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We're now into the blame game, and it seems obvious that a major chunk of the blame for the current mini-round of the ongoing financial crisis is being accorded to short-sellers.

Tonight we are hearing about new disclosure rules for short-sellers, new bans on short-selling certain financial stocks in certain jurisdictions, strong pushing for a reinstatement of the uptick rule, John McCain saying deranged things about naked short-selling, and pretty much everything else short of suggesting that short-sellers be tossed into creeks to see if they float. I'm sure that's coming, of course.

As an aside, my current favorite smart-aleck comment on the crackdown came just now on Twitter from my friend Dick Costolo:

SEC expanding short-selling restrictions to prohibit yelling within 20 yards of a ticker symbol & exercising puts w/out saying "simon says."

The trouble is, blaming short-sellers works, as does, at least sometimes, banning short-selling. First, short-sellers are easy targets -- people who want things to go down, especially things that you own, must be bad people. Blaming them gives you political, financial, and rhetorical power.

Second, to the extent that people are keeping money out of the market because they are petrified of short-sellers, convincing them that less short-selling is going on (even if it isn't) is an easy way to get more capital back into the market. Granted, nothing has changed, but it's a fun superstition, sort of like sacrificing the odd virgin into a nearby volcano. Or tossing a supposed witch into a shallow creek.

The trouble is, of course, short-selling remains important. They are usually the best-informed traders in an issue, as repeated studies have shown. Their ability to bring prices in line is lost, or at least muted, and that can make subsequent price moves even more wild.

At the same time, you can still make money from stocks going down, even in those issues that have had short-selling banned. I can still buy puts, or write calls on stocks, both of which are bets the stock will go down. And if I don't like options I can buy something like the UltraShort ProShares Financials ETF (SKF), which goes up (down) twice as much as the Dow Jones Financials Index goes down (up). Inside said index is, of course, Morgan Stanley (MS) (at a 1.2% weight), Goldman Sachs (GS) (at a 2.3% weight), etc. I'm shorting the stocks that I'm not allowed to. Ooooh! (And this does raise a sort of zen question: If shorting financial stocks is wrong, does it follow that shorting the UltraShort Financial ETF is good? Just curious.)

This moment too shall pass. Eventually volatility will fall, banks will deleverage or merge or fail, and we will see the requisite studies showing that short-selling wasn't the problem, plus that market quality deteriorated in stocks in which short-selling was banned. It's as predictable as the politicians piling on. Too bad no one cares in the rush to be seen having found someone to blame.

Update:

In a predictable twist tonight, SEC Chair Chris Cox has allegedly said he is going to follow the U.K.'s FSA and seek a temporary ban on short-selling. If true, and if it weren't such a stupid idea, it might be funny, like the U.S. doing a half-way step to Pakistan's goofball policy of disallowing market declines. Up with markets!

But even if we dismiss price efficiency, consider the practical consequences of making it impossible to short financials (and don't even get me started about disallowing all shorting): What happens, for example, if you're running a long/short quant fund with billions of dollars and hundreds of positions? Do you give the money back now that you can't trade the short side of your fund? Do you push all the short trades through ETFs? Do you abandon the entire financial sector? And who do you sue when your fund blows up because you're not sector neutral? Short-only funds are, of course, now, turned into commercial real estate companies.

Absurd. Bad enough to have idiot financial services busting themselves and markets with 30x leverage built on a tissue of toxic CDOs, but now we have frantic and destructive rulemaking to prevent over-levered nitwits from crumbling.

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  •  
    Do those of us who have owned SKF have any recourse?
    2008 Sep 19 12:15 PM | Link | Reply
  •  
    @User 225084

    You don't get money when you short a stock.

    You have to post margin (ie set aside some of your own money) before you are allowed to short. If the price of the stock then goes up, you have to add more money to cover your paper losses to at least 50% of the current value of the stock.

    Any remaining value not so covered is borrowed from your broker and you pay interest on that amount until you buy your short back.

    And yes, I've shorted stock before and made money at it. I'm "evil" and profit seeking.

    And one other point. In order to short a stock there must be a willing buyer. The shorter has no way to force anyone to take the other side of a trade. It's all voluntary.

    The party that buys the shorter's shares will lose money if the share price goes down, regardless of who is on the other side of the trade.
    2008 Sep 19 12:20 PM | Link | Reply
  •  
    Supporters of short sellers say that when a stock is overvalued, shorting helps to drive down the stock price to its fair value . But in reality, shorting can way overdo its damage, because the stock price also depends on the psychology of fear and panic, created by heavy selling and unproven rumors . And since the short sellers stand to benefit tremendously, it will be foolish to expect that they will stop when the stock reach its fair value. Thus they eat the lunch of average investor like you and me.

    In a free market, in the absence of manipulation, an overpriced stock will normally comedown in a natural way, e.g. after the earnings announcement, and so on. But if a bunch of powerful short sellers get together, and a launch a concerted effort of taking a certain stock down, the stock can slide - to a value much lower than its fair value, while short sellers can profit tremendously.
    This can also create a ripple effect of negative sentiment in the market, which can in extreme cases snow ball to create serious disturbances in the economy of the country, causing misery to the rest of the country, while these handful of wealthy short sellers are laughing all the way to the bank.

    But it is extremely difficult to rectify the situation, because some very powerful and wealthy sources are supporting it and benefitting from it . They probably have spokesperson to dominate the media like CNBC , and others, and a lot of regulatory agencies, otherwise we would seen simple corrective actions like the "uptick rule" been reinstated.
    2008 Sep 19 12:26 PM | Link | Reply
  •  
    @Smarty_Pants,

    There was not much point to what you wrote there, I'm afraid. Of course I get money when I short a stock. And I get stock when I buy long on margin. Restrictions on what I can do with said new property exist in both cases, and there is a symmetry between the two.

    My point is that the SEC is breaking the symmetry between the two, which is bad.
    2008 Sep 19 12:45 PM | Link | Reply
  •  
    Smarty_pants, I agree completely with your response to glassbox.
    2008 Sep 19 12:48 PM | Link | Reply
  •  
    user225084 wrote: "Of course I get money when I short a stock."

    To which I would reply that it's obvious you have never shorted a stock before.

    The only time money is added to your account when you short a stock is when you buy it back at a profit. Any 'paper' gains you get before that point are subtracted from the margin loan you owe your broker.

    As for short sellers 'driving' the market down, look at the numbers.

    Fannie Mae bottomed in mid July at $8/share, down from $20 two weeks earlier. During that time FNM had an addition of 16 million shares short interest over 15 calendar days (11 market days). That's an addition of roughly 1.7 million short shares per day.

    Yet the average volume for FNM during that period was almost 124 million shares per day.

    So...did the price go down because 1.7 million shares were shorted or because the owners of a majority of the other 122 million shares sold out every day for two weeks?

    If a majority of those owners had switched from selling to buying they would have swallowed the short shares without dropping the price by more than 50 cents.

    Judge for yourself, but claiming that less than 1% of the trading volume is what 'drove' prices from $20 to $8 seems a little far fetched to me. Selling pressure by prior shareholders seems more likely the reason behind the big drop.

    I can only assume that discovering FNM was losing money hand over fist might be one reason why so many prior owners sold. I'm pretty sure they didn't do it because they found out less than 1% of the average daily volume was short interest.
    2008 Sep 19 02:38 PM | Link | Reply
  •  
    And to continue...

    From mid April to end of April, the short interest increased by an average of 1.2 million shares per day on an average volume of 13 million shares per day. That's over 9% of trading volume in short sales..... Yet the price went from $27/share to $30/share.

    Share price went UP when 10% of all volume was short sales!!

    Hmmm.... short sales 1% of volume = price goes down.
    short sales 10% of volume = price goes up.

    Short sales must be a contrary indicator I guess.

    Facts prove that the government is blowing smoke trying to pin blame on a scapegoat.
    2008 Sep 19 02:51 PM | Link | Reply
  •  
    Jeez, Smarty_pants, I don't have more time for you.

    First , it appears that you are arguing with me about something I did not wrote. Note that there are multiple usernames of the form userNNNNNN.

    Second, yeah, when I short a stock, I get money in my account, just to the same extent as I get stock in my account when I buy on margin. This is completely analogous,. There is nothing special about shorting. Get it?

    Once and for all: Selling stock you do not own is the dual transaction of buying stock with money you do not own.
    2008 Sep 19 03:40 PM | Link | Reply
  •  
    Mike, and Smarty_pants : you are forgetting the fact that short sellers operate more than one ways : one is of course short selling in which they sell borrowed shares. I think, a few strategically placed sell orders in a concerted way can kill a rally or cause a plunge - which may not take a lot of shares.
    Secondly, short sellers actively spread negative rumors which can cause frantic selling among regular investors - they sell before asking questions.
    2008 Sep 19 03:42 PM | Link | Reply
  •  
    Ah, I see, only short sellers would spread ugly rumors, even if true.

    Why couldn't User225084 spread negative rumors to drive down the price before buying his shares on margin? Shouldn't that be disallowed too?

    BAN RUMOR_MONGERS!! It's all their fault.
    (note: just being facetious to make a point)
    2008 Sep 19 04:01 PM | Link | Reply
  •  
    Then again, lots of people spread positive rumors or tips which results in the price rising sharply. Isn't that just rumor-mongering stood on its head? Why is that OK? Just because it drives the price up instead of down?

    With that tip-driven high price people like User225084 wind up paying too much for their margin-purchased shares. Then when earnings disappoint and the price drops User84 loses money that he borrowed to buy.

    Gosh, I suppose everyone has to figure out what's fact and what's fiction FOR THEMSELVES. Imagine that. Make your own decision and live with the consequences instead of blaming short sellers or tipsters for your lack of diligence or disregard of risk.

    Caveat Emptor!
    (and when that doesn't work, beg the FED to bail you out)
    2008 Sep 19 04:09 PM | Link | Reply
  •  
    This whole issue is blown out of proportion because it has gone to extremes. Shorting stock adds liquidity and balance. However, it would appear that recently large capital (aka hedge funds) *seem* to have gotten together like packs to take down companies one by one....under these circumstances we need temporary measures to stop this activity while new rules are created to level the playing field. Happens all the time in sports, if someone discovers a way to get around the rules- there is a time out to bring the "intention" of the sport back in line. I expect shorting will be reinstated but with new rules to curb it's activity.
    2008 Sep 19 04:26 PM | Link | Reply
  •  
    All the short sellers in the world couldn't make these companies worthless. These companies made themselves worthless. Guess where the shorts borrow their shares from? The same big banks that are now whining about shorts. Hey, there's interest to be collected and fools to be fooled.
    2008 Sep 19 05:28 PM | Link | Reply
  •  
    Fer Pete's sake, Smarty_Pants. Why are you stereotyping me as someone who buys long, possibly on margin and dislikes short-sellers?

    Quite the opposite is true.

    My contribution to this thread was to point out the strong analogy, or duality if you will, between short selling and margin buying, with the intent of illustrating that if you restrict one type of transaction then you should also restrict the other, or neither, so as to make the playing field level (or the market "free" if you will).

    What's not clear about that? Jeez. You keep arguing with me because you think I'm against short sellers. Even if I happened to be, you should stick to arguing against what I have said, not just arguing because you think you disagree with me and therefore do not like me. Get a clue.

    And you even have good points: Spreading rumours to drive UP the price of a stock is much more common than spreading rumours to drive down a stock. I agree completely.
    2008 Sep 19 06:00 PM | Link | Reply
  •  
    This article is spot-on. To answer "Will any owner lend a building to somebody else whose intent is to sell it in anticipation of a price erosion?" The answer is "If you are confident that your property will continue to gain value, then absolutely." The problem began with the mortgage meltdown, which is due to foreclosures by the American people, and this is the onset of the ripple effect. Foreclosures were up 80% from 2006 to 2007. That's what has screwed the large financial institutions, and in turn, everything else. And anyone who mentions "avarice and greed" is delusional. We all invest to MAKE MONEY. When shares of Merill Lynch go up, women don't cease to be battered and AIDS in Africa doesn't go away. You get paid. And to the poster that lamented the he's "not a trader,"- that's why you pay a money manager.
    2008 Sep 19 06:17 PM | Link | Reply
  •  
    Don't understand why you shorts are upset. Its only a two week ban and, as one of the posters noted, it will only fatten up more stocks for the kill. (i.e. sending them to zero)

    Which is basic problem here - it was starting to look like any stock could be driven to to zero in a few days for no good reason. No rational market permits the kind of price action that happened with Goldman Suchs.

    Somebody (or bodies) determined in advance that GS was going down. All you had to do was look at the puts sold the day before GS announced their earnings - people were buying puts with a 90 dollar strike (when the stock was trading in the 150s) with a Sept 20 expiration date.

    Even after GS reported better than expected earnings, the stock was relentlessly driven down and probably would now be in the 50s if Hammerin" Hank hadn't stepped in. The talking heads on CNBC explained the decline as "the market believes the investment bank model is broken. "

    IMO That explanation is BullSh$t. The kind of decline experienced by GS is nothing less market manipulation and fraud. Shorting may have one of the tools that the manipulators used, but it is probably not the only tool.

    The SEC is using shorting as smokescreen so that they don't have to pursue the real issue - collusion by institutions (hedge funds/ sovereign wealth funds/Al Queda?) to manipulate the market.

    BTW I am not now nor I have I ever been long or short on GS. I actually despise them and believe they have probably engaged in the kind of market manipulation that is being used to take them down. As the saying goes - What goes around comes around.
    2008 Sep 19 08:24 PM | Link | Reply
  •  
    You know why the shorts in the post are so visibly upset - you can see from their language. Many of them have this schizophrenia mentality - borne out of doing nothing good for humanity. And they overplay the part the play in allocating capital.
    2008 Sep 19 08:45 PM | Link | Reply
  •  
    Glassbox, when you say there's no symmetry between a buy and a short, you've got the symmetry idea wrong. The symmetry exists between the short followed by it's eventual cover, and the buy followed by its eventual sell. Both situations involve a buy and a sell. The only difference is in the order in which they occur. If a party is allowed to speculate that prices will rise, then they should also be allowed to speculate that they will fall. It's that simple, and it's pathetic that that should have to be pointed out.
    2008 Sep 20 09:13 PM | Link | Reply
  •  
    Sorry guys, didn't mean to rain on anyone's parade in particular. My Apologies.

    My basic point is that either a) it's nearly impossible for shorts alone to drive the price down unless the current shareholders are selling too or b) even if someone did manage to generate enough volume to drive a large cap stock down they would probably lose a bunch of money trying to cover unless the price was truly "too high" to begin with and others were selling too.

    The entire ban on shorting is just a smoke screen/witch hunt to mis-direct the discussion away from poor business practices or poor regulatory oversight.

    Same goes for government/media claims that futures speculators are 'driving' prices up/down. Every futures trade needs a buyer and a seller. Price moves only when one group overwhelms the other. Same for stocks.

    No way that 1% of volume can push a price down 35% over a two week period unless there's a reason for others to sell too.
    2008 Sep 21 12:07 AM | Link | Reply
  •  
    When Your Right Your Wrong!

    This criminal banking cabal is defying all fundamentals in the financial markets. When will they take their hands off this thing? I guess when they think they've wiped everyone out.

    Short selling provides liquidity and balance in equity, commodity and futures markets. Without short selling you're left with a one sided trade and the makings of a new bubble.

    Everyone that knows where to invest is marked as an evil speculator or an anti American short seller. The sad thing is that the major broker dealers like Goldman Sacks are the main culprits that engage in the largest amount of short selling and "Naked Short Selling", which is only accessible to major institutions.

    The following is a good article on this subject.... www.bearmarketinvestme...

    2008 Sep 24 11:14 PM | Link | Reply
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