Even in the past week’s rush of the Treasury secretary’s attempts, with the craven and thoughtless acquiescence of Congress, to assume near-dictatorial powers over huge swaths of the economy, don’t let’s wipe the depredations against a freely-functioning market of a week ago into the memory hole. It’s still worth thinking about some questions connected with last week’s “short-selling” ban.
1) How—and why—does this short-selling thing work, anyway? What short sellers do, in essence—and the practical realities of it, like anything in modern paper-shufflin’ high finance, can get mighty complicated—is borrow stock and sell it. Then, sometime down the line when they have to return the stock, they buy it back in the market. Why? They are hoping that at that point its price is lower than the price they sold it for, so they can pocket the difference.
In standard short-selling, you have already borrowed or arranged to borrow the stock that you're selling. In the more controversial, and largely illegal, “naked” short selling, you make a deal to sell them before you have actually borrowed or arranged to borrow. This frequently ends with you being unable to deliver the security, leaving an open “failure to deliver” contract that may (or may not) ever settle with the buyer actually getting the stock. (Most believe naked short-selling is especially pernicious, essentially creating fake “fiat” shares that don’t exist and driving down prices. Others have argued the economic differences between naked and non-naked short-selling probably don’t exist.)
Short-selling is risky; an asset going down can only go down to zero, but things in theory can go up, up, up. When they go up, up, up the short-seller is in trouble, since he will have to pay to return the stock he borrowed at a far higher price than he sold it for. That’s one of the reasons not everyone does it—it tends to involve only about 4 percent of outstanding shares in the market.
2) What exactly did the Securities and Exchange Commission (SEC) do about short-selling recently? The SEC's first move against short-selling was back in July, when it reiterated a ban on naked short-selling of 19 financial stocks, including such soon-to-be headline makers as Fannie Mae and Freddie Mac, Goldman Sachs, and Lehman Brothers. (Under the 2005 “Regulation SHO,” most forms of naked short-selling were already illegal.) It extended that naked short-sell ban past the original 10 days.
That first naked short-sell ban wasn’t enough to keep a lot of institutions with lots of worthless assets from continuing to be in trouble—nor should any intelligent market watcher have expected it to.
So last week the SEC announced a wider and deeper attack on short-selling: for a list of 799 different financial companies they declared a two-working-week ban on all short-selling, naked or no. They also reserved the right to extend that ban for 30 days. Since the initial list, they have been adding other companies, many non-financial, by the day. The list now stands near 1,000 and includes IBM, CVS Pharmacy, Ford Motor, and Zale Jewelers.
3) Why did the SEC do this? The SEC order provided no particular evidence, logic, or examples to support the notion that this ban would do anything to change the grim realities that were really driving down the value of securities backed by lots of crappy assets whose market values had been unduly inflated for years, or companies that people just believed had been overvalued by the markets.
The order has vague imprecations about being “concerned that short selling in the securities of a wider range of financial institutions may be causing sudden and excessive fluctuations of the prices of such securities in such a manner so as to threaten fair and orderly markets.” An application of “herding” theory is basically in play, the idea that if people see lots of sales going on, they will start selling willy-nilly, too, with no good reason. What the SEC are really trying to do is impose a subtle and second-hand form of price control by limiting people’s ability to sell as many shares as they would otherwise be able to if they could short-sell—it's one more attempt to prop up a falling market for a couple of more weeks.
4) What’s the problem with the ban in the short term? The nearly universally agreed on downside is that it eliminates one efficient mechanism, as James Chanos put it in a thorough Wall St. Journal piece, for “promoting deep liquidity, vigorous price discovery and open competition…Short selling also improves market quality and efficiency by…improving the speed of price adjustments based on new information… As a former SEC chief economist aptly observed, ‘To ban short selling is to in effect say that the government is going to try to determine what stock prices should be.’”
Is the ban doing what the SEC wanted? An SEC spokesman intimated to me this week that any assessment of the positive (or negative) results of the short-sell ban will feed into the decision the SEC will have to make next week whether to extend the 10-trading day ban. They reserve that right, until they get to 30 days, when existing statutes regarding how the SEC can use its “emergency” powers would mean longer, more complicated rulemaking processes governing any further restrictions on short-selling.
As lawyer and short-selling analyst J.B. Heaton said, “Suppose prices go up since the ban; that tends to suggest to the SEC that the ban is working so they should keep it in place. If prices still go down, the ban is still necessary so they should keep it. No matter what happens, they could easily interpret it as a reason to keep the ban, and that’s a bad sign.”
I did a very rough sample of 20 of the stocks in question—simply taking the list the SEC issued in alphabetical order, the first 10, then the last 10. I found no clear sign of the ban doing much to buoy the stocks, despite the guesses of some market analysts. Of those 20, from close of the day before the SEC made their announcement of the ban (Sept 18) to close yesterday, seven had gone up, an average of 8.8 percent; 12 had gone down, an average of 10.2 percent; and one was exactly the same.
Most mainstream analysts blame the problems they see with short-selling on the elimination of the “uptick” rule, which restricted short sales to instances where, roughly, the last move in the stock had been up. This was meant to prevent a mad rush to the bottom. Of course, it eliminated some of the benefits of short sales for the same reason a total ban does—it didn’t freely allow those with a more negative opinion of a stock’s prospects to act on their intuitions—and was eliminated last year after an SEC experiment in which the rule was taken off of certain stocks. There were no signs of a problem being caused by lack of the rule.
Two discussions I had this week, the first with Heaton and the second with investment strategist Jeff Saut of Raymond James, presented violently opposing views on this matter: Heaton told me of the results of the SEC test and of academic studies indicating that the uptick rule had little impact. In general, Heaton argues against the notion that short-sellers, other things being equal, can wreck a stock. Instead, he maintains that when the short-seller, who allegedly pressures prices down by selling, returns the stock he borrowed, he then by necessity becomes a buyer, who other things being equal pressures prices up.