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Short Ban: Government Policy Created Too Hastily

by: David Merkel September 19, 2008    
David Merkel

David Merkel

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I have been no fan of naked short selling; I have long argued that the brokers must locate shares before a short sale can be done.  Anything less than that is fraud.  But I do not support eliminating shorting, even though I almost never do it.  What would be the effects of eliminating shorting?

  • No more merger arbitrage funds.
  • No more statistical arbitrage funds.
  • Wait, no more arbitrage?
  • 130/30 funds go away.
  • Other quant funds go away.
  • Barbarian hedge funds that do real research go away.
  • Put option implied volatility goes way up.  (A lot depends on whether specialists/market-makers can still short…)
  • Because of put-call parity, call implied volatility goes up as well.
  • Players move to credit default swaps, oh wait, might those get banned as well?
  • Those relying on securities lending income lose out.

Eliminating shorting is stupid.  Enforcing getting a locate is smart.

Now for something that could be smart or dumb, depending on how it is done.  The possibility of a new RTC could be a good or a bad idea.  The main criterion is whether it is proactive or reactive.  My answer may surprise many: reactive is good, proactive is bad.

What we don’t want to do is provide a place for companies to dump lousy assets at inflated prices.  Instead, a new RTC should be a last resort place that the assets of failed companies go to until they are disposed of.  Common and preferred equity should be wiped out, and bondholders should take haircuts.  New loans should be senior to all old loans, similar to the situation with AIG.

Anyone going to the new RTC should feel pain, and a lot of it.  It should be the last resort for companies that are failing.  It should not try to keep companies alive, but merely conserve the value of assets, and prevent contagion.  Remember, if the risk is not systemic, the government should not try to bail it out.

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This article has 13 comments:

  •  
    Sep 19 07:04 AM
    brilliant as usual, looks like a great opportunity for long index funds to get rid of the mess in big style...
    Reply
  •  
    Sep 19 07:10 AM
    Couldn't agree more David. Let's "hope" that any new RTC is of the reactive type. No pain, no gain...
    Reply
  •  
    Sep 19 07:27 AM
    Short term boost in the market, but I do not see how this will correct everything. The bottom line is that financial institutions made bad bets in derivatives. You can't easily fix that with something like the old RTC. If the government trys, interest rates will rise and housing prices and these same derivatives will fall. It is an attempt to forestall a downward spiral and will work until it suddenly does not.
    Reply
  •  
    Sep 19 07:31 AM
    What's so hasty about this decision? Its been long overdue. In fact, if not for a Wall Street insider aka John Mack lobbying over the last few days, this would not have happened at all.

    You see, the 'establishment' ony starts to call for it when it starts to hurt themselves. Meanwhile, the little people have been badly bruised. And yet some continue to stand on the high horse spouting high morality.

    This market is just ruled by financial gangsters! You either play their game or leave. Its not investing. And for that, I will not put my retirement money in it.
    Reply
  •  
    Sep 19 08:00 AM
    The boneheads at the SEC should never have eliminated the "uptick" rule in the first place..which, I believe, opened up the door to naked shorting.
    When I first got into the biz 30 years ago..I would always get a charge out of hearing someone from the floor over the house squawk box saying:
    "The locals are covering their shorts!" What were they doing with their shorts down in the first place!? Couldn't they leave the pit to go to the men's room?!
    Reply
  •  
    Sep 19 08:42 AM
    brokers gotta love this!!!
    be prepared to pay leg and arm if you want to sell even the financial stocks you own.
    Reply
  •  
    Sep 19 10:35 AM
    There is some misperception by investors on the SEC short sale rule. It only pertains to NEW Short sales - existing positions don't have to be covered.
    Reply
  •  
    Sep 19 02:13 PM
    The ban is temporary to give the government some breathing space and fight the fires without them being further fuelled by short sellers. I hope they're banned until a coherent case can be made for the value they add to the well being of the marketplace.
    Reply
  •  
    Sep 19 05:39 PM
    What about all the (idiots... sorry) consumers who are stuck with way more debt than they can handle? Good ole uncle Sam is right there bailing out the investment bankers who created this mess. Who's going to clean up the mess itself? I still do not believe that the mortgage crisis is the core issue. I believe the core issue is debt. Way too much of it every where.
    Reply
  •  
    Sep 20 02:42 AM
    ResourceWise: Yes, it's always "temporary". Just like FDR's "emergency" ban on the private ownership of gold was "temporary". It only lasted 40 years or so.

    As for the value short selling adds to the marketplace, there are boatloads of academic studies explaining the value. It facilitates price discovery which is one of the basic functions of a market.

    Regardless, it's a simple matter of property rights. If I own a stock I should be able to loan it to whomever I please. Property rights have long been under attack in the US, so this is nothing new, but it's just one more step towards banana republic land.

    Note that none of the above applies to naked shorting, which is simply fraud.
    Reply
  •  
    Sep 20 06:07 PM
    The "Short Ban" was not created too hastily. That should have created long ago. It is "emergency" situation right now and it has to be done. So, CALM DOWN !!
    Reply
  •  
    Sep 21 07:15 AM
    I think unlike the RTC from former years which had hedge funds and private capital ready buy - the financial contagion is simply too widespread - everyone appears impacted -foreign countries, insurance, hedge funds, home builders and most importanly a very significant amount of homes.

    From a public policy point of view - there is a point to which a "haircut" can be administered without significant collateral damage and it is here that there are simply limits. Most people are not independantly wealthy investors that can afford to sit back and wait for the repricing. A telling point to this - at this point -is we seem to have a lack of foreign interest (they are impacted as well).

    One thing no one talks about is how the US, like other nations that suffered these crisises, is going to have to make themselves competitive again with govern cuts in employment, services and taxes. We are too big to fail and we have imposed this on other countries (IMF bailouts with strict conditions attached) inflicting great discipline. However this seems unlikely due to the growing leftist tilt in this country.

    Why don't I just hear everyone should be patriotic and demand LESS from the government and services - something like a John Kennedy plan - massive tax cuts.
    Some politicians love to confuse people.
    Reply
  •  
    Sep 21 09:34 AM
    Dead wrong.he world is full of peopel who want to do America harm.Creating a financial panic is one of their goals. This should have happened MUCH earlier IMO. SHORT selling has not been banned TOTALLY. GS repotsgood eranings and the stock is battered from 140 to 85.Is this logical? If the system is destroyed ALL americans suffer.Billons of dollars are spent on"pok brrell "projects.The Chrysler bail out made the government 3 BILLION dollars in 1980s when Buffett was not a billionaire yet.GDP was 3.3% and Unemployment inthis decadeis lower than the 70s 80s and 90s.Tax receipts are up 29% since the 90s the problem is the drunken sailorsin Congress in BOTH parties have spent money foolishly
    Reply
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