What's the problem with short-selling anyway?

We have a great piece on it from NPR right here. I suggest listening to it first before reading the following.

In July SEC Chairman Christopher Cox passed a temporary ban on naked short selling the shares of 19 companies:

In July, the SEC imposed an ``emergency'' three-week order aimed at curtailing so-called naked short selling in Lehman, Fannie Mae, Freddie Mac and 16 securities firms. The rule required investors betting on a decline in stock prices to arrange to borrow the shares before completing a short sale.

With great fanfare, it was announced just a few days ago that there would be an expansion on the ban of naked short selling.

The SEC rules adopted yesterday remove an exception for market makers in options on stocks from rules restricting naked short-selling and tighten anti-fraud regulations related to that activity. The changes make clear that those who lie about their intention or ability to deliver the stocks underlying a short-sale transaction in time for settlement violate the law if they fail to deliver them.

When you first hear about it, the practice seems astounding. People sell stocks they don't even own! How can that be legal? A comparison might be made to selling a car which you don't own. That's certainly fraud, so why is this different? Well, as the NPR piece makes clear, it's a holdover from long ago when when a trader might sell stocks he doesn't have in hand because he hasn't sent a boy with a wheelbarrow across the floor to actually get them. But now, even in the era of digital technology, we still allow the practice because, well, it still works. The vast majority of short sellers actually do make good on their promises to buy. Unlike a car, they're selling something that does exist and which will be theirs in the future. And in so doing, they make a profit.

A problem arises when this practice actually causes the shares to fall, thus providing a powerful motivation to short-sell as much as possible. By forcing the share prices to go lower, the seller makes even more money. And with the practice of naked short-selling, the potential for greater profits is an even stronger incentive for abusing the system. This has been claimed as the reason for the failure of several major companies in the recent financial crisis, which is why there has been and outcry about the practice and the SEC's move to ban it. So far, it sounds like the government actually did the right thing for once. However, there are those who are saying this is actually more political shenanigans whereby those who deserve the blame for long-standing bad practices that have actually caused all this damage shift the blame to those who have long-standing bad practices but who actually haven't caused this problem.

Naked short-selling probably is a bad practice. There's no reason traders shouldn't have to buy the shares before selling them. But short-selling itself isn't responsible for the woes these companies are suffering. It's illegal for traders to make an agreement to short-sell en masse and so doing deliberately destroy a company in order to make a profit. Traders routinely gamble on whether stock prices will rise or fall because it's supposed to be illegal for them to have the kind of information they would need to know in advance what the value of a stock will be. Short-trading is guesswork at best, and as such is not abusive in its nature. It could still possibly cause problems, but it also leads to the devaluation of overpriced stock, an effect which is supposed to be a natural part of the market.

I've read quite a few opinions so far that are completely happy about this ban. And it's not like I'm opposing it. But we need to understand that this is simply a political panacea, not something that will really bring stability to the market. The point of view of short-sellers themselves is that they aren't to blame for anything. According to a man named Simon Cawkwell:

“There's nothing new in short selling,” he said. “The Phonecians [sic] probably did it. To blame short sellers for what's ­happening now is nonsense. If a man running a bank can't finance his business, he is the one to blame, not me.”
Many of those running the banks don't agree. Richard S Fuld, head of Lehman Brothers, blamed shorts for the downward spiral of his share price that ended in bankruptcy. Regulators have become increasingly concerned about hedge funds that have circulated critical or pessimistic material on companies in which they hold short positions. There is concern that short-selling is becoming a self-fulfilling prophecy because of the way it can alter market sentiment.

All this leaves Cawkwell unmoved. He says short-selling is an integral part of the way markets work and thinks rules aimed at curbing it are “pointless”. He said of the regulators: “They don't know what they are talking about.” The fact that the FSA's measures have been restricted to public financial institutions and have been brought in as a temporary measure tends to support his view that short-selling will survive this crisis.

According to him, the responsibility for the crash lies with the government:

“But look at it logically. We had this huge bubble of credit which was ­engineered by the government. It suited Gordon Brown to have all this money around. It produced lots of taxes which he was able to use to finance political schemes. That bubble has now burst. Jobs are being lost. Not because I have shorted shares but because those ­workers have been let down by policies that couldn't be sustained.”

The truth is we don't actually know if short-selling (naked or otherwise) has that much of an effect at all. By those in the know, it's called a fringe activity. I myself am not an expert on it, but more than a few people are saying that this anti-short selling agenda is simply a distraction from more important issues. After all, stock prices of a faltering company will fall anyway.

More important issues should be the focus of our attention right now, such as the possibility of our economic engine simply stopping:

As Senator Christopher J. Dodd, Democrat of Connecticut and chairman of the Banking, Housing and Urban Affairs Committee, put it Friday morning on the ABC program “Good Morning America,” the congressional leaders were told “that we’re literally maybe days away from a complete meltdown of our financial system, with all the implications here at home and globally.”

I don't know about you folks, but that's really scary language.