The Upside of Falling Bank Stocks

Financial stocks are plunging right now: if Fannie and Freddie can be brought to their knees, then no bank is safe. And falling bank stocks are systemically very worrying: the equity cushion is an important part of the way in which banks protect themselves from runs and ruin, which means that a falling share price can become self-fulfilling.

But I'm more sanguine about all this chaos. Indeed, it's entirely possible that the volatility we're seeing on the stock market right now is actually a good thing, systemically speaking.

Heidi Moore feels the poor shareholders' pain:

Shareholders bought shares of Fannie and Freddie precisely because they knew that if the two lenders ever fell in trouble, the government would step in. And now that the government has stepped in, it is determined not to help shareholders...
In the Bear Stearns bailout as well, Paulson was determined not to save shareholders, which was a classic case of blaming the victim of a run on the bank. With Fannie and Freddie, the shareholders may be victims again, which is likely to have an impact on the entire U.S. economy.

But what about the shorts? Won't anybody step up to defend them?

I'm serious. Mohamed El-Erian explains today why Paulson stepped in on a Sunday night to bail out the GSEs:

It reflects the understandable eagerness to minimise forced and disorderly deleveraging in a part of the economy that is deeply interlinked with virtually everything else. The financial system is like the oil in your car. Without the oil, it no longer matters whether you have a solid engine, good brakes or fancy safety features. The car will not function.

It wasn't that long ago that El-Erian was saying that we were leaving the financial phase of the downturn behind, and moving into the second phase, where casualties started piling up in the real economy. Clearly that was a bit premature: the financial crisis is far from over yet, more than a year after it began. And there are many more shoes which could well drop: big banks like WaMu and National City are trading at extremely distressed levels, and we mustn't forget the whole issue of counterparty risk, which if it ever starts to snowball would make everything thus far look like a walk in the park.

Clearly, we're in a world where the biggest risks to the economy remain financial. And it just so happens that there's an easy and reasonably effective way of hedging those risks: shorting financial stocks. Investors around the world who want to protect themselves against market-crisis risk are likely doing just that right now, helping to drive the price of those stocks downwards. Which means that as the stocks of big banks fall, quite a few sensible investors are actually making money. Not because they're betting on Armageddon, but just because they understand the big risks and are hedging them accordingly. Indeed, broad stock indices have been remarkably calm over the past few sessions, in the face of all the financial-sector craziness.

The share-price volatility in Fannie and Freddie over the past few sessions looks to me as though a hell of a lot of people are playing in those stocks, and that most of them are not buy-and-hold investors from years ago who are now finding themselves underwater.

Indeed, I'm almost reassured by all this stock-price volatility. Equity, sitting as it does at the top of the capital structure, is never going to be a safe place to be during a crisis. But it just might be the case that the crazier the rollercoaster ride suffered by shareholders in Freddie Mac, the safer the rest of us can feel, if that rollercoaster ride is partly a consequence of prudent risk management elsewhere in the system.