This describes the situation whereby a share price gets attracted towards at a particular level at which there are lots of options struck which are shortly due to expire.

A good example is RBS in its current capital raising which is set at 65.50 pence (the “Strike price”).  The UK Government has agreed to buy any shares that are not bought by other investors.  Shareholders are entitled to buy shares at the strike price (their “entitlement”) and have to pay for them on 25 Nov 2008 (the “pay date”).  This creates a situation where an investor who fully intends to subscribe for their entitlement can buy those shares in the market before the pay date if the share price falls below the strike price (RBS shares have often dipped below 65.50 pence since their capital raising was announced on 13 Oct 2008).  If RBS shares then rally above the strike price, the investor can sell the shares they bought lower down, safe in the knowledge that they can take up their entitlement and replace them at the strike price.  This process can be performed ad infinitum until the option expires on the pay date.

In reality what happens is that RBS shares trade very close to (get “pinned to”) the strike price, especially as we get the nearer the pay date, so as to prevent these ‘risk-free’ profits being extracted from the market by investors who fully intend to take up their entitlements.  The pinning situation disappears after pay date and a support/resistance level is left at the strike price in its place.  Pinning happens less often in traditional rights issues because many big market participants are already on the hook to purchase stock having already underwritten the rights issue.  In the current RBS example this is not the case because the Government has underwritten the stock placement.

The UK Government’s objective is not to acquire significant stakes in LLOY, HBOS and RBS.  Their objective is to restore market confidence in UK banks by addressing three inter-related areas which have come under the harsh spotlight of the market’s scrutiny.  These areas are :

1.  Do the banks have enough physical cash (or access to such cash) so as to be able to carry on conducting business?

2.  Will the banks be able to refinance their debts when they fall due?

3.  Do the banks have enough capital to be able to withstand likely losses and still remain in business?

The expansion of the Special Liquidity Scheme and the establishment of a Discount window at the Bank of England fully addresses point 1.  The provision of a Government guarantee for their debts provides confidence in a positive answer to point 2.  Point 3 is addressed by the Government underwriting the capital-raising issues announced on 13 October 2008.  There is clearly a hope that given that the banks now have a future, investors will step up to the plate and subscribe for most of the ordinary shares to be issued which will leave the Government with small stakes in the banks which will be sold off in the future (perhaps they will even be bought back by the banks themselves as they will likely be flush with capital in a few years time).  RBS and the enlarged-LLOY are both planning to buy back the Preference shares during 2009 so as to be able to resume paying cash dividends.

A lack of investor confidence that the banks will survive has been the focus of attention.  With this week’s 150bp rate cut by the BoE (such a decisive move is to be applauded), the BoE is well on the way to creating a steeply-positive yield curve which will enable the banks to make lots of profits (against which they can recognise their losses).  The Government has re-engineered confidence in the banks.  It is all over bar the shouting.

There has been some comment about the Fed now having just 100 bps of rate-cutting firepower left and that when rates are this low then cutting them further will be like pushing on a piece of string, i.e. it will have no real effect in stimulating demand.  Doubters of the Fed’s true firepower would be well advised to re-acquaint themselves with a speech given by Ben Bernanke in November 2002 (well before he became Chairman of the Fed). 

This important speech entitled “Deflation: Making Sure ‘It’ Doesn’t Happen Here”, see  http://www.federalreserve.gov/boarddocs/speeches/2002/20021121/default.htm , also effectively kickstarted the Dollar to embark upon a six-year slide (finally reaching a low in mid-2008 before the current Dollar rally began in August when the latest planet-wide mad scramble for Dollars started – which has in turn resulted in the Fed creating currency swap lines with other central banks around the globe).

Essentially Ben highlighted that central banks do not run out of stimulatory firepower once the overnight rate reaches zero.  They can move out along the yield curve, buying 3-month paper and then buying paper of progressively longer maturities in order to force market rates lower (accurately foretelling the Fed’s recent buying of commercial paper).  They can also print currency and distribute it to consumers in order to stimulate spending (adding a ‘use-by date’ to the newly printed currency would encourage consumers to spend it rather than hoard it).  This latter suggestion is what prompted the “Helicopter Ben” tag-line although I always preferred Ben “Gutenberg” Bernanke, but then again I do live in Europe.

It took the Japanese over a decade to get around to “quantitative easing” – don’t expect the Fed to drag its feet if it becomes necessary…