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Value investors take it for granted that a company’s stock price does not necessarily reflect or impact the underlying business. Of course, declining stock prices often reflect fundamental problems in the business, but in times of crisis, stocks may sink for no reason whatsoever, frequently overshooting even the most pessimistic economic scenario. While a declining share price makes it more difficult for a company to raise capital by selling shares, and may distract the management by presenting the possibility of a takeover, in theory, managers of businesses which have sufficient capital and iron-clad anti-takeover provisions can sit back, relax, and maybe even take advantage of the situation by repurchasing shares to benefit long-term shareholders, and granting themselves more stock options at a low strike price. Outside of a few special situations (such as massive use of stock options to reward employees, who are now extremely demoralized, or use of toxic financial gimmicks such as death spiral convertible bonds), a plummeting stock price should be a non-event to a fundamentally sound and adequately capitalized business.

In this context then, the hysteria over the rapidly sinking Citigroup stock seems initially puzzling. After all, Citigroup, with an impressive array of assets (branches in multiple countries and the Smith Barney brokerage chain) and a cash flow of some $3-4 annually, cannot be worth only one times cash flow. Even if Citi’s cash flow is to shrink by 90% in the coming years and all of its assets are to be marked down to zero, then Citigroup’s current $4 stock price may still be a slight undervaluation of its intrinsic value. The above analysis, however, disregards the fundamental unstable nature of a banking business model. Banks borrow short to lend long, and in so doing perform several valuable economic activities, including allowing depositors to pool their capital to fund productive businesses, and allowing consumers to borrow against future income for current investment. This business model is intrinsically unstable, because all depositors realize that if everyone were to demand their deposits back, the bank would be unable to call back all its loans immediately, and so relies on confidence on the part of depositors in the future viability of the bank. Even in this age of FDIC deposit insurance, a bank’s business can be seriously compromised if sufficient numbers of counterparties withdraw their business or funding, or if Citigroup was forced into fire sales of assets in the current climate. While everyone agrees that an outright bank run will be immediately halted by the government (either with unlimited liquidity from the Fed or with the Treasury making a capital injection), the prospect of possible massive dilution of common shares by the government makes the declining share price a self-reinforcing phenomenon. The root of the problem is that the public believes that the stock price is an accurate predictor of a company’s future (”the stock dropped by 80%, something must be wrong”), and confidence is a precious resource to a bank.

In fact, confidence is a necessary component of a variety of business models. While I do not care whether the company I buy my chicken or airline ticket from is in existence tomorrow, I certainly do want the company I buy my insurance or car from to be viable and in existence in the future. For a subset of companies in the stock market, a plummeting share price does indeed affect their underlying business by decreasing the public’s confidence in the companies. These companies are especially susceptible to attacks from short-sellers. Because their businesses can be destroyed by loss of confidence, their stocks will decline to liquidation value once under attack, leading to the needless destruction of productive businesses.

I would like to state here that I am generally in favor of the practice of short-selling. Short-selling provides several useful functions. Firstly, it curbs fradulent IPOs out to bilk the public of their cash. Secondly, many short-sellers see impending problems in a business and provide a useful signal to the public by shorting stocks, thus limiting financial damage to the investing public. Thirdly, shorting is a necessary form of hedging in the stock market, and the availability of strategies involving shorting invites more participants to the market, increasing its liquidity to the benefit of all. However, in the current fearful climate, unscrupulous short-sellers are just out hunting for vulnerable targets, and concentrate their firepower on the weakest of the herd one at a time (ever wonder why banks fail sequentially rather than all at once?). The attacks on banks and insurance companies have an especially corrosive effect on the general economy. Banks are obviously required to finance new businesses, and a vast swath of economic activities require insurance, including sale of bonds and shipping of goods on container ships. While I do not have a good answer to this problem (limiting short-selling to certain times or certain companies seems too arbitrary and would provide too many loop-holes), I suspect that curbing the more undesirable aspects of short-selling will be high on the Geithner’s list of regulatory reforms.

As regards Citigroup, I suspect the authorities will maintain a careful watch for any run on Citi, stepping in to halt a run if they have to. If the government does indeed provide financial backing for Citigroup to halt a run, politics will require that the government take some form of equity stake to gain a profit on the upside. I hope that the government will consider taking only a modest stake in order to minimize dilution of existing shareholders. The threat of massive dilution by the government is part of what is causing the fall in many bank stocks, and by sharply moderating that threat, the government can discourage further short-selling attacks on other banks.

Disclaimer : I do not hold any shares in Citigroup.