Naked Shorts
I hate to agree with The Wall Street Journal editorial page about an economic policy issue, but I think they’re right to slam John McCain’s idea that failure to curb short selling is responsible for the crisis. Totally randomly, this is something I wound up reading a bunch a while back because I read Mark Cuban’s blog to see what he had to say about basketball and he did a bunch of posts on the topic.
But suffice it to say that if you’re the CEO of a company, there are no circumstances under which you’re going to want to say something like “our stock value is declining because I’m mismanaging the firm.” But if you are mismanaging the firm and your stock value is declining, there will be short sellers in your midst. So blaming the short sellers is an appealing option. Consequently, this practice becomes controversial. But it’s a kind of pseudo-controversy — lots of people complaining about it opportunistically, few people focused on the actual policy. In policy terms, the sort of curbs McCain was urging (and that apparently now have actually been adopted) don’t make any difference. As Arnold Kling says, there’s no way for short-selling to force your stock price down unless there’s nobody willing to buy your stock even at its new, lower price. And if that’s the case then that — the fact that nobody wants your stock — is the problem, not the short-sellers. A stock that nobody wants to buy is going to run into serious trouble sooner or later.
41 Responses to “Naked Shorts”
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September 19th, 2008 at 12:26 pm
You can wind up with a nightmare scenario in which everyone defaults, everyone loses their home, and then since homes have all become worthless thanks to all the foreclosures, everyone winds up in the house next door to the one they started out in.
I’m putting all my money in moving-company stock!
September 19th, 2008 at 12:38 pm
Matt,
Sorry to say this, but, though you are usually insightful and careful, here you are being ridiculous.
Not everyone will default. Houses will not be worth zero. Not even in the worst nightmare scenario worse than the great depression.
Mortgages are spread over time. That is, they originated at different dates over the calender: some this year, some last year . . . some 15 years ago, some 30 years ago, and some from before then that have been paid off so that homes are owned free and clear.
the situation is complicated and made worse by the past years of refi and cah-out and home equity loan frenzy. But taking that all into account, and including the large drop in prices that has already happened, there is still a lot of equity in US houses . . . not as much as there should be because Americans are too highly leveraged (i.e., in debt), but there is a lot of equity.
Not all the equity in houses will be wiped out. Findamentally, it cannot be wiped out. That can happen with a stock, because a stock price can go to zero leaving the owner with nothing but a piece of paper. Houses, in contrast, are things of a special kind. They are places people live. they have direct use value, and places to live are a necessity.
When houses go vacant they often attract squatters, a sign of the house’s use value.
It is true that specific houses can become almost worthless – in truth, just illiquid because no one wants to buy the property.
But is there any realistic chance that “everyone” will default, and “everyone” will lose their home? No. Not at all.
This is too serious a problem to be discussed in the way that Sarah Palin discusses energy policy. Sorry for the harsh words. I really respect you and know that you can do much better. You’re not Sarah Palin! I expect more from you.
September 19th, 2008 at 12:44 pm
Hm. My comment at 12:26 was intended for a completely different post–which has now disappeared.
CAP’s commenting system seems to have quirks that The Atlantic could only dream of.
September 19th, 2008 at 12:48 pm
The problem with naked short-selling, as I understand it, is that it can be used as a tool of market manipulation. You can naked short-sell a large number of shares really fast, because you don’t have to actually put up any money. If that is taken as a signal that something’s wrong with the stock, a bunch of panicky people might sell the stock, driving the price down.
In fact, Jim Cramer used to talk about doing exactly this. Of course, this is technically illegal, but it’s really hard to prove when someone’s doing it – since, after all, if the technique works, the naked shorting ends up being justified!
September 19th, 2008 at 12:52 pm
“Houses will not be worth zero.”
Actually, houses can have negative value. It starts when a house is worth less than the copper it contains. Rather than sell the house, it’s more profitable to knock out the walls and remove the wiring and plumbing. At this point, the house gets condemned. Now, any new buyer is faced with the cost of scraping the house if they want to buy the land. If the cost of scraping the house exceeds the value of the land, the property has negative value. You’ve probably seen abandoned properties before. If they were worth something, they wouldn’t have been abandoned. But you’ll notice that those abandoned properties never have any copper in them. That’s because copper is always worth something. Properties aren’t.
September 19th, 2008 at 12:54 pm
Barry Ritholtz’s blog “The Big Picture” is also a very good one for the short-selling issue and other market/economic commentary, and it’s a blog that’s very simpatico with your views.
September 19th, 2008 at 12:56 pm
Matt, I agree with you as a whole and think the new short regulations are overbroad and folks like the over-the-top Overstock CEO are wrong (but worth reading to get an idea of what their specific complaint is), but I do think there are certain technical issues related to the actual practice of naked shorting (vs. non-naked or matched or paired or covered shorting or whatever you want to call it).
It’s complicated, but basically with naked shorting you can short a stock without actually being loaned the share by a broker (so not matched or paired) or even closing out the trade, which allows the possibility of gamesmanship by a massive pool of capital (say, a hedge fund) intent on profiting by driving a company’s share prices down.
Usually this behavior would be most profitable with a company that investors may already have reason to suspect is trading at a premium or that has opaque financials (like every public company in the finance industry).
September 19th, 2008 at 12:57 pm
Holy crap! Matt writes a sensible post about financial markets!
September 19th, 2008 at 12:59 pm
I dunno…seems like a liquidity crunch would be a great time to artifically drive down a stock by shorting. Even a company willing to buy its own stock from the shorter might not have the cash or credit to do it with.
September 19th, 2008 at 1:00 pm
I’m not even sure of the point of this post. The title is naked shorts, but the post only talks about shorts in general. There’s a huge difference between the two.
Short selling has slightly dubious justification in the markets, but overall it’s no big deal.
Naked short selling is illegal and has been illegal since 1934. The SEC, unfortunately, has granted unauthorized exceptions to market makers, and has put in very lax regulations to actually prevent naked shorting.
If one is able to sell an unlimited amount of something he doesn’t have, he is able vastly increase the perceived supply. If there are only 100,000 shares of stock in a company one day, then all of a sudden the next day there are 200,000 shares, the price is going to drop.
The SEC finally put some rules in place earlier this week to curb naked shorting, but they left a huge loophole. One is still able to naked short for 3 days or less quite easily. With a lot of money and a lot of links into the market, 3 days is plenty of time to make some mischief.
September 19th, 2008 at 1:05 pm
“As Arnold Kling says, there’s no way for short-selling to force your stock price down”
In the medium to long term, sure.
In the short term, no.
In the short term, short selling can indeed play a very real role in forcing down a stock’s price.
If the anti-short rule is going to be in place for two weeks, it makes perfect sense.
September 19th, 2008 at 1:07 pm
In the spirit of Mickey Kaus’ maxim of lazy journalism that three anecdotes make a trend:
1. On the issue of the difficult fiscal situation the US government faces, McCain proposes earmark reform, a boutique-y and ineffective measure with marginal impact, largely irrelevant to the problem at hand.
2. On the issue of the rising energy prices, McCain proposes expanded offshore drilling, a boutique-y and ineffective measure with marginal impact, largely irrelevant to the problem at hand.
3. On the issue of the credit crisis, McCain proposes banning naked short-selling, a boutique-y and ineffective measure with marginal impact, largely irrelevant to the problem at hand.
Finally, some thematic unity to the McCain campaign!
September 19th, 2008 at 1:12 pm
It seems to me the problem is that not enough people were short selling securitized mortgage funds years ago.
September 19th, 2008 at 1:16 pm
Naked Shorts. Heh.
September 19th, 2008 at 1:25 pm
Here’s my question: what happens the moment the prohibition is lifted? Isn’t there going to a flood of pent-up “short-sell” demand that just swamps the stock’s price?
In other words, I’m not al all certain that there’s an exit strategy from this. Would you want your money in one of the blessed 722 banks the day after the ban is lifted?
September 19th, 2008 at 1:34 pm
In other words, I’m not al all certain that there’s an exit strategy from this. Would you want your money in one of the blessed 722 banks the day after the ban is lifted?
If I understand it correctly, Theo-Economic Theory holds that those banks–as true believers in the Unfettered Free Market–will be Raptured any day now and taken to Financial Heaven to sit at the Invisible Right Hand of John Galt.
September 19th, 2008 at 1:45 pm
Short sellers, if they’re going to make money, have to buy the stock at the lower price to close their position. So they are those buyers.
Yes, the mismanagement is the root cause. But short-selling creates volatility in that it can speed up reaction to mismanagement. Banning short-selling doesn’t fix management problems, but it does widen the window for correction.
September 19th, 2008 at 1:48 pm
Short-sellers are indeed a convenient scape-goat. I liken them to the guys that are playing the “Don’t Pass” line in craps. Everyone hates them because they profit when everyone else craps out and generally seem pessimistic and un-American.
But, of course, short-sellers like those on the “Don’t Pass” line don’t always win and are taking real risks that the market or table turns on them.
In “normal” markets, short-selling is a useful financial tool and makes markets more efficient. A market in which you only allow people to profit from market gains, is a market in which you get loads of bullshit positive information which leads to overpriced securities and a bubble that eventually pops. The short-sellers balance this.
However, I can’t blame the SEC for banning short-selling of financials in what is/was a full-scale market panic. As other commenters have suggested, short-selling can affect the “ask” price of a stock which itself sends signal to the markets, causing an increase in the speed of downward momentum and hampers the ability of companies to be able to raise capital through equity to stave off the creditors and we have all seen what happens then.
Short-selling is certainly not the root-cause of anything but in this market I think it makes sense to put a hold on a practice that can help exacerbate a near-panic situation.
September 19th, 2008 at 1:50 pm
Well, if you live in a world where people don’t use prices as information, it’s true, short-selling can’t hurt a company. But we’re not in that world. There are billions of dollars in hedge funds devoted to trading on momentum. If you have enough money you can create your own reality and attack a company.
That said, I still think shorting is good for markets. Companies need to grow up and deal with it. If they keep their books clean and manage their debts well it shouldn’t hurt their operations.
September 19th, 2008 at 1:59 pm
Also, you can profit by shorting a stock and spreading scurillous rumors about the company, driving down its prices. This is illegal, and the SEC should prosecute these folks, not outlaw all short selling.
September 19th, 2008 at 2:40 pm
I can think of two things wrong with that title.
September 19th, 2008 at 3:25 pm
15 Jim Pharo, yes, a post short sale ban sell-off is possible, but read 10 tim about the difference between naked short selling and short selling generally.
September 19th, 2008 at 5:04 pm
Only as aggressively as they prosecute those who buy a stock and deceptively talk it up, which is probably 100 times more common.
September 19th, 2008 at 6:27 pm
Short selling can be manipulative, which is why naked shorts in particular are a problem, along with the lack of the uptick rule. Reinstitute the latter, and you’ll cease having problems, because the only short sellers will be those who legitimately believe the company is in trouble, rather than those who think they can artificially drive the price down.
Of course, you could always track the sales and prices of options, which gives you a damned good idea, and also allows people to profit off down markets.
September 19th, 2008 at 7:01 pm
The problem here is that short-sellers can do a great deal of damage in the short-run, especially when irrational forces are controlling markets. Neither Morgan Stanley nor Goldman Sachs are mismanaged (both beat earnings estimates this quarter) yet both were driven almost into the ground by short-seller-induced market panic.
Libetarian-style economics always likes to claim that in the long run markets will fix their own problems. But we don’t live in the long run: we live here and now. You see similar arguments against price gouging laws, claims that gougers will ultimately be punished by the market. But just because you may recover completely from your injuries in a car wreck is no reason to drive irresponsibly, or repeal the traffic laws. Hence the case for market regulations, especially since neither firms nor individuals are assured of recovery even if the market does finally meet out its justice like a dilatory God or slow-grinding Karma.
September 20th, 2008 at 1:53 pm
Yes, there are a lot of hedge funds out there
manipulating stocks with “Naked Shorts”.
Without “securing the borrow” (ie. delivery of the
stock) theorectically they could short
10 million shares of a stock that only has
1 million shares outstanding.
And, they limit their risk of the stock
going up by buying cheap “Call Options”…
which is why you see the volumne of Call Options
going up when they are driving the stock down
with “Naked Shorts”.
Most options are never executed.
And, why they got rid of the “Uptick” rule
last July after being in effect for almost
75 years… I’ll never know. I never saw
any publicity on this.
The next problem will be if they allow the
so called “Market Makers” to do “Naked Shorts”.
It used to be the “Market Makers” had to
maintain an “orderly market” … and they
were not allow to “trade for their own account”.
Now there seems to be a “little conflict of
interest” here because they make 30% to 40% of
their profit now … trading for their own acccount.
So to sum up.
1. Get rid of “Naked Shorts” across the board.
2. Bring back the uptick rule.
3. Have some sort of clearing house that shows the
amount of short selling going on every day … in
all stocks.
4. Fire Christopher Cox and get a new head at the SEC.
September 20th, 2008 at 2:59 pm
Prof. Kling is wrong, because he ignores the role of uncertainty, imperfect information, and diversity of opinion (and/or the limited capitalization of potential investors) in producing a downward-sloping demand curve for any stock. I discuss this point in more detail in my blog.
September 20th, 2008 at 3:19 pm
Excessive leverage is a problem. Fix that.
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