In Defense of Short-Selling

by on July 18, 2008 at 7:10 am in Economics | Permalink

Props to Dean Baker

Short-selling can play a very important role in the market. If
informed investors recognize that a stock is over-valued they perform a
valuable service by selling it short and pushing down its stock price.
This can both deprive the company of capital and be a signal to other
actors in the market that the company might not be as healthy as is
generally believed.

The economy would have benefited enormously if large numbers of
traders had shorted Fannie and Freddie 4 years ago when they were
buying up hundreds of billions of mortgages issued to buyers who bought
homes at bubble-inflated prices. This would have stopped the bubble
years ago. Similarly, we could have prevented the financial chaos at
Merrill Lynch, Citigroup, Bear Stearns and the rest, if traders had
recognized their financial shenanigans and aggressively shorted their
stock. In the same vein, heavy shorting by informed investors could
have prevented the boom and bust of the tech bubble.

The decision to intervene against short-selling is completely
inconsistent with the belief in the wisdom of the markets. Of course
short-sellers can be wrong and depress stock prices more than is
justified by fundamentals, but so what? The government doesn’t
intervene when it thinks investors have exaggerated the true value of a
stock. The public has no more reason to fear under-valued stock prices
than over-valued stock prices. This one-sided intervention by SEC is
hard to justify on any grounds.

1 Mitch July 18, 2008 at 7:36 am

Baker’s post largely misses the point. The issue that the SEC is addressing isn’t short selling in general, it’s naked short selling, which is harder to defend.

In regular short selling, people borrow a stock, and then sell it. In naked short selling, they just sell it without borrowing it first. Does it make sense for people to sell something they don’t actually hold? I don’t think so.

I made money betting against housing and subprime mortgage stocks in 2006 and 2007, so I’m certainly not against short selling in general.

2 Vectorpedia July 18, 2008 at 8:35 am

I don’t believe the goernment should control the free marketplace………short-selling is good for the markets and the SEC should not single out a few institutions.

3 Methinks July 18, 2008 at 9:07 am

I just posted the following on Cafe Hayek in response to a question about this new rule. Given the comments on this thread, I’m reposting it here. It’s long.

Naked shorting is not illegal for market makers, including specialists. They are not required to locate, let alone possess the shares. This exemption is permitted because market makers and specialists are required by SEC rules to provide liquidity.

Everyone else, (who is also providing liquidity by participating, btw) is required to “locate” shares before selling them short. The actual contract to borrow the shares is executed by the broker after the brokerage client executes the short sale. A “locate” basically means that the broker has taken a look at how many shares are available to borrow and allows the client to short the amount it thinks it can reasonably borrow on the clients’ behalf. THAT is the current SEC rule. Shorting without locating first is illegal.

On occasion, some of the shares disappear from the borrow market after the client has shorted but before the locate desk at the brokerage is able to secure the borrow. That results in some accidental naked shorting and the brokerage has some number of days to locate the stock before buying in the client. Usually, they’re able to borrow the “naked” shares within that period of time. If not, the client has to be bought in. The rules are more complicated than that, but I’m a trader, not a locate specialist, so I don’t know them all.

The change in the rule will force the locate desk to actually borrow the shares before allowing the client to short. Now, if the broker locates, and the client doesn’t actually short (which happens all the time), the shares remain unborrowed and the clock on the interest is never turned on. Since the lender collects interest on the borrowed shares and the borrower pays interest, if the shares are borrowed before a trade is executed, that clock starts running whether or not there’s a trade.

Further complicating the situation is dividends. The short seller owes the owner of the stock any dividends that are paid on the stock. If the trader borrows the stock, but never executes a trade, he will still owe the dividend if he has secured a borrow in case he needs to short.

You can see the inefficiencies this will create – especially if a trader trades hundreds of stocks and has to borrow and release for every stock every day. It will become more expensive to short(in all ways cost is calculated, including time). It throws sand in the gears of the market and prevents efficiency by reducing liquidity. This will be especially true for traders who engage in market making activities but are not registered market makers (there are tax disadvantages to being a registered market maker in stock vs. derivatives). Given the added expense, these market participants won’t bother if the short is too expensive. Those stocks will experience lower trading volume and more price volatility.

It has been pointed out that you can short via put options (as one example). However, there are some (usually very small, illiquid and RETAIL driven) stocks for which no options trade and for which shares are already hard and costly to borrow. Those stocks, already illiquid, will see further reductions in liquidity and even more erratic price moves. In those stocks, I’ve seen the specialist (who doesn’t have to locate) sell shares as high as 12% above the previous print just because there are no competing offers. So, that market buy order sent in by some hapless retail guy just cost him 12% plus commission. This is exactly the opposite of a liquid, efficient market.

For stocks for which options do trade, expect to pay a much higher premium for the puts to reflect the added demand. But borrowing shares will be even more expensive, so expect short sellers to simply buy puts instead of locating stock and shorting it outright. Those market makers selling the puts have to sell the underlying stock to hedge their short put position. They can sell shares naked. So, the naked short selling will actually increase instead of decrease! If the borrow or even locate rule is extended to market makers, they won’t be able to hedge their short put positions and the cost of puts will skyrocket to the point that it won’t be worth buying them at all. No negative sentiment will be allowed to be reflected in the market.

The prohibition on naked shorting is arbitrary and the fact that naked shorting has in the past been used to manipulate stock price is used as an excuse to make it illegal – with exceptions, of course. The SEC really doesn’t care about the occasional few naked shorts that result from an honest attempt to locate and borrow the stock or from the liquidity providing activities of market makers. After all, the only reason the SEC cares about naked shorts is market manipulation and a couple thousand naked shares which the client either buys back himself or are borrowed on the client’s behalf in a few days are clearly not market manipulation. The benefits of liquidity that short selling provides far outweighs any perceived risk of manipulation resulting from a few accidental naked shorts. Keeping in mind, of course, that because market makers and specialists can short naked all day long, unless there’s a huge and rising naked short interest it’s highly unlikely that there’s market manipulation.

Incidentally, there was no increase in naked short positions in the financial stocks at the time the SEC announced this “emergency action”. It’s all BS. The move was, according to Chris Cox, “prophylactic”. In other words, the move was intended to prop up financial firms’ stock prices. And it did – especially because hearing it on TV instead of directly from the SEC threw everybody into a state of uncertainty. You really really don’t want to run afoul of the SEC. Shorts immediately began to buy back shares lest some of them had not yet been actually borrowed, creating fake demand for the stocks. This resulted in a fictional run-up in the price of financial firms and the share prices clearly no longer reflected the market’s opinion of fair value for them. So, the SEC executed exactly the kind of market manipulation for which you and I would rot in jail if we so much as thought about attempting it. It was a price control.

4 Methinks July 18, 2008 at 9:18 am

I’d say naked short selling is harder to defend than regular, but defensible nonetheless.

Short selling provides liquidity and reduces the probability of asset bubbles by keeping prices from getting to far above fair value. It can also signal problems withing the company. Short selling does far more good than harm and it would be extremely difficult to execute a market manipulation strategy even with naked shorts. The prohibition on naked shorting only decreases market liquidity and render prices less meaningful. Note what happened immediately after the rule change was announced and to stocks which are hard to borrow.

Borrowing the stock from another person creates somewhat of a barrier, akin to margin requirements in commodity speculation, for example.

Borrowing before the short is executed creates a barrier much greater and costlier than trading on margin.

5 J Thomas July 18, 2008 at 9:37 am

“Short selling does far more good than harm and it would be extremely difficult to execute a market manipulation strategy even with naked shorts. The prohibition on naked shorting only decreases market liquidity and render prices less meaningful.”

Then maybe they should let everybody do naked short selling.

6 meter July 18, 2008 at 10:27 am

Does naked short selling create a dilutive effect for non-naked (covered?) shorts?

Also, one way to bust all of this up is for shareholders to hold their certificates.

7 QM July 18, 2008 at 11:37 am

Also, one way to bust all of this up is for shareholders to hold their certificates.

No need to do that. Instead, just call up your broker and tell him to journal the shares to the cash side of your account. They remain in street name but cannot be lent out anymore (and of course don’t contribute to margin buying power or withdrawable cash anymore).

8 bbartlog July 18, 2008 at 12:10 pm

Also, one way to bust all of this up is for shareholders to hold their certificates.

Yes, but the point of this whole discussion is that this measure has no effect if someone is allowed to do a naked short: they can sell what they don’t have just on the basis of their promise to make good on it later. If naked shorts are disallowed, then yes, refusing to loan out your shares for sale could make a difference.

9 Methinks July 18, 2008 at 12:27 pm

I get it, Katie. Maybe I should have had my coffee before I answered you 🙂

Actually, maybe I shouldn’t be worrying about all this BS on vacation either. The point is to get away, right? But my taking a vacation is apparently as pointless as short sale restrictions and government bailouts.

10 Alex Tabarrok July 18, 2008 at 12:54 pm

FYI, Culp and Heaton provide a nice primer on this issue for those who want to follow up:

http://www.cato.org/pubs/regulation/regv31n1/v31n1-6.pdf

11 happyjuggler0 July 18, 2008 at 1:28 pm

Isn’t naked short selling merely a form of futures? There is definitely nothing wrong with shorting a futures contract.

With this in mind, I don’t see the economic argumaent against naked short selling. On the contrary, the prohibition of naked short selling means I have to borrow from someone, and this is economically inefficient (to say the least), especially when shares aren’t widely held in street name.

The only issue I can see is voting proxies, which is my sole issue with naked short selling. I’ve never been able to wrap my mind around that problem.

As a general rule, whenever you hear someone whining about naked short selling, the people whining are really opposed to short selling, or alternatively are merely looking for a scapegoat for their own shortcomings (think executives who blew it).

In the long run, stocks will gravitate towards “intrinsic value”, i.e. the present value of all future dividends. Anything that tends to move stocks (or any other asset) closer to that intrinsic value, be it up or down in price, is a good thing for the economy.

12 Phil July 18, 2008 at 2:14 pm

I don’t pretend to understand the pros and cons of short selling, but the Baker’s argument doesn’t make any sense to me.

You mean, if short selling had occurred 4 years ago, then it would provide a rationale for short selling today, but since it didn’t happen 4 years ago, but should have, it would be wrong to prohibit short selling now?

13 Methinks July 18, 2008 at 2:28 pm

Happyjuggler,

Bullseye! Fabulous post. Thank you for pointing out that naked shorting is merely a form of future! IMO, you smashed the

The proxy vote requires a long theoretical discussion that could completely hijack this thread. It’s a
discussion nobody is having because it has been determined by popular vote that shorting of any kind is an unamerican activity, treasonous by nature and should be punishable by death. It sounds like hyperbole, but the attitude is really that venomous.

Prices should only go up. Unless it’s oil. Then, prices should only go down. If you disturb this vision of the world, you are obviously a market manipulator who would sacrifice the greater good at the alter of your greed. One trader put it succinctly: “We can’t buy oil and we can’t sell financials.”

14 Dick King July 18, 2008 at 6:56 pm

I don’t understand one thing about naked short selling.

When Jack sells Jill a share in a covered short sale, and it’s time for the company to vote in their board of directors, Jill gets a vote but the person from whom Jack borrowed the share does not get a vote. Therefore, the company gets the correct number of votes.

How does Jill get a ballot if Jack sells a share naked? The company doesn’t even know she exists!

-dk

15 Anonymous July 18, 2008 at 11:48 pm


Incidentally, there was no increase in naked short positions in the financial stocks at the time the SEC announced this “emergency action”. It’s all BS.

According to commenter “bob” at Daily Options Report, who cites precise data claimed to come straight from the SEC, there was indeed a significant increase in fails to deliver (FTD) associated with naked shorting.

16 meter July 19, 2008 at 9:39 am

“According to commenter “bob” at Daily Options Report, who cites precise data claimed to come straight from the SEC, there was indeed a significant increase in fails to deliver (FTD) associated with naked shorting.”

I guess this is sort of what I was intimating when I asked if naked shorting is ‘dilutive.’ Maybe I’m still barking up the wrong tree, but I’m trying to understand the impact.

17 Methinks July 19, 2008 at 9:05 pm

“put market” = “options market”

18 J Thomas July 20, 2008 at 6:04 pm

I wonder, what would stock price manipulation look like to the SEC?

19 happyjuggler0 July 21, 2008 at 1:41 am

ziggurat,

How do you figure that raising capital is hampered by (naked?) short sellers?

The way I see it, profitable and legal speculating on either the long or the short side of the stock market helps better ruun companies raise more money relatively cheaply, and hence create new wealth for society, and hurts relatively poorly run companies ability to raise money, and thus reduces the amount of society’s wealth that is destroyed.

The stock market doesn’t exist to help raise money for any monkey with a harebrained company, it exists to raise money for companies that improve society at the margin.

Captialism works relatively well by giving more money to wealth creators and by taking it away from wealth destroyers. Short sellers help this process tremendously, not hinder it as you seem to think.

20 Methinks July 21, 2008 at 11:23 am

Ziggurat,

The first mistake you make is in thinking that the capital markets exist for companies to raise capital. That’s not the primary function of capital markets. The primary function of public capital markets is to provide liquidity, transparency and price. The benefit of liquidity for the investor is that he is able to monetize his investment quickly and efficiently and with low transactions cost. For the companies’ the effects of liquidity, transparency and low transactions costs for investors are a lower cost of capital. The more liquid the market, the lower the risk for the investors and the lower the cost of raising capital for companies. So, before we poo-poo liquidity, let’s remember that all the benefits of raising capital in public capital markets flow from the liquidity they provide. Social rationales and waxing philosophical about them isn’t going to change any of that. In fact, the biggest social rationale for the stock market is that it aids economic growth by reducing the cost of raising capital by providing liquidity, thereby making more projects economic to undertake. Period.

As far as just shifting the market toward options, I think that options market makers should follow the same rules regarding naked shorting.

Won’t make any difference. The harder it is for the market maker to hedge his short put position, the more expensive the put option. The more expensive the put option, the lower the implied price of the underlying (the stock). The lower the price of the stock in the options market, the more incentive there is to buy the stock in the options market instead of the stock market. This reduces the demand for the stock in the stock market – which, of course, leads to a lower price in the stock market. But it also means the stock price will become less meaningful and less transparent. The price loses integrity. Good luck raising capital if nobody can figure out if your stock price is real or not! But, in exchange for this lack of integrity and lack of liquidity, you’re not going to get a higher stock price.

If you stop options trading altogether, then the action will move off the public exchanges altogether and to structured finance products like swaps. Then, the stock price will be UTTERLY meaningless and the U.S. stock market will be as transparent, liquid and meaningful as the average banana republic’s stock market and trading will move to real markets like the London Stock Exchange.

If nobody can figure out what your real stock price should be and there’s no liquidity, guess what goes up? The cost of raising capital and that increase is going to be expressed as a decrease in the price of the stock.

I’d say that’s a pretty shitty trade-off.

Any leveraged financial institution that borrows short and lends long faces a potential ‘run’ on the bank, absent a backstop like deposit insurance.

Any financial institution that borrows short and lends long ought to take this risk into consideration before levering 30 to 1 and lending to people without even checking to see if they have a job. If it fails to do that, the bankers and shareholders are culpable. Capital markets should not be destroyed in a fruitless attempt to prop up careless institutions.

I think we have seen situations (Bear) where a collapse in the equity was related to a “run” on its assets. Impossible to prove, but also impossible to disprove.

So, it was short sellers, not levering extremely overvalued and now defaulting CDO’s 30 to 1 and lenders cutting off the leverage spigot to Bear that killed it? Very funny. I’m sorry (I’m very sarcastic by nature) but I think you’ve been taking the congressional witch hunt too seriously. You seem too intelligent for that kind of sloppy thinking.

As a trader, if I think the stock has fallen below fair value, I’m a buyer. Full stop. If short sellers drive a stock below what the market considers “fair value”, market participants will buy as much as they can, driving the price back up to what the market considers fair value. So, if the stock price collapsed (and it did), then it’s because longs wanted out because, given new information, they thought it was trading above fair value and the new estimate for fair value was WAY lower.

BTW, leverage has a multiplier effect both on the way up and on the way down. So, if the price of the assets Bear held declined by even a measly 3%, at 30x leverage, the decline in the value of Bear’s portfolio is 90%! What genius at Bear thought this was good risk management?

So, did shorts bring Bear down or did Bear stab itself in the eye? I’m willing to bet millions of dollars that the fruitless waste of time investigation into short selling in Bear stock is going to turn up no market manipulation.

21 J Thomas July 21, 2008 at 1:20 pm

Methinks, thank you for that clear description. I want to describe how I understand market makers actually work, and perhaps you could direct me to a link that explains how they actually work.

A market maker starts with a quantity of money and a quantity of stock. Buyers and sellers come and are often unbalanced — in a given day you could have times when there are a lot more buyers than sellers and vice versa, and other things equal that would result in the price jumping wildly up and down.

The market maker stabilises prices; when there are more sellers than buyers he lets the price fall a little and buys, reducing his money and increasing his stock. Then when there are more buyers than sellers he raises the price and sells stock, reducing his stock and increasing his money, and while performing this service he makes money for himself. He buys low and sells higher, and it could be argued that by reducing the price volatility he is doing something to justify his profits.

What if there are more buyers than sellers for a long time? Well, he keeps raising the price and rational buyers will eventually decide the price is high enough they don’t want it after all. Maybe he’s sold a lot of stock so now he has a lot of money and not so much stock, but when the price goes down he’ll reverse that.

Similarly, if there are more sellers than buyers, he can buy and buy and keep dropping the price so that the stock he buys doesn’t cost so much, and rational sellers will eventually decide the price is low enough that they’d like to buy too, and it evens out. At the bottom he has a lot of stock and not much money, but that will even out when the price goes back up.

The market maker sets the market price. He can set it to whatever he wants, but he isn’t supposed to raise it much or drop it much between two transactions. He decides what it will be but it should stay the same or go up or down just a little bit, and then the next transaction he can change it a little bit more. If he raises the price when too many people think the stock is overvalued, they will sell and burden him with a whole lot of stock to buy at a price he might have trouble selling it. And if he drops the price when too many people think it’s undervalued already they will rush in to buy low. Either way he can lose money. He gets to set the price, but he gets punished when he does it wrong.

What happens if the price goes up to the point that he’s sold all his stock? He has money but no stock to sell. Unless he can sell he isn’t the market maker any more. He can borrow stock to sell. But unless the stock goes down again, it costs him money to do that. But in a rational world with rational investors, as the price goes up fast they’ll stop buying and that takes the pressure off him. When the number of buyers and sellers is balanced over time he can win — buy a little lower from sellers and sell a little high to buyers, and the amount of stock all averages out. The amount of stock he has to work with only goes down when there are more buyers than sellers, and in a rational world there will be a price where that averages out.

But we have a world that is not so rational, with a lot of stock investors who are not so rational. When a stock starts going up or down fast with no explanation, the natural thing is to assume there is a rational explanation that you don’t know. Wait until you find out what’s going on before you bet the farm. Or possibly — panic.

So if the price goes up enough that a market maker is in trouble and there are still more buyers than sellers, the market maker can try a trick. He sells short, and drops the price. If the price is this high because a lot of investors rationally believe that they have reliable information that the company is worth this price, they will want to buy more as the price drops and he will just lose more money. But if the most rational investors wait to see what’s going on while the more panicky ones sell, then he can drop the price and buy. When he has covered his short sales and he also has enough stock to ply his trade, then he can let the price go back up. By this time the rational investors will have looked over all their data and seen no good reason for the price to drop, so they’ll be ready to buy. The price goes back up. Ideally as it goes up there will be enough profit-takers selling to balance the new guys buying high, and his stock doesn’t dwindle away again.

This behavior would say naked shorts aren’t often necessary. He has his own quantity of stock that should be enough to cover the day-to-day fluctuations in buyers and sellers. It’s needed for special problems, for the kind of risks that are the reason he gets the big bucks.

But you say naked shorts are useful and necessary for the times when there just isn’t much buying and selling. If I want to buy a thinly-traded stock and nobody wants to sell for 2 hours, that’s 2 hours before I can get even part of my order. And the market maker can sell me virtual stock (instead of stock he has) and then buy back that virtual stock two hours later from the guy who sells, and nobody has to wait. That looks good. Also, these thinly-traded stocks will be the ones that won’t have much of an options market either. So that alternative is closed.

So, do naked shorts happen mostly in the cases you say, or the cases I say? Is it mostly thinly-traded stocks that just don’t get much action, or is it stocks people are excited about that get a lot of irrational volatile people expressing their irrational volatility?

22 Methinks July 21, 2008 at 4:14 pm

J Thomas,

I don’t know of a good website for you. Sorry. I’ll respond to your questions and you can google too. I’m not sure all the information you want is available on the net, though. It’s pretty specific.

A market maker starts with a quantity of money and a quantity of stock.

No. A market maker in stock XYZ starts with a quantity of money, a leverage agreement with his clearing broker and series 7 and 44.

The market maker stabilises prices

No. The market maker makes two sided markets (posts both a bid and an offer), the result of which is an increase in liquidity.

He continuously calculates a fair value for XYZ and then offers higher than fair value and bids lower than fair value. How wide his market is around his calculated fair value depends on how many bids and offers compete with him for trades. The less competition, the lower the liquidity in stock XYZ and the higher his risk, so the wider his market will be.

What if there are more buyers than sellers for a long time?

Then the market maker gets screwed because he’s taken such heavy losses on his short positions that he goes bankrupt. Market making and specialist firms go out of business ALL the time.

Similarly, if there are more sellers than buyers?

If the market maker ends up long a bunch of stock that has declined in value, then he may very well not be able to post margin and will go belly up. As I said, this happens ALL the time to market making and specialist firms.

The market maker sets the market price.

Not even close. The market maker makes a market. He can tell you the price at which he’s willing to buy and the price at which he’s willing to sell you XYZ, but he has no power to “set” a price. Incidentally, you as a customer, can improve his market by bidding higher and offering lower. He might better your market in response, but that’s exactly the kind of price competition that leads to tighter markets and lower transactions costs. You essentially add liquidity to the market by providing a competing bid and offer.

I think part of the problem with your logic is you’re conflating specialist and market making activities. There are additional restrictions, responsibilities and privileges the SEC extends specialists. One of the restrictions on specialists is how much they can move their markets (again, not setting a price but making a two sided market). Because of the privileges extended to him (like control of the order book), the specialist is restricted in how much and under what circumstances he can move his market.

But we have a world that is not so rational, with a lot of stock investors who are not so rational.

Based on what do you draw this conclusion?

When a stock starts going up or down fast with no explanation, the natural thing is to assume there is a rational explanation that you don’t know.

There’s always a rational explanation. Just because it’s not readily apparent to a given market participant doesn’t mean it doesn’t exist.

Wait until you find out what’s going on before you bet the farm. Or possibly — panic.

Always a good rule to follow when making ANY decision in life.

the market maker can try a trick. He sells short, and drops the price.

Not possible to win to that. Aside from the fact that the market maker has capital restrictions, he also can’t profit from a short unless there’s a drop in demand for the stock. Obviously, he can’t manufacture that drop in demand. So, the trick he would be playing is on himself. He’ll soon go out of business.

But if the most rational investors wait to see what’s going on while the more panicky ones sell, then he can drop the price and buy.

Then it would be the panicky (long, ostensibly) investors, not the market maker, who drive down the price, wouldn’t it?

When he has covered his short sales and he also has enough stock to ply his trade, then he can let the price go back up.

By “plying his trade” you mean, posting bids and offers? There is no requirement for him to own any stock to do that. If the market believes the stock price should go higher, the only way he can keep the price from going higher is to continuously offer the stock lower until he’s bankrupt.

By this time the rational investors will have looked over all their data and seen no good reason for the price to drop, so they’ll be ready to buy.

The only investors who take that long to figure out what’s going on are individual investors. By the time these retail guys figure it out (IF they ever do) the action is long over and they’re all busy posting conspiracy theories on internet message boards. The (good) institutional traders figured out what’s happening in the stock at the same time as the market maker and reacted immediately. Institutions account for the bulk of trading volume.

This behavior would say naked shorts aren’t often necessary.

No, they’re not. And naked shorting isn’t all that prevalent either (not necessarily for the reasons you outlined in your post. Hopefully I’ve adequately explained why and where you were off in your thinking). The tizzy congress is in, you’d think that everybody is shorting everything naked with wild abandon. That’s not even close to true in even the most beaten up stocks.

Is it mostly thinly-traded stocks that just don’t get much action, or is it stocks people are excited about that get a lot of irrational volatile people expressing their irrational volatility?

Setting aside the fact that I have no idea what irrationally volatile people expressing irrational volatility is (there are no such terms in finance that I know of), I don’t think I can answer your question about which stocks are more prone to naked shorting with any degree of certainty. I just don’t have the data to answer that question.

But you say naked shorts are useful and necessary for the times when there just isn’t much buying and selling.

No. I say allowing naked shorting is beneficial for liquidity. Full stop. When a big buy orders show up and there aren’t enough sellers to satisfy the demand, it is necessary to provide liquidity by shorting so that the stock is not driven too far above fair value due to a liquidity imbalance, causing temporary or more prolonged asset bubbles. The likelihood of this happening is higher in less liquid markets – like housing, for example, where shorting isn’t even possible. Keep in mind that naked shorts still have to deliver after a certain number of days. If they don’t, they will be bought-in on their short. The higher the naked short interest, the greater the probability of a buy-in. So, there’s already a way within the stock clearing mechanism to eliminate excessive naked short positions and make naked shorting progressively more expensive. This makes it pretty much impossible for anti-short advocates’ claims of stock manipulation to be true.

23 Ziggurat July 21, 2008 at 9:47 pm

Happy — the situation I’m referring to is one where there is a feedback loop regarding the ability to raise capital and the intrinsic value of the firm. If a firm doesn’t need capital or won’t need it for an extended period of time, then the intrinsic value of the firm would not be very sensitive to stock price. Price and value will converge, given relative stability and time.

I believe that even the Cato economics gurus admit that naked shorting can and probably does increase volatility. With a stock like FRE with a market cap of $5B and a perceived need for capital of $5 B, then volatility is a big deal. Whatever valuation anyone would place on the firm, that value will be highly dependent on how diluted the shareholders will be in any capital raising attempt. If the stock goes up $5, you would own 2/3 of the company, down $5, you own 1/3 (obviously simplified, but assuming all shares are common, etc.).

For any company, there is some value in having a higher rather then lower stock price. For the GSE’s right now, it is a much bigger deal.

Methinks:

Obviously Bear is hard to defend. Nevertheless, I think some of their prime brokerage customers gave them that last little nudge over the edge. There was a big difference between net leverage and gross leverage for Bear. If you cater to hedge funds and do their bidding, I suppose it could be chalked up to rough justice if they decide to make a few bucks on your demise. Once again, not that it is likely that anyone will prove that it happened. Once again, based purely on personal speculation, I think the real game was with the CDS’s, whose nominal value (which, in default, would have become close to real value) may have been a significant multiple of Bears capital. The “bail out” under this theory, is that the hedge funds can’t make astronomical leveraged bets on the failure of financial institutions and then assist them in their meltdown. They could destroy the firm (which maybe needed to go anyway), but they couldn’t use the opaque, unregulated, over the counter CDS market to make huge, potentially destabilizing bets and count on winning. They got to suck up the basis risk of being right but not collecting. Just a theory.

But to your major point regarding liquidity vs raising capital as the rationale of financial markets, you state that they are related. Capital is cheaper because of liquidity, ergo liquidity is primary virtue of capital markets (with a nod to transparency). However, it comes back to raising capital, no? I would say that a market without naked shorting would be liquid enough, and would be willing to live with the minor issues that might be caused by more strictly enforcing regulations.

As far as F&F and your arguments of the options market becoming a proxy for the real market. Consider last week. F&F’s financial situation didn’t really change over the last month or two. Then you get a brokerage report speculating about capital requirements IF FAS whatever applied — just analyst patter with low informational value. Then, following a collapse in the stock price, you get Ackman on CNBC pumping his short idea. That day, the stocks were collapsing. Exactly who wanted on the other side of that trade at that moment? The mere fact that the Cox naked short announcement precipitated a minor short squeeze seems like at least weak evidence that naked shorting was a factor. In a situation of relative stability and your arguments regarding the self correcting nature of markets seems persuasive enough. I just don’t have that sort of faith in markets. George Soros got rich with what he referred to as reflexivity — which seems to me to mean that instead of price changes being a random walk, market changes can change the nature of the market. In other words, feedback loops.

It is just a matter of degree — everyone admits that naked shorting doesn’t add a LOT of liquidity, generally. Perhaps my dislike is irrational prejudice — nevertheless, I can see a difference between the real economy and derivatives, even if it is just conceptual. Let the high rollers run their highly leveraged bucket shops but keep them the hell out of the real economy.

24 J Thomas July 22, 2008 at 1:48 pm

Methinks, yes, I was looking at stock market specialists as market makers. They do make markets when there’s a market that has a specialist, right? Like the NYSE and Amex.

After looking at your explanations, I have a proposal. Namely, let the Federal Government set up a stock market. The computer costs should not be particularly large, and lots of it can be automated. They handle whatever reputable companies want their stocks traded with them.

You log into their website and look at the book which is available to everybody — anyone who wants to buy or sell at a set price sets their price and amount. So if you want to trade immediately you can buy at the lowest sale price, or sell at the highest buy price, or you can put in your own order inbetween and wait for somebody to nibble, or even put in your price somewhere else — if you want to sell high or buy low your order won’t be the first in line. Anybody can look and see where your order fits in.

This gets you all the liquidity you need. And it completely avoids the appearance of price-rigging and fraud etc. The federal government holds your stock for you, and there is no question whether you own the stock you sell. The process is automated and the federal government isn’t in the business of stock fraud anyway.

The government could provide this as a free service, and they might more than pay for it in the savings they get from the IRS already knowing all about your trades.

No market makers, except that anybody who has both stock and money can place a high sell order and a low buy order at the same time. No brokers. No specialists. No SEC investigations into brokers etc. If someone does some sort of shady practice the records of what they did will be available for everybody else to see how it worked and learn whatever they learn from the experience.

Liquidity. Transparency. There might be higher spreads than there would be with shady market makers. I think it’s worth a try. Anybody who thinks they can get a better deal on another market can transact with the other market instead.

The nation has very little to lose by trying it.

25 J Thomas July 22, 2008 at 11:57 pm

“The government could provide this as a free service”

If it’s free, who’s going to pay for the lights, the computers, the tech support, the rent on the building, etc.?

Ah, taxpayers? I wouldn’t mind if a small sum be added to the income tax for people who use the service. But at the least we should look at how much it costs to charge for it, versus how much revenue results. If the cost of billing turns out to be a significant part of the total cost, better to just add it to the Bureau of Fisheries budget or whatever.

“The federal government holds your stock for you, and there is no question whether you own the stock you sell.”

Careful, now. When you buy stock you don’t own stock.

I regard this as part of the problem with the current system. You don’t exactly own any individual dollar bills in your bank account, so the bank loans them out and trusts that everybody won’t want their money at the same time. Now it turns out that you don’t own any individual stocks, so it’s possible for your broker to do the same thing. They can sell “your” stock if they think the price will go down, and if at some later time you sell it for less they can just credit your account with part of the money and pocket the rest. They can treat stocks the way banks treat money — if they dare. Why should customers have to put up with that?

Get an automated system. The system has X number of shares of stock. Those are owned by whoever the database says owns them, and nobody else. If a company is traded both on the federal system and the NYSE, and you want to transfer stock from NYSE to the federal system, then go through all the correct actions and it should be possible.

“I think it’s worth a try. The nation has very little to lose by trying it.”

Careful. For you to be make that claim, you’d have to have evidence that the markets are currently inefficient and that they would be made more efficient by your system. Instead, you think that some liquidity might disappear with your system. Since the primary function of markets is to provide liquidity, removing it is a big cost.

I don’t actually know what would happen. But if it’s a market that competes with existing markets, and customers don’t prefer it, then they get to “vote with their feet”. Most of what we would lose would be the costs of setting it up and running a system that few use. If it’s popular then customers must value whatever it is it provides.

The liquidity theory makes a lot of sense, but it’s still a story, not much better than Apple’s story about what customers value about their products, or Oracle’s story, etc. Customer actually value whatever it is the value, and the stories might help the marketing people and the advertising people.

My guess, without any real data, is that the spreads might be wider and the intra-day volatility smaller. I might value that, myself. If I buy additional shares of a stock because I think it will be worth considerably more next year, I don’t care so much that I can’t sell it for the same price I pay to buy it, this particular minute. I don’t care what price I could sell it for this minute, I’m buying now. I care what price I can sell it for next year. But it bugs me if I buy at $50 in the morning and it goes to $40 in the afternoon and then closes at $50 again. If I’d just waited I could have saved 20%. But if I wait it goes to $60 instead. Somebody is making money off those price changes, and it isn’t me. They could have a 25 cent spread the whole time it goes from $50 to $40 and back and it doesn’t do me any good. If the spread was 50 cents or even a dollar, and the price the stock actually sold at only changed a few dollars across the day, that would suit me fine.

Market makers go bust a lot, and they make a whole lot of money first. That’s their pay for providing liquidity. Do I want the market where sometimes market makers collect their fee from me and occasionally they give me money? (Can I get some of their money back when they go bust, or is it somebody else who gets it?) Or do I want the more stable market? If we have both, I get to choose. That doesn’t look like a big cost. Unless I choose wrong, and then I can cut my losses.

26 Methinks July 23, 2008 at 11:52 pm

It is counterfeiting. It is STEALING the property rights of people who ACTUALLY own stock in the company.

It’s not counterfeiting and when people own shares in their brokerage accounts, they don’t own stock in the company. I’ll repost an explanation from the SEC.

“Broker participants in dtc own a pro rata interest in
the aggregate number of shares of an issue held by
dtc. And their beneficial owners, the end customer,
owns an interest in the shares in which the brokers,
themselves, have an interest. Consequently, there are
no specific shares directly owned by either broker participants,
dtc, or the underlying beneficial owner. As
a result, the beneficial owner’s ownership cannot be
tracked to a specific share, but rather, his ownership
interest is represented as a securities entitlement at his
or her own broker dealer. Each of these beneficial
owners don’t own the actual shares that have been
credited to their account, but rather, they own a bundle
of rights defined by Federal and State law and by
their contract with the broker.”

If a new startup company reaches the point of profitability that it can pay dividends, for a heavily naked-shorted company, that presents a real dilemma.

Companies with increasing profitability are unlikely targets for shorting – unless there’s suspicion that they’re profitable like WorldCom was “profitable”.

There’s a dilemma in naked short selling, but that isn’t it. The company pays the dividend based on the number of shares it issued. The shorts owe the dividend and the longs are owed the dividend. In the case of “phantom shares” the shorts, not the company, end up paying that dividend. So, yes, the long always gets the dividend regardless of whether he owns a “phantom share” or a “real” share. What changes is who pays the dividend.

Also, jr. mining companies, for example: Young promising companies can be naked shorted into oblivion and die, even though management is doing everything right, getting good drill results, containing costs, putting together a mine plan, etc.

I disagree with your assessment. Let’s assume unfettered naked shorting with no risk of buy-in (which is not the case now), just for the sake of argument. If market participants lose confidence in the company’s fundamentals, they may take a short position. If enough market participants believe the company is overvalued, and short the shares, more supply of the company stock will be created once the shorts exceed the float. Unless demand for the stock at a given prices increases to at least match supply, the stock will keep falling.

First of all, this is unlikely to happen to a company such as you described. A company “doing everything right” with increasing margins is rarely thought to be in decline and unlikely to be targeted for shorting. Secondly, if the shorts are wrong about the company’s ability to produce cash flow, the lower stock price will result in a higher return on equity. A high return on equity usually attracts buyers and shorts will be quick to cover. Keep in mind that shorting is more dangerous than taking a long position – buy-ins notwithstanding. The most you can lose on a long position is the difference between the amount you paid for the stock and zero. The most you can lose on a short position is infinity because there is no limit on how high a stock price can go. So, shorts are easily spooked by any hint that they might be wrong.

If the RAMPANT naked shorting today had been allowed when Microsoft was tiny, would it even exist today?

Well, the rules regarding shorting have only gotten more stringent since Microsoft was a wee company, and it did survive. Probably because it was a sound company. Anyone who shorted it was punished by its success.

Incidentally, not all shorts are short because they think the company is going bankrupt. You’re familiar with a long/short strategy where you take a long position in an undervalued asset and a correlated short position in an overvalued asset? Once the prices have corrected, the position is unwound. Usually these are not big price differences – sometimes the under or overvaluation can be just a few cents. If properly executed, this strategy reduces the volatility of the portfolio. However, if the companies in question have small floats, some naked shorting may result just because of the small float.

BS. SEC is NOT doing its job to go after the naked shorts and force them to cover.

I don’t know how good a job they do and I’m pretty sure you don’t know either. Buy-ins even on located shorts happen pretty frequently even if the stock is not on the Reg SHO list. I speak from experience on this. It’s just the chance you take.

I think the biggest problem with “phantom shares” is the proxy vote issue. But, I’m not sure if it’s a bigger problem for management’s ability to protect itself from shareholder wrath or for the shareholders. It’s something I want to think about some more.

27 Methinks July 24, 2008 at 10:38 am

JThomas,

This thread is about to roll off, so this will be my last post.

You need to consider a few things here.

IFirst of all, you’re conflating short selling, naked short selling and using naked shorts to commit outright fraud and market manipulation. The latter is wrong on all grounds and should and be prosecuted. But the fact that there are some naked short positions does not mean that there is also market manipulation. I’m not surprised that you aren’t differentiating. Chris Cox, under extreme political pressure, is not either in his editorial in the this morning’s WSJ. What he fails to mention in the editorial is that the SEC did not prohibit naked short selling for market makers. If there’s no difference between fraud and naked short selling, why not remove the market maker exemption? Here’s a rule to remember: the regulator always ends up in the pocket of the regulated. Look no further than fan and fred.

The other thing you have to understand is that capital markets exist to add liquidity. The side effects are lower transactions costs and price discovery. The capital markets do not exist to protect companies from going bankrupt nor do they exist to protect companies from negative opinions nor do they exist to reduce volatility. If you want price stability and no public opinion about your company, stay private. Just as you don’t accept the argument that shorts could go bankrupt, thus it’s okay to short (which, is not an argument I made, btw), you cannot accept the argument that shorting could lead to a company’s demise as an argument against shorting. The vast majority of the companies on the Reg SHO list are either companies that don’t have viable business models or are simply overvalued and need to come down in price.

Just as you can’t make a reasonable argument against buying stock because it could lead to gains for the shareholder, you can’t make a reasonable argument that shorting is bad because shorts could make a profit.

There’s the argument that it reduces the spread. But I don’t care about the spread, I care about the price.

You care about the spread because it is a very real cost. You have to cross the spread when buying and selling.

I don’t have time to address everyone of your misconceptions. I suggest you take some time to learn more about capital markets, how they function and finance in general. It’s usually not a good idea to come to conclusions and demand action based on a vast amount of ignorance of the subject.

28 J Nilsson July 31, 2008 at 4:50 am

Transparency cannot be bad. The naked seller should tell the buyer that he will only own a promise to deliver a stock, not a real stock. The analogy with a Rembrandt painting is good. Naked stocks will undermine the value of real ones.

I am not a moralist but “telling the truth” is the closest to objective morality that we get.

29 sbklein September 22, 2008 at 10:31 am

A few factual corrections: First – The business Fannie and Freddie were doing 4 years ago (2004) has actually been very profitable. The problematic business is from second half of 2005 – early 2008. Second – During this period FNM and FRE stock prices were falling and were popular shorts because private label issuers were stealing market share by loosening standards and lowering fees. The shorts in this case had what was ultimately the right bet for exactly the wrong reason (they thought FNM and FRE were being made irrelevant by the private label issuers). My point is that short-sellers don’t have a corner on the market of good judgment about values – they get it wrong as often as others do. And that even in retrospect, people with otherwise solid-sounding arguments can still get the facts wrong.

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