In law, it is often difficult to prove intent, and particularly difficult to prove criminal intent. The bear raids on Bear Stearns and, in the London market, on HBOS, the bank which used to be the Halifax Building Society, have created a prima facie suspicion that speculators were deliberately creating a false market. There is no doubt that this would be a criminal offense, both under British and American law. Yet it would be a difficult offense to prove.
The first difficulty is to establish who made the bear sales, and whether they did so in agreement with each other. The formula of creating and profiting from a bear raid is, of course, familiar from the history of stock markets, and can be traced back to eighteenth century stock jobbing, as described by authors such as Daniel Defoe. Before that, it could probably be identified in the highly sophisticated Dutch markets of the 1630s, when one could buy or sell puts in tulips.
In the nineteenth century, the authorities of the Stock Exchange had to deal with the criminal millionaires of the railway age, such as the partnership of Fish and Gould who manipulated the stock of the Erie Railroad. One of the dramas of the railroad age was recounted in an early twentieth century pamphlet on the capture of the Illinois Central Railroad by the Harriman interests, from those of the Fish family. The pamphlet has the striking title “The sandbagging of Stuyvesant Fish.” Somebody seems to have sandbagged Bear Stearns, and other people may have sandbagged HBOS.
It may be difficult to find them; it will certainly be difficult to prove their guilt. In the first place, it will be difficult to prove who had made the actual sales and purchases of stock — a difficulty which was often too much for early investigators. In the last three weeks there have been very large volumes of bear sales.
Even if it were possible to identify all the relevant bear sales, it would be extremely difficult to show which of them were intended to create a false market. In theory, it would be possible to reintroduce the post-1929 U.S. legislation which made bear selling illegal in most circumstances. Similar regulations were introduced in the United Kingdom. In the period after the Second World War, bear sales were impossible for most investors in most circumstances. These regulations were only gradually relaxed. However, it would now be impossible to outlaw all bear sales without simply transferring the business overseas to other markets.
The problem is most acute in the case of financial stocks. All banks are highly leveraged by comparison to other stocks, at least in ordinary circumstances. Recently, private equity deals have led to great increases in the leverage of some otherwise ordinary businesses. Bear Stearns and HBOS were both highly leveraged to maximize their profit opportunities, in a way that would be seen as perilous in any non-financial company. All banks, as a matter of routine, trade in debt, including their own debt. Whereas a manufacturer or retailer would be unlikely to be ruined by a few days of closure of credit markets, a bank can be perfectly safe on Friday and dead in the water on Monday. Like the unsinkable Titanic, banks can be holed below the water line if they cease to be able to borrow.
Some discipline needs to be found if the banking system is to be protected. The modern world economy depends on banks, more so than the business world of 1900. Yet our banks are still vulnerable to the deliberate creation of false markets in their shares or in their banking liabilities. What happened last week is a greater threat to world finance than Enron.
Lord William Rees-Mogg
March 24, 2008