Short selling

With politicians everywhere blaming hedge funds and short sellers for the financial crisis, I guess it was only a matter of time before short selling was completely banned. Over the past week, gradual steps have been taken to make it harder. First naked short selling (selling a stock without even borrowing the paper so you could cover having to buy it later) was banned. Then the US banned all short selling of financial stocks on Friday. Everyone else followed. And now the Australian market has banned all short selling, fearing an avalanche of overseas investors swamping the Australian market.

I’ve been trying to work out all week what I think of short selling. On balance, I agree with this pundit, Douglas Kass, in the FT. Short selling didn’t cause this crisis, it just made it happen faster. But there are a few problems with short selling, particularly if you don’t have to disclose – there are huge motivations to create negative rumours if you have a short position. And they are easier to believe than positive rumours. But I doubt that short selling was solely responsible for Macquarie Bank’s 50% bounce in stock price this last week – there would have been plenty of genuine punters out there terrified that it was next.

So in normal times, the sensible thing would be to enforce the rules (many of which already existed) against naked short selling, and require disclosure. But in today’s panicked state, with enormous volatility being exacerbated by shorting, there is a real risk that a company will go under because the higher volatility, magnified by the availability of short selling, puts them under some key ratios for a short period of time. So I’m reluctantly agreeing with the short selling ban. Not a sensible long term decision, though.

And I think that those listed fund managers and banks which, over the last year, have taken steps to stop lending their own stock, because it encourages the short sellers, have been purely acting from self-interest – a well regulated market does include short sellers.

  7 comments for “Short selling

  1. mitchell porter
    September 30, 2008 at 4:35 pm

    Somewhat off-topic: Kevin Rudd just said that “Australia’s four major banks are among the world’s 20 double-A rated banks”, but I have been unable to find out who issues the ratings. Would it be ratings agencies like Fitch? If so, is there a canonical list of ratings agencies?

  2. October 3, 2008 at 6:19 am

    mitchell,
    The ratings he is using are the S&P ones – see here.
    All of the aussie majors are rated AA, with no adverse outlooks.
    There is no real ‘canonical’ listing – S&P are probably as close as it gets. Personally, I have my free cash in one of the aussie majors, with no intention to move. Whileit may be a bit cynical, it is there as I have full confidence that there is no way the government would let one of them go down. I would count it as highly unlikely the would even let one of the regionals go. They know that the consequences would be dire.
    I also have very good confidence that none of them are even close to being in trouble – I have worked in many of them.

  3. Paul H
    October 11, 2008 at 2:54 am

    There’s one thing I don’t get about short selling. Obviously, for the strategy to work, you need to find someone who holds the stock you wish to short, then loan it off them for a fee, then sell it and wait for the price to go down (assisting it southwards if you can).

    But why are the holders of potentially vulnerable stocks willing to play along with this? Surely they realise what is going to be done with the stocks?

    If you hold, say, a banking stock, and the banking sector is looking fragile because of mortgage defaults, and then a short seller approaches you, why on Earth would you lend him the stock and play into his evil scheme?

  4. October 12, 2008 at 1:01 am

    Short selling is fine. But if they cannot get a handle on naked short-selling than it would be better if they banned the whole lot. Short-selling helps the market. Naked short-selling distorts market prices. Hence its naked short-selling that must be banned.

    Naked short-selling is one side of fractional-reserve in shares. Therefore its fraud. Therefore it ought to be banned. Now it is banned but no-one is enforcing the ban. They are too busy enforcing ridiculous regulations like capital requirements, or insider-trading laws.

    So they won’t enforce the ban on naked short-selling. Being that this is the case its probably better to ban all short-selling until such time as all the fraudulent shorts are cleaned out of the system.

  5. October 12, 2008 at 1:07 am

    Right now we have fractional reserve in everything. Thats what the derivatives boom is all about. Anything you can buy derivatives in we have a subterranean fractional reserve presence in that underlying asset. So we have underpricing of the assets that are subject to this fraud. Which amounts to just about everything you can think of that derivatives are available for.

    So thanks to this fraud we have low prices currently for commodities… even though massive price rises and shortages are just around the corner.

    This is what happens when you spend all your time subsidizing the banks and giving them special cartelization rules.

  6. October 13, 2008 at 2:02 pm

    @Paul H: in the past the supply of stocks to short sellers came from large institutional investors, including index funds. Since much short selling was performed by “long/short funds” which would buy stocks that they considered cheap and (short) sell those they considered effective, during the long bull market, index investors were never particularly concerned about short selling. While the stocks they loaned may have dropped in prices, or at least underperformed the broader market, they earned some extra income in the process and meanwhile other stocks, which they also held, went up in price. It was only once equity markets started to fall sharply that some investors began to question the merits of stock lending.

    @graemebird: it is my understanding that prior to the ban on short selling, naked short selling represented a very small proportion of total short selling. I’m not sure whether or not you are arguing that naked short selling was fraud even for those specifically authorised to do so. In any event, however much blame you can put on short selling what we recently saw in markets, I think it’s hard to put all of this on the doorstep of naked short sellers.

  7. October 14, 2008 at 2:57 pm

    Paul H,
    The only things I would add to stubbornmule above is that shorting is not always bad for longer term holders. If you are holding a stock for 20 (or so) years, short term selling activity is neither here nor there. In the mean time, the extra income from lending the stock is handy to boost returns. As it also adds to liquidity in the stock, it may (long term) actually help. Besides, there is no guarantee that a shorted stock will go down.
    .
    Stubbornmule,
    To answer your question of graeme, from previous conversations with him, I would think his position is that all naked shorting is fraud, whether authorised or not.

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