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loophole allows hedge funds 2 manipulate stock

  1. 3,815 Posts. secret.

    Incase any of you guys missed it and find it interesting ( from this morning's 'The Age' online).

    The volatility that has infected the Australian stockmarket in recent months may be playing havoc with your investments, but not everybody is unhappy with the situation.

    Traders love it. It's how they make money. There is an apocryphal tale that sums it all up in which New Yorkers wake up one morning to read: "There was no trading on the New York Stock Exchange yesterday. Everybody was happy with what they had."

    There is a vast global industry looking for any means possible to exploit a price difference here, an arbitrage opportunity there. When it works properly, it is part of an efficiently operating market.

    But lately in Australia it appears it hasn't been working properly at all. A clever bunch of traders - some local but most based offshore - have taken advantage of a legal loophole that has resulted in wild gyrations in stock prices.

    They are known as hedge funds. And lately they have targeted Australian banks and financial stocks which have been hammered on the stockmarket.

    Take the Commonwealth Bank, Australia's biggest bank. Its share price is now 30 per cent below its November peak. Last week, it announced a smallish rise in its provision for bad and doubtful debts which sent the entire financial sector into a share price tailspin and took the broader market with it.

    This week, it was ANZ's turn. With a couple of Australian companies such as Centro Properties, Allco Finance and MFS in financial difficulty, ANZ raised its provisions for bad and doubtful debts. Again, all the banks were slammed in the biggest single-day fall in 19 years.

    Most of the problems on global financial markets relate to trouble in the US housing market. It was American banks that fed the beast that has now turned so viciously upon them. US banks like Citigroup - the world's biggest - along with financial giants such as Morgan Stanley have written off tens of billions of dollars in bad debts. And there is more than likely worse to come. They have gone cap in hand for emergency funding to Asian and Middle Eastern governments and investors who have gladly bailed out Wall Street's fallen financial giants in return for a slice of the action.

    So it may come as a shock to learn it is Australia's financial institutions that have incurred the wrath of global investors.

    Australia's banks - which are enjoying rude health and project a relatively rosy outlook - have been savaged far more than Wall Street's errant financiers even though they have yet to write off a single extra cent in bad debt since the credit crisis hit last year. At the moment, they are simply making prudent and relatively tiny provisions in case

    Compare the relative performances. The ASX financial index has been slashed by 30.3 per cent since November 1. But on Wall Street, the cause of the problems, the Dow Jones banking index has fallen just 21 per cent.

    How could that possibly be? The answer is that the traders have found a chink in Australia's regulatory armour.

    The hedge funds have found a way to manipulate the market through a process known as short selling. This is where traders sell stocks if they think the share price will fall in the future. Then they buy them back at a lower price later on. It is perfectly legal and even encouraged as it can add liquidity to markets.

    In recent years, however, the practice has become more sophisticated and incredibly complex.

    Ordinarily, all trades have to be registered and must be disclosed to the stock exchange by nine the morning after the transaction. It is crucial information that ensures the efficiency of any market and ensures transparency.

    But the hedge funds have found a legal loophole here that has allowed them to keep their trades secret. They get around the rule by "borrowing" shares. Where do they get them from? The chances are, if you have put money into a share investment fund or a superannuation fund, those shares are held by what is known as a custodian.

    The custodian looks after the stock and does all the paperwork, allowing stockbrokers and super funds to get on with their business. The custodian charges a fee. But often a custodian will offer funds or brokers a discount if it can be allowed to "lend" the shares to other market players - such as hedge funds. And of course the custodian gets a fee for that too.

    The hedge funds use these borrowed shares to sell into the market and force down the price. And they have obtained legal advice that, because they have borrowed the shares, they don't have to report the trades as "short selling". So the true scale of the selling has been hidden from authorities.

    In recent months, the traders have stepped up the pressure. On top of the selling, they add in a nasty rumour to drive the price even lower. Given the sudden collapse in Centro Properties and Allco, these have been surprisingly effective.

    For most of the past few weeks Babcock & Brown has been the subject of rumours about the personal financial health of its key executives. Its chief executive, Phil Green, was damning in his condemnation of the lack of disclosure that has allowed the share price of his company to be manipulated.

    There is a similar disquiet at the upper echelons of Australia's big banks. And most want the rules clarified and the laws tightened.
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