Choice. Just choice.
A bit old, but let us today linger for a moment on a story printed in the Pioneer Press on February 28 by banking and finance reporter Nicole Garrison-Sprenger, noting the fact that the “short interest” in the stock of U.S. Bancorp had nearly doubled between mid-January and mid-February — to 37.5 million from 20.9 million. It was the third-biggest change in shares in the period, according to Barron’s.
Wow, what a horrible thing! All these people — the Darth Vaders of the investment world — betting that the stock of the company was going to drop. (A short sale is a bet that a stock is somehow overvalued. To profit on such a trade, the short seller borrows the stock from a broker on behalf of an investor, then sells the borrowed stock in the open market at the current price. The idea is to return the borrowed stock to the broker down the road by buying the stock at, it is to be hoped, a lower price, pocketing the difference as a profit.)
One would have thought that the market believed the world was going to collapse any SECOND for this company. And the company reinforced it: U.S. Bancorp “did not offer anyone who could comment” on the situtation. Absolutely incredible. Why?
Well, back in December of 2005, U.S. Bancorp issued $2 billion in convertible debt. At the time, the company’s common stock was trading at just under $31 a share. The “strike price” of the convertible: $36.85 a share, meaning that the holders of the bonds have the right to convert the bonds into common stock once the stock reaches $36.85. Thus, when the converts were issued, they were more than $5 a share “out of the money.”
Fast forward to February, 2007. U.S. Bancorp (NYSE: USB) stock is on a tear, trading to a 52-week high of — you guessed it — $36.85 a share. How about that.
Welcome to the world of hedge funds — pools of loosely regulated private funds that pursue a wide variety of strategies, including the shorting of stocks.
The last figure I saw put the number of hedge funds at 8,600, with well over $1 trillion of assets under management. An even more important statistic is this: more than 120 hedge funds are focused on (surprise): convertible bond arbitrage. The idea of convertible bond arbitrage is that the investor buys the convertible bonds of a company and sells short the common stock of the company. This strategy — it’s called a delta hedge, but we won’t get into that — becomes especially relevant when the convertible bond is trading near its strike price.
What’s interesting about this is that the bet here isn’t necessarily on the common stock falling, but rather on the potential for high VOLATILITY in the underlying shares and convertible bonds. That’s because, based on the hedge ratio used by the manager, the arb can profit from movements in either the convertible bonds or the common stock.
The point here is this: U.S. Bancorp could have defused this whole story by explaining this to the reporter. The short interest had less to do with a negative bet on the company’s future, but on a complex trading strategy that had more to do with the potential for volatility in the stock.
Shame on you, U.S. Bancorp. Dumb. Dumb. Dumb.