It has come to my attention that regulators are not familiar with the concept of the Butterfly Effect, wherein (from Wikipedia) :
The butterfly effect is a metaphor that encapsulates the concept of sensitive dependence on initial conditions in chaos theory; namely that small differences in the initial condition of a dynamical system may produce large variations in the long term behavior of the system. Although this may appear to be an esoteric and unusual behavior, it is exhibited by very simple systems: for example, a ball placed at the crest of a hill might roll into any of several valleys depending on slight differences in initial position. The butterfly effect is a common trope in fiction when presenting scenarios involving time travel and with "what if" scenarios where one storyline diverges at the moment of a seemingly minor event resulting in two significantly different outcomes
Hence, we come to this Bloomberg story - SEC May Restrict Short Sales in February to Curb Bets During Stock Plunges:
Jan. 23 (Bloomberg) -- Concern that short-sellers accelerate stock declines may prompt the Securities and Exchange Commission to adopt a rule next month aimed at curbing bearish bets when equities are plunging.
The regulation would require the trades be executed above the best existing bid in the market when shares fall 10 percent in a day, said Brian Hyndman, the senior vice president in transaction services at Nasdaq OMX Group Inc. In a short sale, an investor borrows an asset and sells it, hoping to profit from a decrease by repurchasing it later at a lower price.
Forcing short sellers to wait for a stock to rise above the best price bid may prevent them from flooding the market with sell orders and causing losses to multiply. Some exchange officials say the restrictions known as uptick rules don’t work, citing studies that show they may be less effective during panics that drive prices down and volatility up.
Well, the most glaring problem with this approach is that it attempts to purposefully break market equilibrium. Regulators are not trying to quell the market in times of extreme volatility, they are trying to effectively control stock prices and guide them in a certain direction. Note that there are no proposed rules to prevent the climb of a stock! Since there is no curb on the rapid climb of a stock's price, this idea is highly imbalanced. Do you know what happens to imbalances in a market that seeks to attain equilibrium? Usually the opposite of what caused the imbalance as economic forces seek to right a fallen ship.
If one recalls what happened when the ill thought out short ban was implemented in 2008, the convertible market choked due to an inability to hedge and option prices soared. Shorts are a necessary component of our marketplace. They facilitate:
- Liquidity in fast moving markets, not to mention providing a floor in markets that are dropping significantly. Remember, even short sellers have to buy back stocks to cover their positions. Without those buyers of last resorts, when the long only guys finally realize the jig is up on their ponzi-scheme stock the selling will simply keep going until their is virtually nothing else to sell.
- True price discovery in that it is quite risky to short stock knowing the long term movement of the stock market is upward. Thus, most short sellers perform a considerably higher than average amount of due diligence on their prospects. This leads to a truer form of price discovery. Don't believe me? Ask the pensions guys that held (be sure to click each of these links to get the full picture) GGP (GGP and the type of investigative analysis you will not get from your brokerage house), for retirement, or Bears Stearns (Is this the Breaking of the Bear?), or MBIA (A Super Scary Halloween Tale of 104 Basis Points Pt I & II, by Reggie Middleton) or Ambac (The Ambac FAQ), or the many regional banks taken over by the FDIC (As I see it, 32 commercial banks and thrifts may see the feces hit the fan blades), or...
- Fraud detection in finding the Madoffs of the corporate world. It was short sellers who found the funny business in the books of Enron, Lehman Brothers (see Is Lehman really a lemming in disguise?"), and soon to be (if regulators are doing their job) Pre-paid Legal (The Flim Flam Scam gets SEC'd - I'm not going to say I told you so, again!).
So, hypothetically (of course) what happens when a company such as PPD (see The Flim Flam Scam gets SEC'd - I'm not going to say I told you so, again! and Flim, Flam, Scam: Would a PPD Ponzi and Pyramid scheme cause your wealth to Scram?) issues a statement that says we are an admitted sham that has a economically unsustainable business model that takes advantage of poor earners in their time of need all while management sells virtually every single share they can get their hands on into the corporate equity buyback program - virtually every single share!. Oh, by the way, we bought back 4% of our stock and have Y-O-Y 10% increase in EPS because of it. Hooray!
The stock shoots up. The moral amongst us throw up. Fundamental analysis, basic math and common sense go the way of alchemy and the quest to turn lead into gold, and
the crooks upper management go Azimut shopping with those banging Italian chicks on the bow...
I have a better idea. Let's implement the rules on the books instead of making new ones. You know, the rules that were designed to force corporate management to be more honest and forthcoming about their company and it's assets? Instead of trying to stop short selling, you can eliminate the reasons to short a stock, of course except for those cases where the STOCK DESERVES to be SHORTED.
Let's walk through a couple of Reggie's best recommendations?
- Eliminate the commercial real estate practice of "Extend and Pretend". If a loan (or any asset) is underwater on the books, declare it so. Period! This will assist in making the companies less susceptible to speculation. Either they are in decent shape or they are not.
- Disincentivize the corporate purchasing of shares to mask a fall in economic earnings. If companies want to truly return money to shareholders they should do just that. Return the money to shareholders. The term is called a CASH DIVIDEND. CASH.
- Reverse ALL of the FASB games that have been implemented as of late, namely:
- FAS Statement No. 157 and all related Mark-to-market accounting fantasies
- FAS 166 and 167 implementation delays: Chances are that if its off balance sheet, its off kilter. This off balance sheet mess not only provides fodder for short seller speculation, it allowed the bulk of this asset securitization crisis (be sure to click the link to read up on it from beginning to present) to occur in the first place. If Lehman, Countrywide, Merrill, WaMu, etc. weren't able to hide so much from average investors, they may still be in business today... The off balance sheet mess is nothing but Enron, restated.
More on the topic...
FASB Issues Statements 166 and 167 Pertaining to Securitizations ... Jun 12, 2009 ... 166, Accounting for Transfers of Financial Assets, and No. 167, Amendments to FASB Interpretation No. 46(R), which change the way entities ...
FDIC OKs Delay of FAS 166, 167 Effect on Capital « HousingWire Dec 16, 2009 ... FAS 166 and 167, which take effect in January, will require financial institutions to bring certain securitized assets onto balance sheets.
FDIC expects FAS 166 and 167 to increase bank capital requirements ... Aug 27, 2009 ... Federal Deposit Insurance Corporation (FDIC) directors agreed at their August 26th Board meeting that following implementation ...