company stocks has been banned through 2 October on an emergency basis. And indeed, we are now under water on two of our four bank shorts (BAC and HBSC Holdings), and even Goldman Sachs (GS) and Wachovia (WB) were up sharply although we are still ahead on those two.

While we are now ruing our decision not to cover our Bank of America short on Monday (when we were 23% ahead), it is leavened with the realization that while today would have been a great opportunity to resume the position, we would not have been allowed to. (We are allowed to maintain our previously existing positions, however.) We think the proposed government plan to, in effect, bail out the banks for bad management with taxpayer money by buying their worthless toxic assets is a terrible idea. These companies irrationally bet that real estate prices would go up forever and the way capitalism is supposed to work is that when you screw up, you suffer the consequences. Bailing these companies out with taxpayer money would reward failure, keep broken institutions in business that we’d be better off without, and deepen the financial hole the government itself is in.

We hope that the plan is rejected by Congress, but even if it is not, we don’t believe it will work to prop up the value of these failed companies. There is no way the government can afford to purchase all the toxic assets out there unless they are valued at a steep discount, and doing that probably will cause many financial institutions to skirt dangerously close to insolvency (as opposed to holding onto the assets marked at book value in the hope that they will eventually recover value, or else that the overall financial condition of the institution in question will improve enough to render the issue of the valuation of the assets a noncritical issue).

As for the ban on short selling, it reflects the SEC’s agreement with our thesis that [a] the level of systemic risk here is high and [b] in the shadow of potentially high risks, valuations for those financial firms under pressure are likely to gyrate wildly (as we have recently seen in the cases of Bear Stearns, Merrill Lynch, Lehman Brothers, and AIG…if we had been really smart, we would have been short all those companies!).

So for now, in the knowledge they are irreplaceable and the expectation they will still payoff big, we are holding firm on all four of these short positions.