So, what does the banning of short-selling mean to the market?

It’s a good question. In our view, short-selling is no more to “blame” for markets falling than long buying is to blame for markets rising. In other words, it does have an impact on the downside but only as far as it adds to the number of sellers. It is not the sole reason for a share price falling.

We keep hearing commentators and analysts tell us that the likes of ABC Learning and Babcock & Brown are fundamentally strong companies. We are told that they hold great assets and that the market is failing to recognize it.

a couple of months ago that it was a misleading argument. Sure, these companies may have good assets, but that is only one side of the balance sheet. Don’t forget about the debt on the other side. If we only concerned ourselves with the assets then share prices would never go down.

Cause and Effect
It is easy to confuse cause and effect. Short sellers aren’t the cause of a share price falling. The cause is due to something that the company has or hasn’t done. The effect of the company doing (or not doing something) leads to investors selling those shares. In some cases this will involve investors short selling.

In reality, the ban on short-selling is likely to have almost zero impact. There may be short term price action to the upside as those who currently have short positions buy back the stock to close out. Secondly, those investors that use short selling to hedge a long position may choose to close out their long positions, which could put pressure to the downside.

But for those professional investors wanting to trade ’short’ they need look no further than the Options market. Options traders will be able to implement reasonably simple strategies that will give them almost exactly the same exposure as if they had used the share market to short sell.

In financial terms they call it a “synthetic short.” By simply buying an ‘at the money’ Put Option and writing an ‘at the money’ Call Option the trader can replicate a short trade. It is not exactly the same, but if an investor really wants to short particular stocks it is an easy way to do it.

The bigger question is what will happen to the markets next. We all have an interest in share prices rising, but are we really interested market manipulation?

ASIC and the ASX have rules against investors falsely manipulating the market. Yet its actions to restrict short-selling are doing exactly this in the short term. The banking stocks again look likely to be the main beneficiaries of this policy when they eventually start trading this morning.

What Happens When the Party is Over
The party on the stock market will doubtless continue today after Friday’s celebrations. But as is usually the case with a big party, there are plenty of hangovers.

Governments and regulators have thrown everything at the markets over the past week to try and ‘fix’ things. It may work. But if it doesn’t they haven’t left themselves with many other options.

All Roads Lead to Beijing

Section One:
We all know the China story. We see the consequences of it on our stock market five days each week, BHP and Rio Tinto rise and fall as commodity prices rise and fall. Even when the US market is rising and falling there is the tendency to draw everything back to China and its economic prospects.

All roads lead to Beijing.

The question which everyone wants answered is ‘Will China continue to grow?’ The Chinese government enforced the closure of many industries leading up to the Olympic Games as it attempted to improve the air quality for athletes. Now the Olympics are over it is game on again for China and for its industry.

The amount of construction in China cannot be overstated. It only took watching the Olympic road cycling races or the marathon on TV to see the sheer number of uncompleted building projects in Beijing.

Today in Shanghai, China’s tallest building will be officially opened. The 492 metre, 101 storey Shanghai World Financial Center is the worlds third largest building after the Dubai Tower and Taipei 101. According to the owner of the building, Minoru Mori “total office space in Shanghai is not so large, there is not enough taking into account the business potential of the city. If you supply a good space, then the demand will follow.”

We admit that a statement like that sounds like a property bust waiting to happen. But not yet. And possibly not for a long time yet.

One thing that is often overlooked is that China still has an enormous rural economy. A rural economy where the average annual income is little more than $600. Even in the urban areas the average wage is only about $2,000 per year.

China isn’t standing still. The wages growth for Chinese farmers was 10% for the first six months of this year. Rural wages will need to grow too.

The last thing that the Chinese government would want is for the countryside to be emptied. Now, that’s the extreme and in reality it isn’t going to happen, but the point is that rural wages cannot afford to be left behind. Rural Chinese citizens will need an ever greater incentive to stay rural as the cities become bigger and richer.

That among others is one of the next big challenges for China.

The Most Important Story This Week:
The gold price has rebounded recently following a brief period under USD$800. It wasn’t that long ago that it was trading above USD$1,000, so which way is the gold price going to go next? Money Morning technical analyst Gabriel Andre gave his view on that during the week. Gold to Test Support

Monday: Rule 1. When taking over as CEO of a company make sure that you shift the blame for all the bad stuff on the previous mob. ANZ in Denial

Tuesday: With net profit totaling just $556 million, down from just over $1 billion the previous year, Suncorp has maintained its dividend payment at $1.07, which means that it has a dividend payout ratio of 183%. Financials, Is It Safe?

Wednesday: just like the BHP Billiton results, much of the earnings increase has come as a result of commodity price increases. While that is fine, and it deserves it having suffered through periods of low commodity prices, there is little in the results that would convince BHP that it needed to pay any more than is already on the table. Rio Tinto Releases Results

Thursday: Macquarie may not have the same exposure to leveraged funds that Babcock & Brown [ASX:BNB] has, but it is still being dragged down nonetheless. It is going to take a complete cleanout of this sector before investors can start to have any confidence in companies that have any association with leveraged infrastructure funds again. Not So Big Macq

Implosion of Babcock & Brown
It has been quite an interesting week. Record profits for BHP Billiton. Big profits for Commonwealth Bank of Australia. Talk of interest rate cuts in September. Increase in profits for Qantas.

But the story that has interested us for a lot of this week has been the implosion of Babcock & Brown. It is part of a story which we have been musing on ever since our days with The Daily Reckoning. Back then we expressed some concerns about the sustainability of infrastructure funds and the business model that they operated under.

Of course, Babcock & Brown is or was one big fund, a hedge fund, not a “small investment bank” at all. It has all the characteristics of a hedge fund, which in hindsight made it the first hedge fund to be listed on a stock exchange.

It borrowed money from investors (in this case shareholders), just like a hedge fund. It borrowed a stack of cash from banks, just like a hedge fund. It sought to take over or take control of large assets; it was not afraid of leveraging its position; it was prepared to pay a premium for an asset providing it believed it could still make a profit; it sought to resell assets back to the public; and most important of all, it paid executives massive performance bonuses based on profits… all just like a hedge fund.

What surprises us is that they managed to get away with a flawed business model for so long.

The amusing end to this charade is that based on the investor presentation on Thursday, B&B truly seem to believe that they have reorganized the company so much that it is a completely different beast. Not so. Part of the supposed reorganization trumpeted on Thursday was the change to the board. You don’t even need to look at it closely to see that it was just musical chairs. Six of the eight members of the ‘new’ board served on the previous board. Then if you add in the new CEO Michael Larkin who was previously CFO then you have seven board members with an indelible link to the current woes of the company.

One of the management changes was to create a new role called Chief Investment Officer. The person to take up this position is B&B’s current Head of Global Infrastructure; surely the very man who has ably assisted B&B to get to the position it is in now.

The company looks more and more like a secret men’s club the longer you look at it.

There is so much more that we could make comment on, but there just isn’t the space to do so. Therefore, the final comment we will make is on the salaries for senior executives at B&B, just in case you are not yet convinced that the company was and probably still will be, a hedge fund.

In 2007, Babcock & Brown made a net profit of $639 million. Pretty impressive. However, it would have been a lot higher if total executive remuneration hadn’t stripped $160 million or approximately 20% away from this.

Compare that to engineering company Worley Parsons who this week reported a net annual profit of $343 million and paid its senior executives just $15 million or 4% of net profits in total.

We would be surprised if this wasn’t the end of the story. The next phase will be to see if any investors take legal action against B&B or brokers or planners over the marketing of infrastructure funds as safe and reliable, growth and income investments when in fact they were all highly leveraged hedge funds.

The news just goes from bad to worse at Babcock & Brown [ASX:BNB]. The company has already had to write off and sell off assets from funds including B&B Power [ASX:BBP].

It is continuing to suffer for the rapid expansion in its structured investments that it and Macquarie rolled off the investment banking production line over the last few years. It was inevitable that bankers would have little interest in the long term sustainability of a fund as they were more focused on bringing in as many deals as possible in order to collect big pay cheques.

B&B have had to suffer far more pain that Macquarie due to the fact that B&B are a less diversified organization. When structured products started to go smelly, Macquarie were able to refocus their attention elsewhere. For a company that modeled itself as a smaller version of Macquarie they are probably wishing that they copied the diversity of Macquarie as well.

Farewell Phil
We note with sadness that Telstra (lack of) Public Policy & Communications head Phil Burgess is to resign and return to the United States. We’re not sure whether he managed to achieve anything for Telstra [ASX:TLS] while he was here, except for managing to aggravate a lot of people in government and the telecommunications industry.

Things are looking bleak at Babcock & Brown. But will B&B’s confidence crisis prove fatal? And if you’re an employee, is now the time to quit your ship before it sinks?

Shocked staff at the Sydney-based investment house watched in dismay last week as B&B’s share price plunged 52% in two horrific days on the market. B&B’s banks are reviewing a AU$2.8bn loan and the firm is facing a potential fire sale of its international infrastructure assets.

A senior cull is also looming at B&B, which is said to be restructuring the boards of its funds and replacing several chairmen with independent directors.

Should besieged B&B chief executive Phil Green get the boot too? And should you bolt from Babcock before it all gets really bloody?

What’s Going On, BB Power?

20/06/2008