Short Sale Ban: Learning From Mistakes 12 comments
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The verdict is in. There is growing recognition that last September's ban on short selling in certain financial stocks was a mistake.
Most of the professional trading and investment community do not see short selling, per se, as a problem. There are several debatable issues: the uptick rule, credit default swaps, and mark-to-market accounting for assets intended as long-term holdings. Short sales were not controversial among professionals.
The Academic Verdict
There is some fast work from the academic community. A team led by Columbia Professor Charles Jones, Chairman of the Economics and Finance Division, has a strong data-based analysis of the short-selling ban. They note that despite the initial pop in these stocks, they actually did worse during the market decline over the period of the ban. More importantly, they note that liquidity in these issues got much worse. The average trader faced wider bid-ask spreads leading to more costly trades. Short sales add liquidity and even fuel rebounds when fundamentals change. As many noted at the time, there were various ways to avoid the ban, including purchases of put options and inverse ETF's.
The SEC Verdict
SEC Chairman Christopher Cox acknowledges this error. In a just-released interview in the Washington Post, he is quoted as follows:
Cox said the biggest mistake of his tenure was agreeing in September to an extraordinary three-week ban on short selling of financial company stocks. But in publicly acknowledging for the first time that this ban was not productive, Cox said he had been under intense pressure from Treasury Secretary Henry M. Paulson Jr. and Fed Chairman Ben S. Bernanke to take this action and did so reluctantly. They "were of the view that if we did not act and act at that instant, these financial institutions could fail as a result and there would be nothing left to save," Cox said.
Our Take
We should note first with applause the rapid data-based effort by unbiased academic investigators. We can all enjoy the effect of the Internet. Instead of waiting more than a year for academic publication in a peer-reviewed journal, results are now available more quickly. If there is criticism, that is also available to all. It is a major improvement in the way academic research becomes relevant.
We find more difficulty in the Cox "go slow" concept. It is clear that events were moving more rapidly than policy. Paulson and Bernanke were correct in identifying a problem, but the focus was wrong.
Eventually we will see an academic study that pulls together the key elements:
- The unregulated credit default swap market, easily manipulated with modest amounts of capital;
- The widespread publicity surrounding the CDS trading, implying insolvency of the institutions in question;
- The speculative put buying by those profiting from this pattern;
- The mark-to-market implications for institutions not involved at all;
- The possible manipulation of widely used ABX indices, affecting the entire market.
This all needs investigation. Will it be on the agenda for the new Obama team? We hope so. Learning from this lesson is absolutely essential.
Disclosures: None
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This article has 12 comments:
Sadly, as most mutual fund, market makers, and hedge fund managers that short will tell you most of the shorts are done to cover themselves and what isn't often is shoveled back into the market providing stimulus or the all to fond, snapback relief rallies everyone was touting until 2008. And those that don't run bear funds who are required to bet against the market so you should really blame the people who invest which would be silly wouldn't it. After all, it is their money, can't they do whatever they want with it. Would you like someone to tell you you have to stick all your money in the market, because if you don't you are essentially shorting it?
Strangely, I hear few people blaming Goldman who under Paulson's tenure sold tons of toxic CDS contracts, AIG who sold them as well with the help and encouragement of Goldman and then bought them from Goldman, not JP Morgan who also inflated the derivatives market to the point even a 1% default rate would make economic catastrophe for the banks.
Nor are people blaming the Fed that is sucking up money as fast as it can and asking banks to keep money parked in the Fed with interest which just deflates whatever stimulus the Fed, Congress, or the Treasury implements. Also such contrary actions just increase uncertainty and instability.
Nor are people blaming all the lobbyists and banks who asked Congress to remove the Glass Stegal act that prevents banks from putting all their cash (oops i mean your cash) into risky investments with no real oversight. The banks I am talking about are probably the ones most people have their money parked so I understand the conflict of interest complaining to them.
Likewise, I understand no one complaining about the elected leaders who pushed through this piece of work or refuse to re-install Glass Stegal or any other real regulation of CDS derivatives and banking chicanery. They were all the leaders everyone voted for and are currently all the leaders everyone voted for.
How about the Base 1 agreement to let banks hide their losses in off balance sheet accounting. Want to blame the regulators that allowed that? No one wanted to do it when they implemented it to artificially wipe away the losses (actually it just hid them) so the market could recover after the dot com bust. In fact, it was used to encourage banks to do more of the same.
As you can see, there is a lot of blame to go around. Rather than finding out the solution, it has been politically expedient to make up someone to blame who not too many people know rather tha identify the root problems and solve them.
If I had New Years wishes (Hoping on a Christmas is too late) I would wish for real bank transparency, real economic information unobscured by inflation and unemployment number fudging, real regulation of the derivatives market, and a re-enactment of Glass Stegal even though almost all the big banks around merged banking, brokerage, and insurance into vast holding companies (Gee I wonder why that is. And I wonder why no one trusts their financial disclosures and don't want to loan them money even overnight), and a revocation of Base I accounting rules that enable the type of crookedness that is the root cause of this market collapse.
The market downturn is not a force of nature, and is not unpreventable. Normal economic cycles are not preventable. This cycle is not normal, it has been perpetrated by insidious worms that have eaten down to the fabric of our economic and financial foundations and are now threatening our very stability and livelihood. And yet, I don't think we have taken the effort to look this disease in the eye and call it for what it is... not shorters, but corruption.
It's the probable manipulation of CDS spreads and the ABX indexes, the negative publicity attacks on certain companies, the rumors spreading like wildfire, the dead certainty that Paulson would come in and wipe out shareholders, that made the whole thing so powerful.
CDS are insurance and should be regulated as such, with a requirement of insurable interest and adequate capital. Had such regulations been in effect, CDS manipulation would not have brought the market to its knees.
Ultimately, the SEC is responsible for preventing and punishing market manipulation, a responsiblity the agency, under the leadership of Christopher Cox, studiously avoided and continues to avoid. We need to know how many more "specific and credible" allegations the SEC has received and ignored, above and beyond the Madoff case.
CDS allowed buyers of this 'credit insurnace' to bet on the default of unrelated companies where the buyer of the CDS had no insuranble interest. Those who owned CDS then had a huge financial incentive to spread rumors that could make their CDS holdings more valuable or even to trigger an actual payoff event.
CDSs should be banned.
So, it continues now, as it was at the time of the corrective wave of regulations in the '30s, to be in the interests of individual investors to have restrictions on institutional short sellers.
It is always in the interests of individual investors to have robust regulations that prohibit the nonsense of these rumor mongering, tail-wagging, over-leveraged, cry-baby, self-important, big shots swinging other peoples money around. Remember, unlike individuals, there is no cost to them if they lose l money (they can get another job in a snap as they are considered "talent" on Wall Street), but great bonuses if they should luck out and make some.
The structural advantages of the institutional players must be reduced to allow the average guy to have a fiar shot. We are so far from that now --- America IS gangland Chicago.
Put the criminals in jail. Start over clean.
On Dec 25 09:27 AM HiSpeed wrote:
> The impotent SEC needs to put the uptick rule back into effect.
> They need to enforce the ban on naked short selling.
The ban on short selling actually destroyed the hedge funds as convertible arbitrage, pairs trading, and quantative trading was turned upside down.
Delevering the hedge funds only causes a larger problem because they are the natural buyer of the distressed credit assets.
Unfortunately, Main Street does not understand the concept of short selling. How quickly have they forgotten short selling is as American as Lewis and Billy-Ray in Trading Places!
www.youtube.com/watch?...
Middle class workers who save through their 401K's and others with IRA's feel the effects the most.
Also margin trading should be changed to require at least 50.% cash instead of the 10.% .
The simple fact is that doing away with the CDS market will cause practically every single debt instrument on planet earth to fall in value. Without a mechanism to protect investors' capital through a default swap, buyers will simply demand higher yields, to compensate them for the additional risk.
Yes, there were people with no insurable interest betting against the demise of Bear Stearns and Lehman Brothers. And, yes, those people were proven right--BSC and LEH were sick companies, with too much debt, and too little capital. In most of the cases, the CDS's were bought to protect investors in LEH preferreds and bonds, investments that would never have been made in the first place without a CDs market in place.
There are all kinds of regulations coming, and the cynic in me is certain that they will do more harm than good. A lot of people have lost a lot of money, and they think they can go back and retroactively cure their stupidity by asking a liberal Congress to start passing laws. I remember how Sarbanes-Oxley was supposed to prevent a re-run of Enron. All it did was give company directors cover, to run the same shenanigans on Wall Street, this time with trillions of dollars instead of $5 billion. You'll forgive me if closing the CDS markets won't cause a lot more problems than they hope to fix, just because a few guys who've never heard of credit default swaps until a few months ago think it's a good idea.
The following comments are right that since CDS can be written without collateral backing them up. Basicaly this makes CDS the front for grand fraud (as opposed to petty - being only a few billion dollars). In essence, you package mortgages, slap a fully insured sticker you get selling another fraudster CDS insurance at too low a premium and then dump it on unsuspecting bankers. It doesn't take a brain scientist to get how this works.
The mortgage marketers get to dump junk morgages onto to banks as AAA. the fraudster who wrote the contract just disappear into the woodworks since they got premiums years in advance with no need to pay and plenty of reason to spend all the premiums (after all no collateral is needed). And the seller of the mortgage bond tells disgruntled junk bond holders to go find the CDS insurer if they want the money back.
Barring this, if the liability is found to default to the mortgage writer (an unfortunate event for the likes of Goldman etc.) the writer either goes belly up too, cries for government support, or denies all claims for one silly reason or another as they hope the claimant goes belly up first hiding under Base I accounting. If you recall, this gem was passed during the dot com boom and makes it impossible for anyone to see the off balance sheet transaction like CDS made by banks to help banks recover from dot com like busts. It also prevents any regulator from sussing out their bad deal since no one knows about it.
If you don't think this type of thing is happening take a look at AIG and Goldman, Bear Stearns, JP Morgan, Citibank, and Lehman. Those are just the biggest ones. It is hard for them to hide even under a big TARP.
They got their Christmas present at the cost of the rest of the public.
As Reagan put it, "If not us... who. If not now, when?" Now is a good time to start fixing this mess since the game is already up and not a lender under the sun is willing to believe a banker's balance sheet anymore. For the last half year everyone has been playing an easter egg game called, "find the $40+ trillion dollar CDS rotten egg amongst the forest of financial institutions." We don't really want to be doing this by Easter or 2009 will be looking extremely ugly indeed.
What's worrisome is the idea that people who (a) don't understand them; or (b) think that the do far more harm than good, should be able to destroy the market entirely. Credit default swaps didn't ruin Bear Stearns--BSC management did. It's like saying that nobody is allowed to buy fire insurance, just because in a handful of cases a year, some commit insurance fraud by setting fire to their own homes.
The Law of Unintended Consequences is real. And destroying the CDS market will only increase yield spreads that are already at Depression levels, and the money now being made by speculators on CDS instruments will merely go to the short side of the debt themselves.