Is HBOS in trouble?

HBOS does have some exposure to the type of mortgage-related debt that has caused so many problems for US banks. However, the scale of its holdings in the toxic debt are minimal compared with the big US banks. Analysts are relatively sanguine about HBOS’s ability to weather the storm.

So what’s going on?

HBOS and its volatile shares have been the victim of a combination of two insidious elements: short-selling and malicious rumour-mongering.

Short-selling is an accepted part of the way hedge funds operate. Hedge funds are a motley collection of funds with varying degrees of risk that have a few things in common: aiming to make money in all market conditions, the ability to bet on shares falling as well as rising and well-paid managers.

How does short-selling work?

Most investors simply buy shares and hold on to them for the long term, watching the price rise and fall, and making money only when values rise. This is known as taking a long position. Short-selling is designed to make money when shares fall. A short-seller will borrow a parcel of shares from a long investor. He will then sell the shares. As long as the share price falls, he is on track to make money. When the share price falls far enough, the short-seller buys the same amount of shares as the parcel he originally bought and hands them back to the long investor. He makes his profits from the difference between the price he sold the shares at, and the lower price he bought the shares at.

Is that illegal?

Short-selling is not, in itself, illegal. It is an accepted market practice. However, it is illegal when the short-selling is accompanied by malicious rumours. Short-sellers make money only when share prices fall. Markets feed on gossip, snatched conversations and, yes, rumour. In most conditions, it is pretty hard to move shares by spreading rumours. But at present there is so little trust in financial institutions as a whole, that a few carefully contrived rumours can wreak havoc. In the week running up to the implosion of Bear Stearns, its management insisted that the bank would be fine. Bear subsequently blamed its decline on the rumour mill. It is a financial chicken and egg — which came first, the ill-health or the rumours of ill-health? And which had the greater effect?

When is spreading a rumour illegal?

If people sidle up to you in a pub and whisper that HBOS is having a serious cash crisis and is close to collapse, they have not committed an offence. But if they have shorted HBOS stock, and start spreading the rumour knowing that they will bank a big profit if the share price collapses, then they are guilty of market abuse. It is known as “trash’n’cash”. Market abuse is illegal, and carries a maximum seven-year prison sentence.

So can we expect to see arrests?

The Financial Services Authority has never successfully prosecuted anyone for “trash’n’cash” activities.

First, it is difficult to tell who is doing the short-selling. They do not own the stock they sell, but borrow it. Further, they do not borrow it in a simple fashion, but use complex financial instruments (contracts for difference and put options for the finance geeks among you) which help to mask their identity.

Then, even if you know who is making the money, it is extraordinarily difficult to work out who is spreading the rumours from trading desk to trading desk, over e-mails and on mobile phones.

Who are the bad guys then?

The culprits are mainly hedge fund players. But the problem for the team at the FSA, and for HBOS, is that no one really knows.

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