Karn Evil 9

Welcome back my friends to the show that never ends. After witnessing the shotgun marriage of Bear Stearns and JP Morgan, the Treasury's sloppy handling of the GSE rescue, a Lehman bankruptcy and a Fed seizure of AIG, the locust that are the shorts (hedge funds et al) have descended on Morgan Stanley. In spite of the fact that Morgan Stanley reported good earnings, certain market participants are now pushing another venerable Wall Street investment bank to the brink of oblivion.

Although one can blame the shorts for finishing the job, Wall Street executives and various industry regulators are truly responsible. It was management who permitted their capital markets genius lever up 30 or more times to make bets on various asset backed structures. Where were the controls? Where was the Fed? No one wanted to derail the gravy train. As repulsive as the short-selling vultures may be, they are just feeding in carcasses left by "financial innovators" who hubristically believed they could turn pools of collateral which had little if any chance of paying off. Sure, the short selling uptick and naked short-selling rules are back tomorrow, but the damage is done. As long as financial institutions have this nuclear waste on their balance sheets, the vultures will descend on one financial institution after another.

No firm is immune and the street knows it. Nearly every financial stock, bond or hybrid which has not engaged in a merger (and some which have) traded lower today. Credit default swap spreads blew out today. Morgan Stanley CDS was offered at 1055 basis points today. As I predicted on my desk, Morgan Stanley is talking to Wachovia (itself the subject of doomsday speculation) among others about a merger. Goldman Sachs and Wamu (talking to JPM)) could be the next targets.

Investors holding securities of firms considered "too big to fail" should be warned that they may not be too big to be seized by the Fed. This is not a short-term phenomenon driven only by shorts. This is a major dislocation of the credit markets. Wall Street and the financial sector will look strikingly different when it is all over. The street will be littered with broken dreams. Hopefully business models will not be nearly as broken as they have been during the past few years.