An attempt to deal with the short selling problem
Recently a wave of short selling has hit a number of stocks, notably financial stocks. Financial stocks are particularly good targets for this because they are highly leveraged, and often have publicly traded debt securities, so the list of profitable arbitrages is long. Fannie Mae and Freddie Mac, government sponsored private corporations that hold about $5 trillion in mortgages, have recently been targeted by short sellers because of their leverage and weakened financial positions. Now the US government has put in place emergency rules to limit short selling of Fannie, Freddie, and other financial firms such as Lehman Brothers.
Apparently, there has been systematic abuse of the rules governing short selling. Speculators and traders have been able to use the same securities many times as collateral in their short selling transactions. The result is that they are able to sell an almost unlimited amount of stock (and that’s in markets that supposedly have transparency and well-enforced rules). WSJ:
Short interest, or the amount of short positions outstanding, is at an all-time high, at 18 billion shares, for NYSE Euronext listed stocks. The battle between regulators and short sellers has a long history — dating back at least to the South Sea Bubble of the early 18th century — and short sellers have usually won. It’s hard to prove that short sellers manipulate markets or that they perpetuate false rumors that pummel stocks.
In a short sale, a trader borrows stock and then sells it, in hopes it will later fall in price. If it does, the short seller then buys the stock in the open market at the lower price, returns what was borrowed, and pockets the difference.
The SEC said Tuesday’s move aims to stop “unlawful manipulation through ‘naked’ short selling.” Naked shorting refers to the practice of selling stock short without taking steps to borrow it. Critics say short sellers band together and sell shares of a company all at once, overwhelming the market and driving its stock price down. That can set off a chain reaction, with shareholders getting nervous and selling. Critics say the short sellers then close out their bets at tidy profits…
Under current rules, a short seller must first locate shares to borrow, but does not have to enter into a contract with the share lender. Often, more than one trader is able to borrow the same shares, creating a multiplier effect in the size of the total short position. Under the emergency order, a short seller would be required to have an actual agreement to borrow the shares. The new move would effectively take shares out of the market for borrowing…
The SEC has started clamping down on short selling, indicating it is worried about the impact such trades are having on the financial system. It’s investigating whether traders used a combination of false rumors and short selling to drive down shares of Bear Stearns earlier this year. Lehman is engaged in a public fight with certain short sellers, which has also prompted an SEC investigation…
Some market observers say the SEC’s elimination of the so-called up-tick rule in 2007 has contributed to the current market volatility, and they want the agency to reinstate that rule instead of taking the emergency action. The up-tick rule barred short sellers from selling unless the stock price was rising, which had the effect of cushioning the market impact of such selling. It was a symbolic barrier against the kind of short selling that could cause stocks to fall precipitously…
The efficacy of regulators in limiting short selling apparently has a long and undistinguished history, according to the piece:
For nearly as long as stock markets have existed, authorities have tried to restrict short selling. And for as long as they have tried, they have failed. In 1733, in the aftermath of the South Sea Bubble, the British House of Commons banned what today would be called naked short selling. The law remained in force for more than 150 years, even though, as financial historian Charles Duguid noted in 1901, “it was at no time seriously operative.”
On Apr. 10, 1792, the New York state legislature banned short selling. Five weeks later, two dozen stockbrokers banded together to sign the Buttonwood Agreement, which created what became the New York Stock Exchange, where short selling occurred with abandon. Last month, Pakistan banned short selling on the Karachi Stock Exchange for a month, after declines. In the 1990s, Hong Kong temporarily banned short sales, and the Malaysian finance ministry proposed that anyone caught short selling should be punished by caning. Neither measure prevented those markets from falling during or after the 1998 Asian crisis.
Efforts to restrict short selling are “silly but harmless,” says short-selling expert Owen Lamont, formerly a finance professor at Yale and now a money manager at DKR Fusion in Boston. Mr. Lamont adds that the SEC initiative “might have some impact on investors’ faith in the system. But I don’t see how it could possibly stabilize the markets in a fundamental way.”
It is said by some that short sellers had an important role in bringing down Bear Stearns a few months ago. But what made Bear Stearns vulnerable, among other factors, was that it was leveraged 33 to 1 on its capital, a figure that would have been considered shocking and unthinkable a generation or two ago. Short sellers may magnify the problem of excessive leverage but they did not create it. One of the ironies of our current situation is that highly leveraged short sellers such as hedge funds are among those spotlighting the fundamental problems of high leverage in the economy that are painfully being reversed today.
July 17th, 2008 at 2:48 am
Gee whiz, all this time I’ve been thinking the market’s and dollar’s troubles happened because of the Bush Republicans’ corrupt fiscal buffoonery (while the Democrats promise they’ll do even worse). Fortunately, nefarious short sellers have been unmasked as the real culprits, and all will be well after America’s righteous government gives the globalized financial markets a stern no-nonsense talking-to.
Forbes reports:
Note the switcheroo in the first paragraph. It’s not hedge funds that enable naked shorting; it’s the big brokerage firms which are major stock repositories (and whose gross irresponsibility was essential to the housing bubble). Perhaps they’re campaigning for regulations that will provide a pretext for new fees on their short-selling clients. As for the second paragraph, some time ago I cut my losses in Byrne’s stock.
Forbes continues about the SEC:
In effect, apparently the SEC is dragging its feet to accommodate the creation of overpriced leverage. Derivatives are not usually created by individual investors or hedge funds, but by the fine people who brought us the housing bubble, the Internet bubble, the emerging-markets bubble,…
September 24th, 2008 at 11:36 pm
1) Conservatives, since Ronald Reagan have consistently run bigger deficits than liberals.
Conservatives can always be depended on to act in their own selfish interests no matter how harmful the consequences to our nation.
2) Conservatives have enlarged government by several magnitudes of order.
3) Conservatives dangerously redistributed already top-heavy American wealth to a tiny sliver of mostly undeserving persons at the top.
4) Conservatives strongly supported hedge funds, including derivatives, sub-prime mortgages, naked short selling, and other high roller schemes because modern conservatism is rooted in the religion of cowboy capitalism and the absence of regulations for investors.
5) Conservatives have embraced the three-pronged strategy installed Reagan of “privatization, Localization, and Deregulation.” (If it doesn’t help the rich, get rid of it.)
6) Conservatives see themselves as more patriotic, because they confuse the self-interested protection of wealth and property with patriotism.
7) Conservatives blame the poorest and least educated Americans for falling prey to predatory lenders, which is like blaming robbery victims for theft.