Short-selling is extremely dangerous, compared to going "long" (buying a security in the hopes it will go up). If you buy a security, the most you can lose is all the money you've invested. On the other hand, if you sell a security short, your loss is theoretically potentially unlimited--if the price soars, you're on the hook for the difference between the current price, and whatever you sold it at. I knew a guy who made a killing shorting the market in 2000. But not before he almost went bankrupt doing the same in 1999. As traders like to say, "the markets can stay foolish longer than you can stay solvent".
Nonetheless, there's been a great deal of short-selling activity, especially, understandably, in financial stocks. First Bear, then Lehman, and now Morgan Stanley have blamed their woes on the short-sellers. Arnold Kling thinks this is ludicrous:
How can short-selling destroy a good company?
The simple answer is that it can't.
First of all, short-selling can't force down your share price. Short-selling only forces down your share price if buyers don't emerge to defend your share price.
Banning short-selling cannot protect a bad stock. If nobody is willing to buy XYZ at a price higher than $.02 a share, then the price at which XYZ will trade will be $.02 a share (or lower). It doesn't matter whether you have short-sellers or not.
What drives stock prices down is the lack of people willing to buy them at the higher price. If the company has sufficient value, there will be sufficient buyers.
I think this is a tad strong. If short-sellers flood a market, they can overwhelm the buyers, especially when you have a massive credit contraction in the markets. Also, short-sellers are not historically known to be above spreading untrue rumors in order to drive prices down further. Felix Salmon speculates that institutions with deep pockets and long time horizons are probably going to do very well out of the market's current problems.
If you read the above excerpt, you will see that the selling of some traders becomes a substitute for the short selling of others. This is a very general mechanism in financial theory, namely the ability to recreate a desired net position in a synthetic manner through other markets.
Perhaps most importantly, while short selling is a problem for Morgan Stanley, and his shareholders, it is not the primary problem in this crisis. The problem is in the debt markets, not the equity markets: financial firms are finding it very, very difficult to roll over their paper. (More on this later). The ban on short-selling does nothing to combat this problem, and indeed, by shaking public confidence in the stock price, might push investors into being more conservative on the debt than they otherwise would be.
Also, short-sellers are not historically known to be above spreading untrue rumors in order to drive prices down further.
What do you call idiots like Charlie Gasparino(of CNBC infamy) that spread lies in the hopes of pumping up a stock?
Thanks very much for this helpful post. Though, what I still don't understand is, if short selling is so dangerous, why is it so often portrayed as a strategy for managing risk?
Short selling is a market mechanism for investors to find protection in a down market, punish poor business strategies, and profit from fraudulent management practices. Claiming short sellers are rumor mongers is a denial that rumors are also used to boost stocks, which was done quite extensively prior to 2001's market crash.
For me the real joy of the unworkable ban was that the exreme short sellers concentrating on AIG in New York and HBOS in London had just (I estimate) lost a good packet when they had to cover after the takeover terms were known. It is losing money which effectively discourages short selling, not laughable bans.
Megan,
Gilchrist, Himmelberg and Huberman (JME, 2005) have an interesting paper on distortions caused by short selling constraints. Even without an explicit ban, going short is a more costly undertaking than going long. The ban just exacerbates the distortions.
http://people.bu.edu/sgilchri/research/jme_05.pdf
The basic idea is that investor beliefs have some distribution, and if it's difficult or impossible to short sell, you're going to be left with only the optimistic investors (the top portion of the distribution), and the stock price will be inflated. This lowers the cost of capital below what it should be and firms over invest.
Enjoy.
Michael
While the shorts can't bring down a fundamentally strong company, at least without fomenting fear and even then its difficult, banning short selling can have an effect.
The simple reason is that there are many institutional longs which cannot and do not attempt to alter their in response to market fluctuations.
For example, the University of North Carolina extracts 12% of my paycheck every month to invest in a set of funds I have chosen. The investment is mandatory. I couldn't stop it even if I wanted to, which I don't because market drops represent a better long term opportunity.
This means there is always institutional money flowing and slight therefore a slight trend upwards. There is also a lot of long money already in the market which is not going to move on this kind of news.
So short selling presents the opportunity for rapid response to negative market news. It is no accident that a large fraction of shorted shares are borrowed from large institutions that are basically ignoring the day-to-day fluctuations.
Without short selling, it is more difficult though obviously not impossible to generate a sharp downward movement. You have to have enough flexible longs willing to oversell the natural input of more longs into the market and it has to happen very quickly.
Moreover, banning shorting creates hedging issues which are to sort out. Suppose you want to write CDS on Goldman, or take out some other position which exposes you to risk. Now the most liquid method for hedging that risk has been closed to you.
As an note it is not clear to me why insurance on Money Markets would not have been enough. My interpretation of the situation was not so much evil shorts but a Money Market crisis which was inducing large moves out of Commercial Paper into T-Bills and thus making short term financing more difficult.
Since, Morgan and Goldman have to borrow short directly rather than using retail depositors this exposed them to enormous interest rate spread risk.
This had the effect of a run. Why not stem the run instead of going after shorts.
A cynical person might suggest that it was an attempt to induce a massive rally that would make it look as if the administration was solving the problem immediately. I trust that Paulson would not play such games with the market but I am somewhat confused by the failure to avoid the appearance of market manipulation.
Won't the would-be short sellers just turn to put options?
"...financial firms are finding it very, very difficult to roll over their paper. (More on this later). The ban on short-selling does nothing to combat this problem..." Megan
Really? It seems to me that one of the reasons that the credit markets froze up is that banks and other lenders were being spooked by financial firms' plummeting stock prices. Not able to raise capital, the firms' reserves were eroding, thus endangering their ability to meet obligations. And all of this was happening even if the firms had little or no exposure to the bad debt that caused all the trouble. Placing a temporary ban on financial shorts was an extreme, but necessary measure to break the downward spiral. As long as it's temporary, then it's probably OK. Naked shorts, on the other hand, should be illegal.
Clearly I defer to Megan, but "This American Life" defined *naked* short selling as selling stocks you do not own. Did I misunderstand or is there more to it?
The scope of the profits aren't any larger than on the long side. But yeah, it's extremely risky. Look what the SEC has done today. Hell, the market may end the week on the positive side--as if nothing has even happened.
Chris M--a "short" is where you sell shares you borrow. A "naked short" is where you sell shares you don't have at all.
IS there a social networking answer to all this toxic debt? A kind of myspace for distressed assets?
A website that, after getting and unwinding mortages from banks, finds or pools willing investors. I suppose the plummeting value of those mortgages is a problem in that equation (hey, who wants to buy some things not worth their selling price! c'mon...) but a large part of the problem seems to be a herd mentality. Everyone panics, and conditions decline irrationally; if individual actors could be paired with each other, it could restore calm to the system, coudn't it?
Just a bad & ignorant idea.
This is stupid and wrong.
When you buy a share of stock, you push the price up. When you buy a lot of stock, you push the price up more.
when you short a share of stock, you push the price down, when you short a lot of the stock, you push the price down more.
Seriously, is this in any doubt or am I totally nuts.
Normally when I buy or short 100 shares of GE, it doesn't move the stock at all. I suppose that on a very rare occastion I might move the price of GE a penny but that would be amazingly rare.
If I tried to buy or short 10 million shares of a thinly traded stock then I would absolutely move the price of the stock.
Can someone answer me? Is there ANY disagreement with what I wrote here?
Large volumes of short selling can drive down the price of an asset, particularly with "naked shorts". The 'uptick rule' existed to prevent exactly this from happening. I find it curious that the SEC moved to ban short selling wholesale, where it probably would have been sufficient merely to reinstitute the uptick rule. Perhaps SEC is hoping to use 'theater' tactics to reassure the public that they are taking BIG STEPS to solve the problem.
"When you buy a share of stock, you push the price up. When you buy a lot of stock, you push the price up more.
when you short a share of stock, you push the price down, when you short a lot of the stock, you push the price down more.
Seriously, is this in any doubt or am I totally nuts."
or you have a unique power to affect price while the people selling the stocks you buy or buying the stocks you sell have no such effect
Naked shorts, on the other hand, should be illegal.
Naked shorting was already illegal before this mess started. The SEC, before now, just chose to ignore it. You can thank all that deregulation/ignore the regulations on the books mentality of BushCo.
Claudius has it right, I think. It's not that shorting in and of itself is bad -- it's that shorting can make downward movements happen much more precipitously than they would otherwise. In a normal market that's fine, even good, but right now fast movement can result too easily in crises of confidence. We need to slow things down, make the markets move a little more slowly.
As I understand it, AIG's problem was not that it was insolvent, but that no one would lend it money, in part because the stock price had plummeted in recent days, driven by shorts who were rightly seeing problems with the company's financials. Had short selling been banned, the stock price probably would have come down much more gradually. By giving people time to get used to the new realities, AIG may have never faced the crisis of confidence and never needed a bail out in the first place.
Megan, you made the point the other day that Bernanke was right to bail out Bear because he hoped that one intervention could help halt the downward spiral, and it was a reasonable gamble. I suspect that's the same motivation for this move. It's like halting trading on a particular stock when it's acting crazy due to bad or good news -- give everyone some time to think things through, make sure people are thinking rationally and not reacting emotionally.
Sound reasonable, or am I missing something?
All this attacking of short-selling has left me confused. First, it was outrageous and immoral to "go long" on oil such that speculation had to be restricted. Now, it's outrageous and immoral to "go short" on financial stocks such that short selling has to be restricted? I fail to divine the consistent principle here.
Despite the snark in my previous comment, I am legitimately interested in the answer since I will cop to not being particularly well-versed in the intricacies involved here.
But what happens when a stock becomes toxic at a low price?
Wouldn't investors be hesitant to buy into a stock that was shorted to a low price, even if said company is financially sound otherwise?
Sort of the, "you jump first rule"?
thus, since no-one want to jump in due to uncertainty, the company is done for.
Wasn't the uptick rule implemented because of this in the 20's and 30's? Because companies would short rivals sticks to bludgeon them out of business?
Good post thanks,
I need to se every two years or so how short selling works. It grays out on me.
Chris,
Short selling on its own isn't a strategy for managing risk. But by combining short and long positions and options, one can create a "market neutral" position.
What I read was that the ban was intended to halt short selling of financial company stocks, which was killing their market cap at the very time they were looking to raise capital against it to cover their bad investments. I don't know if the blanket ban was put on because they couldn't ban shorting of individual stocks, or if they just wanted to shut down all downside speculation to try to keep the market indices from crashing further (a particularly hamfisted way of doing it, it would seem to me). Of course there are other ways to speculate but the goal was to slow the crash and buy time.
The scary thing is all the smart guys are standing around scratching their heads and don't seem to know how to get out of this mess. Nationalizing the bad loans is not a good answer but it may be the only one they can all agree on as being effective. So we load up the national credit card some more and the public eats the bad loans; essentially we gave Wall Street $800bn or so of free money. That's a pretty nice stimulus check they're getting.
Christ is all in all. All these things are temporary. people tend to do crazy things when they want to make more and more money thinking that it will make them more content. May you find eternal security in Christ, so whether the stocks go up or down you are stable in the heart and are not motivated to do unscrupolus things in the name of making more deal or more money or trying to achieve status.
Megan, how can you say such crazy things?
How dare people try to buy and sell things when the SEC needs to look busy, after 8 years of doing diddly squat about oversight and enforcement. Don't you understand the market importance of strong, decisive, nonsensical overreactions to ongoing structural problems that have nothing to do with short-selling?
"I need to se every two years or so how short selling works. It grays out on me."
Short selling is easy to understand.
Naked short selling, on the other hand... I think This American Life did it best when they explained the whole thing as a holdover from when stockbrokers had their "boy" run paper stocks over to each other wheelbarrows.
I think the issue with shorting stock has the cause and effect a bit backwords. The underlying symptom is falling asset prices on balances sheets of Lehman and AIG. AIG was 'long and wrong' on insuring various mortgage securities. When this position became too large relative to its capital those who held the contracts wanted AIG to start to get paid (the actual timing and level depending on the credit rating of AIG). AIG simply didn't have enough liquidity to pay. In short I think it was a balance sheet problem that led to a stock problem, not a stock problem that ended up being a balance sheet problem. The declining stock price certainly makes a bad problem worse but then it wasn't the fault of the shorts, it was the management team that underwrote the contracts.
Cameron wrote: "Large volumes of short selling can drive down the price of an asset, particularly with "naked shorts". The 'uptick rule' existed to prevent exactly this from happening. I find it curious that the SEC moved to ban short selling wholesale, where it probably would have been sufficient merely to reinstitute the uptick rule. Perhaps SEC is hoping to use 'theater' tactics to reassure the public that they are taking BIG STEPS to solve the problem."
The SEC removed the uptick rule from a large portion of securities a few years ago. Studies by the SEC and by academics showed that the uptick rule was worthless in terms of preventing manipulation. Why? Because most shorts were made when the stock was on the increase anyway.
@scott
You're right. But the point for this moment in time is that the declining stock price made a bad problem worse faster than it had to because of the short positions against AIG. Had AIG's stock price dropped more slowly, people would have had time to get used to the idea, and maybe it wouldn't have needed bailing out at all.
Putting a halt to short selling right now is not an indictment of short selling, any more than bailing out AIG is a vote to nationalize all insurance carriers in the future. Rather, both are pragmatic responses that will help calm a spiraling financial crisis.
Obama finally had a better day than McCain. I wondered what Cox' (supposed) error was. He needs to call 1-800 Lawrence Summers now IMHO. OTOH, we have (ex)Goldman Sachs folks at Treasury doing a great job for peanuts and had the Democratic insiders at the FMs making millions for leading 'socialism in one institution' to paraphrase what the Soviet model was called and helping us to crisis. To get back to the main point, short sellers are only spending their money to correct pricing for fun and profit. For instance there were undoubtedly short sellers when oil was, what, $150 a barrel. That held the price down; it might otherwise have been $200.
"Naked short selling, on the other hand... I think This American Life did it best when they explained the whole thing as a holdover from when stockbrokers had their "boy" run paper stocks over to each other wheelbarrows."
In modern times, naked shorting is difficult to stop at the point of execution for the simple reason that the biggest traders all use different brokers for execution and clearing.
The executing broker doesn't know what positions his hedge fund client holds so he can't stop them from naked shorting (since he doesn't know which short orders are naked shorts, which are "standard" shorts and which are just sells).
When you buy a share of stock, you push the price up. When you buy a lot of stock, you push the price up more. when you short a share of stock, you push the price down, when you short a lot of the stock, you push the price down more. Seriously, is this in any doubt or am I totally nuts.
Every share you buy, someone else is selling. Every share you sell, someone else is buying. There is no such thing as a sale without a buyer or a purchase without a seller. So, no, selling doesn't lower the price, nor does buying raise it. The price is determined by supply and demand.
If the Fed starts taking over and selling the CDOs, I want some smart guys to start an ETF to buy and hold this stuff. Unless you think that more than 50% of the mortgages in a given CDO are bad (and maybe there are one or two out there like that, but it is very unlikely), then if we can buy them for 20c on the $, we will make a mint! Seriously, this is all just mark-to-market - when there is no freakin! market. I generally agree that something is generally worth what you can find someone to buy it for, but in this case the instrument is backed by real assets. Sure those assets weren't as god as they were touted to be, but they are not as bad as people seem to think either.
The "longs" forget that shorts also help stop a slide. When a crash starts, the shorts have to buy in sometime. If there'd been a large short position on UAL during the Google News debacle, the person closing the short would have been enough to short-circuit most of the programmed selling.
If there is a full meltdown, no shorts buying could make things worse instead of better.
Yes, the SEC chose to ignore naked shorting, a big part of the problem
also, when combined with credit derivatives strategies, a clever group of manipulators can cause a bear raid
1) Short a stock (preferably naked short, so you get a free derivative)
2) bid on credit default swaps
the stock tanks, the debt appears riskier (hey, people are bidding up the cost of credit insurance, right?) then exit when the media or the moronic ratings agencies start clubbing the target company.
Many of these "failures" have simply been bear raids and this dolt Chris Cox just stands there with his thumb up his ass
It seems to me that most commentators are simply marching out their personal boogymen and blaming them for the turmoil. Today's Wall Street Journal had a rather odd column that blamed accounting standards. I've also responsibility laid on the doorsteps of 'speculators', 'naked shorts' and TV shows about flipping houses blamed. Silly.
As for me, I suspect the whole mess was caused by the designated hitter rule in the American League. Or UFO's.
It is contradictory to argue that short selling doesn't (indeed, can't) cause even a temporary disequilibrium in the price of a stock, and then assert that we have a disequilibrium in the price of mortgage-backed securities.
The latter assertion is a critical element for those who argue that the present crisis is a problem of lack of liquidity rather than insolvency, i.e., that fear is causing the prices of mortgage backed securities to fall below their appropriate level (with mark to market consequences) rather than the low current prices reflecting the best current estimate of the securities' true value.
And analogis between shorting stocks and attacking fixed forex currencies is misleading, since the latter can be defended by central banks, and the decision to devalue can be as much a question of political will as economic fundamentals, e.g., Sweden's raising overnight rates to 500% when the krona was attacked shortly after the collapse of the pound.
Human nature means that there will never really be free markets. Oh noes...
The rapid decline in AIG's stock price was large part due to the Fannie/Freddie bailout. The Fannie/Freddie deal was 'protect the bondholders, stick it to the stockholders'. This meant that the stockholders of every financial institution in possibly parlous condition had to see their stock as worth less as soon as the Fannie/Freddie deal was announced. So they sold.
What is the problem with short selling? It is asymmetric to long buying on margin. If you buy long there are two big limitations. First you do not obtain unlimited margin credit. Second, you buy order must be met by a sell order. These are fire breaks.
Naked short selling assumes unlimited credit. In recent weeks naked short orders out numbered the entire stock floats of the companies shorted! Hit them with enough shorts and the company stock has no place to go but down. Thus there is no brake function because the Naked shorts have not actually secured shares in advance of the short sale. The old uptick rule addressed this somewhat, and the new rule to certify borrowed shares.
Naked short selling is a terrorist tool in the wrong hands. Exam George Soros, not an American, operating offshore, sell several billion shares of Nasdaq stocks on one day in the Spring of 2000. Nobody was expecting it except Soros who was already shorting the indexes. When it was all over 9 trillion dollars evaporated from the markets.
Real time markets are subject to rumor with explosive damage to the downside. Once the stock starts moving down from the shorts, the trading desks pick up the action and the electronic sell programs kick in. That is just gaming the system because nobody can determine fact or fiction before the damage is done. The stop loss orders are in to prevent disaster. It is akin to some punk yelling fire in a move theater or in a nursing home. You can't police this conduct because the damage is too great once the harm is done. You can't bring back Indy Mac which was destroyed by short sellers.
How was it destroyed? The naked shorts attacked both the common stock and the stock held in their public portfolios. They planted news stories that assets might not be insured. This caused a run on the bank. This reduced the equity to loan ratio, the regulators stepped in and seized the bank. Indy could have stayed in business with private equity and could have raised cash if their portfolio was not beening destroyed. More shares of Indy were shorted than Indy had shares.
There will be new regulations against short sellers. This is not some pubic service that they preform like sharks eating garbage from the sea bed. This is manupulation, stock fraud, mail fraud and likey a Rico violation.
The bulk of the market assest in this country belong to its citizens. The Government has an obligation to keek markets safe from manipulation and menace. Most citizens are not expert investors but that is no reason to take them apart by allowing manipulators to steal from them or worse letting slime like Soros rip off citizens with impunity. Soros owes IRS 2 billion in back taxes. He is involved in MoveOn and a foreigner attempting to influence the election process in America.
The shareholders should also sue Cox of the SEC and the hedges for economic duress.
In closing, the rule of law does not give a First Amendment privilige to yelling fire in a movie theater. A free marketplace is a priviliged activity demanding disclosure; it does not imply Caveat emptor just becaue the word free is used. The point being that the word "free" is not without legal limitation. The Government is well within its bounds to entiely eliminate short selling if it wishes. Markets would then be long and each party to the buy and sell bargin would have an equal stake and be identically situated in terms of advantage. That is a free marketplace, not a relationship of victim to executioner.
The dopes in the news keep saying that the value of derivatives can’t be measured. That’s ridiculous.
The real estate appreciation line of the last 80 years is virtually linier at bout 1% per annum adjusted for inflation except when it gets to 1995 where it leaves the tarmac and bubbles. The way to measure the derivative is to interpolate the 80 year line thought the base of the bubble. The line then provides a reliable baseline value for derivatives.
The government and pendants are banding around rules of thumb of “30 cents on the dollar.” This is absurd because the value of the derivatives goes up over time. The deal is really a steal for the government. The asset cannot lose value. To here the news media talk one would think that the taxpayer is getting nothing more than bad debt and being robbed. It is stunning stupidity. These are for lack of a better description, assets that mature in the long term but to say they have no value is ludicrous.
Please feel free to pass my post around to anybody that says derivatives have no value or can’t be given a firm value. Dispel their ignorance and it may actually help lawmakers get a grip. I though Harry Reid gave another all is lost performance at the table with Paulsen. Is anybody from Nevada out here? How can you stand this wimp?
Naked shorting is prevalent and Cox has ignored it, except when it affects the stocks of his buddies, ie. the financials.
Most people don't know is that brokerage margin account contracts allow your brokerage to take your shares and give them to a short to sell. In essence, your brokerage is forcing your investment down.
They(bush, berneke, paulson, and cox) didn't have to go as far as banning shorting. All they needed to do was stop naked shorting (easy to do - deliver shares or pay for them) AND stop brokerages from taking your shares out of your account and giving them to the shorts to sell.
Shorting is an important part of the market. Its really hard to do by the way. I found its harder than going long ... remember the stock market goes up 2/3rds of the time, vs. down 1/3 of the time.
Been at this game for about 25 years as both broker and manager and let me fess up to you Meagan: I shorted for clients without the stock to back it up at least a thousand times. And I knew this was a part of organized efforts to bust a stock, sometimes a perfectly good company stock. What you don't seem to understand is that massive shorts are almost always "covered" by buy stops and/or similar positions on other stock on other exchanges. Writing puts with a stop is also done. The real true short risks next to nothing...unless the stock is thinly traded (too few shares outstandidng) and I've never seen any big spec ever play a stock or commodity like that. Shorts have been a speculation vehicle for at least twenty years but rationalized (falsely) as a hedge. Hell, if you want to hedge there are a hundred ways you can do it without going short, but rarely does an investor go short, he just bails out and lives to buy another day. Bear Raids, in which large groups of short sellers with massive capital short a stock to near zero for no reason other than that they can. Soros? The pig of all time. He single handedly broke several South East Asian countries until big bad China stopped him cold when he tried that stunt there. Massive shorting needs to be controlled by position limits, period.
I've not worked equities. I've spent most of the last 20 years working commodity derivatives. With that said, it seems to me that the equivalent of naked short selling happens in the commodities markets everyday. I can sell an outright swap or a futures contract and close the position out at my leisure. For that matter, I can always buy a put and sell a call at the same strike (if it's close to the market the premiums should about cancel out) and create a synthetic naked short, which should work as well in equities, no?
And if naked shorts were effectively illegal in the U.S. and there was a demand for that sort of thing, what's to stop the creation of an OTC derivatives market offshore that does the same thing (i.e. an outright swap on an equity)?
I have been at this business for over 25 years. I have seen the locate rules(making sure you are able to borrow and deliver the stock), and the uptick rule( when it was in effect) flaunted or ignored.
Part of the reason that "naked" shorting has been so widely used was that Morgan Stanley and Goldman Sachs, et. al., did not want to offend their biggest customers( prime brokerage hedge funds) by forcing them to cover their undelivered open shorts. They closed their eyes to the abuses of the system, until this week.
Now they are Shocked! Shocked! to find rule breaking and gambling going on. They are reaping what they sowed.
I have seen bear raids on big and small companies alike. All you need is some turmoil and questions and some very large companies can be brought to their knees price wise. And believe me, the shorts will spread rumors, lies and innuendo. I have seen it and heard it.
Legal shorting is a great market mechanism, for hedging and for taking advantage of price dislocations and poor company execution. But bring back the uptick rule, it was there for a reason, and expel from the business anyone who executes or clears a naked short.
Banks are particularly vulnerable to bear raids because they are heavily regulated entities. If you raid CSCO or SLB, they will just take their ample cash on hand and take the company private. Hence, it doesn't pay to raid them.
But GS came under attack Thursday. Over 25% of the company's stock changed hands in that one day, and the company, which had just reported a profitable quarter on the 16th, was briefly sold down to about 15% below book value. The company doesn't have any of the toxic waste that, say, Citicorp does...bear raid.
Banks lend their cash, because they are regulated and the government requires them to, it's the nature of the business. And don't forget HUD's 'affordable housing' quotas. But if they don't maintain adequate capital ratios, banks are seized by FDIC. So it's possible to break a bank by shorting it's stock. The defenses of a typical corporation against such tactics don't exist for a bank. So if we want a stable financial system, then we have to come up with a way of disallowing massive bear raids. Shorting should be allowed, but not massive coordinated shorting to cause an artificial failure due to the regulated nature of the entity. So how do we accomplish that? Is the uptick rule enough, or do we need more of a firewall?
I'd also like to know who is doing the shorting. Are foreign entities involved? Part of the solution is disclosure and transparancy. Perhaps the folks at Ft. Meade and Langley should get off of their derrieres.
"The problem is in the debt markets, not the equity markets"
True, for the most part, but the same rating agencies that were slow to downgrade CDOs during the bubble seem quick to downgrade the debt of financial institutions during the bust based partly on the declines in share the share prices of those institutions. So shorts can drive a company's share price down, forcing a downgrade, which then requires the company to sell illiquid assets to raise more capital, which then raises questions about the viability of the company itself, in a vicious cycle.
I hate the argument that short selling is bad. I think naked shorts are bad because they can, in theory, create excess short sales outstanding.
But there has to be a way for people to bet against a stock. Simply not owning a stock is absurd.
"I play the stock market of the spirit--and I sell short."
--Ellsworth Toohey, THE FOUNTAINHEAD
Howard is correct
short selling is only analogous to buying on margin if you have borrowed the stock that you are shorting
if you don't have the shares to short, you are getting a free ride. The SEC and brokers police long "free riders" once I bought more stock than I could cover by settlement date (in error) and my broker was on may case, naked shorts seem to be able to do whatever the hell they want , until now
"Perhaps most importantly, while short selling is a problem for Morgan Stanley, and his shareholders, it is not the primary problem in this crisis. "
Um, since the Fed is jumping up to back some number of these firms, the impact isn't just limited to Morgan Stanley but to the taxpayers as well.
And shorting isn't really risky at all if you are covered. In theory, you can't naked short (that's worth a laugh since it happens constantly) so the risk of legally shorting a stock is pretty small.
"But there has to be a way for people to bet against a stock. Simply not owning a stock is absurd."
Buy puts. You lose some granularity and they are a bit more complicated to work out, but they work fine. I straddle volatile stocks all the time and often win both on the way up and the way down. Pretty good way to lose money if you don't know what you are doing, too.
"All this attacking of short-selling has left me confused. First, it was outrageous and immoral to "go long" on oil such that speculation had to be restricted. Now, it's outrageous and immoral to "go short" on financial stocks such that short selling has to be restricted? I fail to divine the consistent principle here."
Well, the consistent principle is the impact of the action.
Going long on oil can artificially constrain the market and since oil is a critical commodity that some people will pay any price for, the result is that a strategic investment can basically put people over a barrel. Going long on electricity is largely what Enron did to California.
Going short on a stock that is in trouble, particularly a financial one where their credit rating is tied to their financial health (as AIG was) can create a death-spiral. As AIG dropped, their rating dropped which required them to show cash to make up for the greater risk, which required them to desperately grab for money which depressed their long-term health, driving their stock price lower. Consider that AIG went from needing a $20B bailout to an $85B bailout in one working day. Ultimately they gave up the company and agreed to an 11.5% loan just to be able to self-destruct more slowly than they were.
In either case, investors were taking advantage of the fact that they can move a LOT faster than the people impacted by their actions and that the people impacted by the decision were captive to the act. That is, AIG *had* to do what they could to save the company, which pretty much guaranteed that the stock would drop precipitously just as many people *have* to buy gas even if it's $5/gal because there is no time to create or find alternatives. Going long on frozen concentrated orange juice wouldn't have the same impact because people aren't captive to that commodity.
Question for debate:
Is this crisis a financial Katrina, or an Act of God.
That is, is this something that could have been avoided if government regulators were on the ball in the first place, policing accounting methods and transparency. Or was it simply an unforeseeable circumstance that could have turned out differently, with little way prior to the crisis to know what the "right" sort of government regulation would have been?
(note: I really only mean regulation in the sane sense: i.e. rules that essentially try to support transparency and good information and reduce outright fraud. I don't consider things like arbitrary price caps, banning certain sorts of legal contracts between two consenting parties, and so on to be legitimate regulatory functions)
Seems to be the consensus to get rid of naked shorting?
And to Bad@11:13, this was no "Act of God" in that we are talking about human error in the form of greed or lack of caution.
Had the mortgage products been structured properly, and rated accurately, different result.
If the financial firms were not so highly leveraged, different result.
If people made their mortgage payments on time, different result.
Had the government at the federal level much earlier banned some home selling practices, different result.
And I continue to be amazed at how the home buyer gets a pass on all this. While the government was focused on other things, and while those on Wall Street thought they were smart enough to maximize profit, it was the actual home buyers and sellers who made a mockery of the process that leads us to where we are.
Okay, I have a comment to make! You all ready? -
This stuff is too complicated. Everyone is saying the opposite of everyone else, on this forum, in the news, in various columns... No one agrees on anything. Please don't blame McCain or Obama for what they're saying; they are no stupider than the rest of us.
I would suggest just leaving the Presidential candidates out of this. Tell them: Never mind! We know you're not economists. We'll get back to you at the next crisis.
Give the crisis another, greater run, and selling will be banned.
What the government is attempting to do, reinflate asset prices to support the already accumulated debts, is doomed to fail. The required credit expansion simply cannot be accomplished without bringing on the default of the US government. We will limp through for the next 4-8 years, but as the SS and Medicare liabilities begin exacting their toll, the next, larger crisis will be in US government debt.
A lot of the explanations for the current crisis seem to rest on some variety of craziness. (e.g. mortage lenders started making bad loans for no particular reason, suddenly homebuyers became irrational, one day virtually everyone went out and bought a home they couldn't afford.) I spent a lot of time studying economics, but I must have missed the classes in which markets are driven by sudden bouts of acute mass insanity.
It does make the analysis easier though. No more of that tedious supply and demand stuff. Just lot's of people running around being nutty.
What the government is attempting to do, reinflate asset prices to support the already accumulated debts, is doomed to fail.
Yeah, that's the part I can't get my head around. At some level, they really are trying to prop up the price of real estate, aren't they? I mean isn't that what's implied in the government buying up bad debt from banks? And isn't that utterly hopeless?
Doesn't it make more sense to do what Sebastian Mallaby and Paul Krugman suggest, have the government buy equity in banks (infusing them with new capital) and/or force the banks to raise capital themselves (by canceling dividends etc.), if what we're worried about here is restoring liquidity?
If short-sellers flood a market, they can overwhelm the buyers, especially when you have a massive credit contraction in the markets.
The thing to remember about short sellers is they buy as many shares as they sell (since they must cover their shorts in a finite period of time). Remembering that puts their limited influence in perspective.
Thus it is really impossible for them to drive a stock price down permanently -- if you sell and buy the same amount of shares, you have zero effect on its price. If you sell first, then buy the same amount later, you have offsetting effects. Your position in the stock at the end is zero, so your effect on its price then is too.
I mean, is anybody really worried about people manipulating stock prices by first buying a company's shares and then selling all the same shares a little while thereafter? Why not? It's the exact same thing as shorting but on the upside.
All that large-scale shorting of a stock can do by itself is create volatility -- create a temporary pressure downward that must be followed by offsetting pressure back upward when the shorts are covered. That doesn't make the shorts any money -- that costs them money.
So a short hopes to make money by having the longs follow the price down. If the volatility draws scrutiny to the balance sheet of the shorted business from the longs, that's good -- it increases market efficiency. Then it is up to the longs ...
Seems to be the consensus to get rid of naked shorting?
Not here. Naked shorting is almost the exact same thing as "regular" shorting except you borrow the sold shares from a different party -- instead of (typically) a broker, effectively the person you sell the shares to. You cover the short the same way, by going into the market to buy shares long. The net result of buying and selling shares in the same amount is the exact same too.
The only meaningful difference is that the quantity of shorting isn't constrained by the amount of shares that can be borrowed from your broker, so shorting in greater quantity is possible, resulting in greater volatility -- but NOT resulting in the shorts being any more able to move a stock price down permanently, becausse they still have to buy long just as many shares as they sell. So their net buying-selling still comes out to 0 (zero).
Here's a paper on the economics of naked shorting (.pdf) .
But we just had to give the wealthy and big corps those huge tax cuts; and we just had to invade and occupy Iraq.
Sure might've helped absorb the damage if we hadn't blown our wad on those two things, wouldn't it. Now here we are.
To mix a metaphor, they are trying to hold back the sea with our hands.
liberalrob,
The Bush Administration has been a war-happy fiscal fraud-you will get no argument on this from me (I wish Gore had won in 2000), but even if the tax cuts had not been passed during the Bush Adminstration, the solvency position of the United States would not be noticeably better. The accumulated bad debts dwarf the net taxes that would have otherwise been collected, and the unfunded liabilities we accumulate every year dwarf everything else.
We have been spending far more than we have been taking in for a very long time, but it is on the coming demographic changes that it will catch up to us. What needs to happen is for more people to actually work at producing goods and services that they then trade for the goods and services they consume. And we actually need to be saving at the individual level for our own retirement needs. People should only retire if they are literally unable to work, or when they have actually saved enough on their own to do so.
"Short-selling, for curious readers, is the practice of selling a security you don't own, in the hopes that the price will drop and you can buy it back before you have to deliver the actual security."
can you explain how its possible for somebody to sell something they don't own? I'm clueless on the practices of wall street...