Market manipulation scaring small investors away - need trading reforms

Posted by Shyam Moondra

New York Times reported that small individual investors pulled out staggering $33 billion from the mutual funds in the first seven months of this year and invested that money in bonds that are considered relatively safe. It is estimated that individuals have over $8 trillion parked in bonds, gold, and Treasury securities. This unprecedented abandonment of stocks is motivated by many factors:

• The wounds from 40-50% losses caused by the market crash of 2007-2008 are still fresh. At the slightest sign of market weakness, these risk-phobic investors look for an exit.

• Recent slowdown in the economy has raised doubts in the minds of many investors about the sustainability of the recovery. Some are convinced that we are headed to a double-dip recession, as happened during the depression of the 1930’s.

• In recent years, the stock market has become very volatile; the stocks move up and down without any significant reason. It is a widespread belief that the markets are manipulated by institutional investors through their frantic computerized trading.

The investment banks and hedge funds short sell a stock to push it down (often spread false rumors about the targeted company to aid the process of bringing it down) while also trading in options. Then just before the monthly options are to expire, they start covering their short positions and push the stock up. In the process, they may lose some money in trading stocks but they make proportionately more money in options and thus come out ahead. Sometimes they move a particular stock up or down to make the options they wrote worthless and thus pocket the premium the buyers paid. They repeat this process every month in many targeted high-beta stocks and make money at the expense of small investors. Some of these big players also use what is known as "pump-and-dump" strategy in which they take substantial long position in a company, usually a lesser-known small-cap company, and then publish inflated views or research reports about those companies that help move the stock price up ("pumping"), enabling them to sell their holding (“dumping”) at a profit. Some times these big players also use their research departments to make money in their trades. As an example, research departments of some investment banks were touting that oil was headed to $200 per barrel while at the same time they reportedly held long positions in oil through their energy hedge funds. The investment banks and hedge funds call the above trading practices as "investment strategies" and deny that they are engaged in unlawful manipulation. The fact is that if a market player can make a stock or commodity move in a certain direction at will, then that's manipulation.

More recent form of market manipulation is called "quote stuffing." The SEC is reportedly investigating the practice of day traders in which very large numbers of buy or sell orders are placed and canceled almost immediately. It is also reviewing another practice known as "sub-penny pricing," where orders are priced in increments smaller than a penny, but are far from the price at which the stock is trading. Yet another manipulative practice is to initiate buy or sell orders for 100 shares at a time at successive higher or lower prices at a rapid pace to make it look like a trend is emerging, which, in turn, induces other investors to place their bets. These trading practices are very easy to execute with the advent of high-speed computers. Some of these practices may have played a role in the May 6th "flash crash," a panicked disruption in trading that saw the DJIA drop hundreds of points in minutes.

The stock markets were created to help companies raise capital so that they could build new factories and hire more workers and the stock prices moved up or down based on the company fundamentals. Now the markets move up and down in a yo-yo fashion without much change in the underlying fundamentals. The increased volatility caused by market manipulation has turned the markets into gambling casinos that has made small investors desert the equity markets altogether.

We urgently need new regulations to stop market manipulation by the investment banks and hedge funds. The government has already taken some steps in the financial regulations bill such as close oversight of hedge funds, restrictions on proprietary trading by banks, higher capital ratios required for banks, and a total ban on naked short selling that should help reduce the market volatility. However, to lure small investors back to the equity markets, more needs to be done:

• Ban "quote stuffing," "sub-penny pricing," and other computerized trading schemes designed to manipulate the markets.

• Investment banks and hedge funds must be required to hold stocks they buy for a certain minimum period (e.g., for three business days until the trades have been settled) before they can sell those stocks. This will reduce computerized day-trading and induce investors to invest rather than speculate.

• Impose higher taxes (as high as 50%) on profits realized from short-term trading.

• The investment banks must not be allowed to own research business. Currently, they have arm's length relationship between their trading and research departments but that is not enough.

• Pass tough laws to discourage "pumping-and-dumping" so that big players can't make money at the expense of unsuspecting small investors. Strengthen SEC resources to investigate and enforce the laws vigorously to stop market manipulation. The CEOs of the companies that are found to violate any of the new regulations must be given mandatory jail terms and their companies must be fined heavily to discourage them from manipulating the markets.

• Change the tax laws to stop investment banks and hedge funds from escaping from paying their fair share of income taxes. In a recent quarter, a major investment bank paid only 10% in taxes because it reportedly executed its trades through a complex web of off-shore subsidiaries and hedge funds that made it possible for it to reduce the tax levies. It's time we close all these tax loopholes.

Extend the Bush tax cuts for one more year and then gradually eliminate them for the super rich

Posted by Shyam Moondra

In 2001, at the height of relative economic prosperity, President George W. Bush pushed for and got enacted unprecedented income tax cuts since the trickle-down theory pursued by President Ronald Reagan. The Economic Growth and Tax Relief Reconciliation Act of 2001 was especially generous to the rich who benefited the most. This Act, however, had a unique sunset provision which required that the enacted tax cuts expire on January 1, 2011 unless the Congress passed a new legislation making those tax cuts permanent. So here we are with this raging debate between the Republican tax cutters and Democrat spenders at a time when our budget deficit is running at record levels. Treasury Secretary Tim Geithner has said that making the Bush tax cuts for the super rich permanent would be a perpetual $600 billion-a-year mistake.

First, the timing of the original tax cuts and now making those cuts permanent seem very odd. The Bush tax cuts were enacted when economy was doing well. When economy is doing well, one would expect to increase taxes to thwart inflationary pressures and to raise tax revenues to reduce budget deficit and national debt. This is what common men would do - when they feel financially secured, they pay off their debt. Now, at the present time, when economy is not doing so well, one would expect that taxes be kept low to induce consumers to spend and keep the economic recovery alive. At the same time, given the record budget deficit and mounting national debt, one would argue that at some point taxes would have to be raised or else we would put our national credit rating at risk, in the mode of Greece-like crisis. If the deficit and debt problems are not addressed in a credible manner, the government will be forced to take stern cost cutting measures in the future that would trigger civil unrest and interest rates will go through the roof creating economic malaise for years to come.

It’s clear that the Bush tax cuts were ill-timed. It’s also clear that canceling those tax cuts right now will most likely push us into a double dip recession. Therefore, it seems sensible to extend the Bush tax cuts for everyone for just one more year and as the economy recovers, those tax cuts should then be gradually eliminated, first for those who are making more than $250,000 individually ($500,000 for family) and then in subsequent years for those who are making between $100,000 and $250,000 individually ($200,000 - $500,000 for family), while making tax cuts permanent for the rest of the taxpayers. This gradual approach will keep the current economic recovery going, increase tax revenues to reduce federal budget deficit and national debt, and bring fairness to our tax code which was heavily tilted in favor of the rich under the Bush presidency. Republicans’ desire to make the Bush tax cuts permanent will only add to the already record high budget deficit. While the Obama administration and Congress should also look for ways to cut government expenditures, the humongous deficit will undoubtedly require a combination of both reduced spending as well as tax increases. President Obama needs to show leadership and hammer out a compromise on gradually canceling Bush tax cuts for the rich and reducing expenditures. It’s important to note that President Bill Clinton’s efforts to achieve a balanced budget was instrumental in our sustained prosperity that eventually led the stock markets to record levels. At this critical juncture, we need to replicate the Clinton strategy to ensure our prosperity for the next generation.