Friday, September 19, 2008

ACAS, the SEC, and the Stock Buyback Authorization

There are several theories to offer about ACAS' recent surge from under 20 to past 25.

First, let's simply erase the possibility that people suddenly "get" ACAS and its business. They don't. Understanding ACAS' business would involve reading something more complete than Yahoo's sloppy synopsis and separating the noise from the signal to hear ACAS' story.

Second, it's not the case that ACAS benefitted from the new rule barring until October 3 establishment of short positions in 799 specified financial stocks. The rule doesn't bar maintenance of existing short positions, and the list doesn't include ACAS.

The culprit seems to be the sudden and entertaining interest on the part of the SEC in enforcing rules that have long required actual delivery by short-sellers of certificates to the people who thought they were buying shares of companies rather than a mere promise of shares' delivery. The SEC, after long nodding amiably at "naked" short sellers even as it recognized an epidemic of failure to deliver certificates (see the update at the post bottom), now claims, "the SEC has zero tolerance for abusive naked short selling."


I imagine what the SEC means is that naked short selling, despite being illegal, is still fair game as long as it is not deemed "abusive." I thus expect no serious SEC enforcement. Nevertheless, fear of enforcement -- perhaps by short-sellers' brokers (some activity triggers action by participants of registered clearing agencies) -- has apparently caused long-naked-shorted stocks to be bid up in price (spreadsheet here). The new rule amplifies Regulation SHO (effective sinve January of 2005, for what good it's done) with "enahnced delivery requirements" that allow sellers of securities at least three days, and sometimes more, for securities to be non-delivered before the rule is violated. Anyone engaging in short-term manipulation thus has ample time to hit and run, as the cure for violation is to purchase the non-delivered shares.

When the G-8 Economic Summit came to Houston in 1990, they prettied up the streets by rounding up all the mentally ill homeless that used to be found casting demons from vending machines and preaching heaven or damnation to passersby based on whether they felt generous with their wallets. This doesn't sound like a big deal until you appreciate how ubiquitous the presence of the homeless is in some parts of Houston, such as near downtown and near the Texas Medical Center. Sometimes, it's sporting to try to imagine the kind of command hallucilation would cause a grown man to stand on one foot, opposite fist in the air, and hop in place while yelling incoherently. It was clear as day that these people aren't out on the street exercising their choice to live free of employment or shelter, but are ill. They don't have access (or perhaps, they don't have interest) to pursue ordinary hygenic activities, so they can look and smell and otherwise present a poor impression to visitors. Houston still has episodes of trying to handle "the problem" of the homeless, often in ways that aren't legal. The G-8 Summit served as the high-water-mark for organized anti-homeless activity, though. I don't know whether, with the world looking at Houston for a week, officials jailed these folks for vagrancy, or whether officials found funding to have them psychiatrically evaluated in a county mental health facility until their disinterest in treatment programs could be fully appreciated (after the end of the summit), but they were all back on the street, hard at work casting demons from vending machines, shortly after the Summit was concluded.

I expect this kind of pretend concern for naked shorts' abusive practices will last about as long as naked shorting remains in the headlines. I do not expect to see any offender jail time, just enforcement window-dressing. Just as buying on margin ordinarily forces investors to pay interest, selling short should be expected to cause short-sellers to pay a rental fee to the supplier of the shares sold short. Failure to enforce delivery requirements artificially cheapens the cost of short-selling. Just as getting free margin loans would be considered a frightening risk to drive prices irrationally upward (by adding buying pressure), non-requirement of securities delivery makes it artificially inexpensive to sell shares one doesn't have and elevates the risk that prices will be depressed through the cheapened availability of selling pressure. The SEC's long-running non-enforcement is obnoxious and irrational and fosters unnecessary fear. Foisting enforcement upon clearing houses might cause activity, but the fact the SEC can't be bothered to prosecute offenses is simply boggling. As Mr. Chiarella can tell you from firsthand experience, the SEC was once very active in persecuting -- er, prosecuting -- people suspected of unsportsmanlike behavior even when there was no law broken at all.

The fourth possibility is interesting: ACAS closed 2Q2008 with most of a $500 million share buyback authority uspent, due to lack of non-blackout trading days. Trading at about a third below its NAV and offering a dividend north of twenty percent, I'd think share buybacks would be a solid mechanism to ensure Company benefit from capital available for share buybacks. The downside of the share buyback is that as ACAS loses equity to share retirement, its 1:1 maximum debt:equity ratio deprives ACAS of much more money that it might have invested. In other words, at a 0.7:1 ratio (a ratio ACAS recently kept to avoid running into liquidity problems in the face of NAV risks under FAS-157), a $100 million buyback would cause a $170 million reduction in available capital for investment (because reduction in capital for investment must be matched with a reduction in borrowings for investment, if the debt:equity ratio is to be maintained). If the return on $170 million invested in currently-available deals (net of its interest expense) exceeds the twenty-something percent return on ACAS from dividends, ACAS would rationally prefer to enter deals than to retire shares through a buyback program. Given the state of the deals I expect to be available in this economic environment, I would be entirely unsurprised to discover that ACAS preferred to enter deals.

On the other hand, if ACAS' management expects to return to above-NAV in the medium term, they may view the timeline of the investment in share buybacks as from-purchase-till-reissue and conclude that the total return is not only the twenty-something-percent dividend that isn't paid on retired shares, but the appreciation from >$7 below NAV to whatever premium exists at the next issuance. If ACAS were to sell shares at ACAS' last-reported NAV (over $27) in two years (and there was no NAV improvement in that time), the "exit" might be something like one third (~33%) above recent prices, which atop the >20% dividend would provide an annualized yield easily exceeding 35%. The outlook for a strong risk-adjusted return on a share buyback could be great indeed; without any "exit" ACAS yields the 20%+ dividend return, and need never issue shares again if it's not attractive.

The things to look for in ACAS prices are #3 and #4, I'd think. claims ACAS' short status is exactly the same as it reported earlier this week:
The short interest is evidently not part of the data offers with a 20-minute delay, given the short-rule-related price increase observed in ACAS and the unmoving short interest reported at SQ. If undelivered positions were being traded out, and re-initiated with other brokers, for no net reduction in short interest, the price would not have moved as a result of the transactions. The price action and timing suggests short positions' closure, but there's no short interest change reported at ShortSqueeze.

Maybe ShortSqueeze data is no better than Yahoo data. If anyone has a good source for short interest data, please leave a comment!

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