September 22, 2008 05:38 AM UTC

Bailout Part II: The ban on short selling.

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• by: Danny the Red (hair)

(We have some very knowledgable people here on Pols – thank you for posting this Danny. – promoted by DavidThi808)

Short selling has long been a scapegoat for market failures, but any trader worth his salt will tell you its not short selling that is the problem.  Part of the bailout plan is a set of orders issued on Sept 18th temporarily banning short selling of 799 financial stocks and other related practices (others are lobbying to get on the list).

Short selling – a bet that a stock price will decline – is the practice of selling stock without owning it, hoping to buy it later at a lower price and thus make a profit.  It is both good risk management tool and important component to healthy functioning market.

In fact, short selling is often one of the first warnings that something is wrong with a company.  In addition, in a bad environment short selling is one of the few ways to limit risk and/or make money

Before dismissing short selling ban out of hand, let’s examine the problem the ban is trying to address.  The “problem” according to the treasury, is that financial firms are subject to market confidence which can be destroyed by a coordinated short assault.  While perhaps true, why not ban downgrades from the NRSROs that spark real panics?

The real problem is that short selling is asymmetric with buying actual securities.  

Short sellers are supposed to borrow securities they sell in order to have something to deliver to the buyer, in a process called covering.  In a practice creatively called “Securities Lending,” institutions that own large portfolios of securities lend those securities for a fee.  This process has two impacts: 1. these large institutions  do due diligence on the short sellers (because the short seller ads counterparty risk) 2. Since the short seller must find a security to deliver, it puts a natural cap on short sales.  The more the shorts pound a stock the harder it is to find a sec lender with that particular stock, and the higher price they demand for its loan.

Unfortunately not everybody borrows the stock and they instead the short simply “fail to deliver”  To differentiate from “covered” short selling the practice of purposely Failing to Deliver is called naked short selling.

New rules instituted in 2005 to regulate brokerage complicity in the Naked Short practice.  However, the rules included permissive language such as “that broker-dealers have grounds to “believe” that shares will be available for a given stock transaction,”  which makes it impossible to enforce the no Naked Short rule.  In addition, even though there is a rule, there is no punishment for the rule and on Wall Street rules without punishment are meaningless.

The SEC has issued two other temporary rules related to short sales which have some merit.

One is a rule that temporarily requires institutional money managers to report their short sales.  It shocks many that they have not been required to report this up until this point, but the industry lobbied hard to prevent the disclosure of shorts.  

Second is a temporary suspension of the limitation on the repurchase of a company’s own shares.  The so called “safe harbor” rule exist to prevent a company from manipulating its own stock.  The temporary suspension of this rule has merit as it allows companies to defend their stock price.

Verdict

No way.  A temporary ban on all short selling is a terrible idea.  A more proper response is permanent severe penalties for fails to delivers on all securities, that escalate on both the failing party and eventually the broker handling the sale.  This would allow shorts to continue, but it would remove the artificial asymmetry that is created by naked shorts.

A permanent order requiring disclosure of shorts is a no brainer-the fact that it hasn’t been a required disclosure indicates the folks running the SEC have no brains

If institutional money managers were required to report shorts, a permanent rule could be put in place that would suspend the repurchase “safe harbor” rule for any company under certain types of attack by shorts.  However, this would have to be explored after data was collected surrounding the behavior of shorts and a determination of whether their behavior distorted the market.