Lessening the Sting of Wachovia-Like Surprises

THE TRAVESTY OF Wachovia 's (ticker: WB) almost $9 billion second-quarter loss is not the money that was lost, but what the loss says about the capacity of American corporations to mislead investors.

On Wachovia's home page (http://www.wachovia.com/) there's a video of the new chief executive, Robert Steel, most recently a top Treasury Department official. Beside his picture it says: "Wachovia CEO: We're strong and committed."

If you watch the video, you'll hear the new chief executive say: "So although the nation's financial news lately has been a bit troubling, and Wachovia certainly isn't immune, I want you to know that our company is on exceptionally sound footing."

If Steel does not order staff to remove the video, the Securities and Exchange Commission should. Of course, the SEC would rather target short-sellers, a politically impotent group that everyone can feel good about hating, than develop regulatory solutions to address the epidemic of corporate doublespeak that almost no one can interpret.

It might seem heavy-handed to pick on Steel, who became Wachovia's chief executive on July 10. He has impeccable credentials, having been a senior Goldman Sachs executive before taking a pay cut to serve as a Treasury undersecretary.

It seems he likely knew when he recorded the video that 12 days later his new firm would report a massive financial loss, lower its dividend to five cents from 37.5 cents, exit the wholesale mortgage business and fire more than 11,000 people. In the ninth paragraph of the company's press release announcing the new CEO, the company preannounced its second-quarter results.

That being said, a staffer should have whispered in Steel's ear to tone down his rhetoric.

The difference between Steel's video statement, and Wachovia's financial statement, shows why it is critically important for investors to understand options trading. At a time when so many corporations seem to say one thing, and do another, understanding options trading can help investors understand what the most sophisticated investors on Wall Street are thinking about stocks, or the broad market, at any given time.

Sometimes options trading patterns are misinterpreted, or just wrong, but nothing is perfect. A lot of investors bought defensive put options ahead of Wachovia's earnings. The stock initially declined, though it was recently trading higher, likely due to short covering. (Short covering refers to investors buying back stock that they had borrowed and sold, betting that the stock price would decline.)

Yes, just last week, the SEC banned naked short-selling on 19 companies, including Lehman Brothers (LEH) and Fannie Mae (FNM) and Freddie Mac (FRE), to "enhance investor protections," but the ban seems more symbolic than anything else. All good traders know options can be used to push around stock prices, and even to short stocks. Wachovia's stock was not on the SEC list.

To benefit from falling stock prices, all you really have to do is buy puts, or buy puts and sell calls. Loopholes exist to all regulatory solutions; this is why the SEC should encourage corporations to speak more clearly to investors.

It would be too easy to conclude that the primary source of volatility in the stock market is the group of traders spreading rumors and then betting the stocks will decline. Surely, they play a role, but the big problem is that the SEC lets corporations get away with mostly saying whatever it is they want to say and lots of people with ordinary incomes get hurt.

Could the reason for the SEC's laxity be because so many SEC staff eventually leave to work on Wall Street, or at its law firms? Could it be because money is to politicians what air is to breathing, and Wall Street has lots of money that can be used to support politicians who can pressure regulators? All we really know is that politics is the art of compromise, and unfortunately the same is often true when it comes to securities regulations.

One options veteran says the differences between Wachovia's earnings report and the CEO's video should remind investors of the virtues of using options to reduce the risk inherent in owning stocks. "To be a naked long is a very insecure, uncomfortable, or foolhardy position," he says.

In these days of corporate doublespeak, think of hedging stock as the options equivalent of President Reagan's admonition to "trust, but verify."

Comments: steven.sears@barrons.com