Monday, December 14, 2009

Predatory Capital

I have been using the term predatory capital to refer to large amounts of short selling by hedge funds and the in-house proprietary trading desks of "banks" to attack and even destroy individual firms in the stock market. By artificially pushing the stock price of a company down fast and steep enough, predatory capital can dramatically restrict or even eliminate a company's ability to raise capital, and in the world of modern finance virtually all but a few large technology companies are constantly raising and rolling debt and other forms of capital. We saw this in spades during the recent crisis with Bear Stearns, Lehman, AIG, Fannie, Freddie, Citibank, Merrill Lynch, et al essentially shut out of raising any capital which prevented them from surviving without government intervention. This was a complete failure of "free and open markets."

In a "normal" market, a modest or even moderate level of short selling is okay and maybe a healthy thing. Short selling adds no productive capacity to either the economy or the markets, but is tolerated since it gives idle capital an opportunity to earn a higher return than if left idle.

But in a market under stress, as we had in 2008, that "idle" capital was not seeking to find "productive" assets and investments that would be of long-term value to the economy, but simply short-term profit for the sake of short-term profit with no long-term beneficial effect.

Short selling for short-selling's sake is not investment and does not add any productive "information" to the markets.

In a properly functioning market, the balancing of participants increasing or decreasing their economic stake in companies creates the information that shows us how the market values a company and its prospects. Sure, we tolerate people using short-term trading, options, and even short-selling to "tag along" with the market trend, but those "followers" are tolerated precisely because they merely "follow" the flow of information and do not distort the flow of information in any significant manner.

But once that short-term trading and speculation becomes the preverbial tail wagging the dog and begins to distort the flow of information about participants who are buying or selling true, long-term economic stakes in companies, then the markets are no longer providing accurate information or prices. That is what we saw in 2008.

In fact, the improvement in the economy over the past six months proves that stock prices in the latter half of 2008 were not accurately forecasting the future of the economy and the improvement in revenues and earnings of companies.

I will not claim the term predatory capital as my own invention, but it is not commonly used. In fact a Google News search finds zero hits. Nor is the term or any search matches found in the Wikipedia.

A Google search does come up with some mediocre and unhelpful results, but I did find this interesting result from a review of Jack London's book War of the Classes  in The New York Times dated 1905, that sounds eerily prescient of our current times:

Hmmm... "predatory capital wandering the world over seeking where it may establish itself". I couldn't have put it better myself.

But whether corporations absorb the government or government absorbs the corporation does not seem to be any dominant trend. We do a little (or a lot) of both, but the pendulum continues to swing in both directions with no clear bias towards one direction or the other. The point is that predatory capital exploits any such chaotic motion, not just as a source of modest short-term profit but to profit from the decimation or even destruction of capital that is productively deployed.

My apologies to Mr. London if I have distorted his intended meaning of the term predatory capital.

-- Jack Krupansky

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