28.9.08

CAUGHT SHORT. Reason's Brian Doherty objects to the government's ban on some short sales.
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.)
Regulators have imposed a number of specific prohibitions against naked short-selling, but those prohibitions might simply be distorting the information content of prices.
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.
The short sale is a symptom of trouble. If the fundamentals suggest a lower valuation for the stock, it will go down, short-sale ban or not. If the fundamentals do not, the short seller who hopes to trigger lower prices to cover a naked short position has a lot of buying back to do. Mr Doherty suggests, charitably, that the regulators would like to prevent a rational expectations hyperdeflation.
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.
There's still a lot to learn about complex adaptive systems here. Mr Doherty suggests that the recent elimination of the uptick rule (on which a short sale could only be entered on an upward price change) is not to blame.

Two discussions I had this week, the first with [J.B.] 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.

Saut, on the other hand, noted that he’d seen those academic studies on the uptick rule, but is still sure that it does matter and that highly capitalized hedge funds, once they get rolling with shorts, can and do wreck companies. Such drama about the short-seller’s occasional role as wrecker is well exemplified by this 2005 Time article. However, truer to the typical reality of the short-seller is this more sober account from 1996 in Business Week describing the slow, steady, important, and risky work in spreading economic information that the short-seller generally provides.

But here we have the fundamental dilemma of economic policy in a market system in which the payoffs serve both as signals ("the slow, steady, important, and risky work in spreading economic information") and as rewards in themselves (which is how hedge fund managers earn their keep).

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