The governments of Spain, Italy, Belgium and (of course) France recently imposed 15-day bans on “short selling,” which means they are prohibiting people from making investments that would be profitable if certain stocks fall in value.
According to the politicians, the bans are being imposed to protect financial markets from “speculators” who cause “panics” by “betting” in favor of bad news.
But this type of regulatory intervention doesn’t seem very effective, at least if the U.S. and U.K. experiences are any guide. Here’s an excerpt from a Bloomberg report.
British financial stocks dropped 41 percent in the four months after regulators imposed a ban on short selling following the collapse of Lehman Brothers Holdings Inc. in September 2008. The benchmark FTSE 100 index fell 15 percent in the period. When the Securities and Exchange Commission prohibited short-sales for three weeks in September 2008 a Bloomberg Index tracking the 880 U.S. stocks affected fell 26 percent, outpacing the Standard & Poor’s 500 Index’s 22 percent decline. …“In contrast to the regulators’ hopes, the overall evidence indicates that short-selling bans at best left stock prices unaffected and at worst may have contributed to their decline,” said Alessandro Beber, a professor at Cass Business School in London who’s studied short-sales bans in 30 countries. …“EU policy makers don’t seem to understand the law of unintended consequences,” Jim Chanos, the short seller known for predicting Enron Corp.’s collapse, said by e-mail. “The vast majority of short-selling financial shares is by other financial institutions, hedging their counterparty risks, not speculators. The interbank lending market froze up completely in October to December 2008 — after the short-selling bans.”
Beber’s research (cited in the excerpt above) has been confirmed by other scholars. Simply stated, if investors realize that something is over-valued, it is going to fall in price. Governments can hinder and delay that process, thus increasing volatility and uncertainty, but they can’t stop it.
But here’s a very big reason why these laws are stupid (at least from my amateur perspective*). Most rational people presumably would agree that the housing and financial bubbles of the last decade were a bad thing. But most of us know it was a bad thing because we have 20-20 hindsight.
But what if there were lots of people back in 2005, 2006, and 2007 who recognized a bad thing as it was happening? And what if they had the ability to deflate the bubble (or at least slow its increase) by making investments that assumed housing and finance were heading for a fall?
We could have saved ourselves a lot of economic misery if that was the case. Heck, short sellers probably did save us from a lot of additional economic agony by stopping the bubbles from getting even bigger.
In other words, short sellers are the good guys. To some extent, they put a damper on “irrational exuberance” and therefore reduce the subsequent economic damage.
But don’t believe me. Here are some sage words from Cliff Asness.
…what goes through the minds of the politicians and bureaucrats and what do they say to themselves? Perhaps it’s the following: “What this crisis absolutely requires is that a really futile and stupid gesture be done on somebody’s part and we’re just the guys to do it.” It was funny when Bluto said it in “Animal House.” …So, they decide to outlaw shorting in a giant number of stocks… Never mind that the short sellers were in many cases the heroes who uncovered much of the ugliness in the financial system that needed uncovering. The government’s actions here will unambiguously hurt our capital markets and economy long-term. …At the risk of restating the obvious, short-sellers play a vital role in any free market. In a world where everyone can only hold long positions, managers have less incentive to work hard, improve stale business models or keep their companies competitive and efficient (sound anything like government bureaucracy?). Short-sellers keep companies, managers and markets honest, and without them the disciplining mechanism is much weaker.
By the way, Asness made those comments back in 2008, and his analysis was confirmed by subsequent events.
Andrew Lilico, meanwhile, is equally astute in his analysis.
Short-sellers make money by identifying situations in which the world is worse than the Market thinks. They expose cases where managements or governments are disorganised or lying or have themselves been deceived. Given the events of the past few years, it would seem very foolish to try to deter people from properly analysing companies or governments to see whether they might actually be less robust than they claim. Surely we want more such analysis, not less! …short-selling (and other forms of speculation) are extremely valuable. They improve market efficiency…and they expose errors made by the management of companies and by governments, early, when those companies and governments might still have a chance to rectify things. Banning short-selling is a classic case of shooting the messenger because one does not like the truth he tells.
The bans on short selling are classic examples of Mitchell’s Law. Politicians do stupid things such as bad monetary policy and corrupt housing subsidies. Those misguided policies cause bubbles that eventually pop. But rather than learn that bad policies are foolish, they use the economic damage as an excuse to implement additional forms of intervention such as short-selling bans. The only constant is that the political class gains more power and control.
* Caveat: I’m only commenting on public policy, not how you should invest your money. I’m only a policy wonk. I know less about financial markets than Barack Obama knows about economics
[…] be a very economically beneficial way of correcting markets when something is over-valued. Heck, we would all be much better off today if there had been some short selling to pop the housing bubble before it got so […]
The problem in our financial markets is that computers are selling stocks several times a second according to computer programs that no one knows the unintended consequences of.
I guess I’m an ignoramus but I think purchase and sales of stocks should be between human beings not computers.
Do we know the unintended consequences of “between human beings” trades?
Nope.
Human beings program the computers to do what the human beings tell them to.
And no trade of stocks occurs unless there’s a buyer and a seller.
Does it matter if both sides are a human being directly acting, rather than a human being telling a machine to act in certain ways on their behalf?
(If the computerized trading causes a “flash crash”, then at least one of the computerized players is going to get burned, hard. And that makes it a self-correcting problem, doesn’t it?)
“Short selling is a contrived practice used by traders, not investors.”
Swimming is generally done by fish, not trees.
Damn those evil fish!
(Really, your statement makes that much sense.)
“Investment” is one reason that people participate in the securities markets; the market system is large enough and stable enough to that there is predictability and stability and the good chance that your invested assets will at least grow in absolute price proportionately with “the market” in general, thus keeping inflation from eating your wealth.
But those “investors” are not buying stocks in ABCD Inc. because they wish to support the corporate name and value of ABCD Inc. They are hoping to ride along with the fortunes of ABCD Inc. for their own profit.
How does that differ from “trading”?
Unless short selling is more easily manipulated than ordinary trades, I don’t see why it should be treated any differently.
Before condemning the temporary banning of short selling in selected bank stocks, people should watch this presentation on illegal naked shorting and its relation to the financial crisis in 2008.
http://tinyurl.com/almj8s
In fact, one should also read some of the information at this web site that has done a great deal of investigation into naked short selling and the way shorts use the financial media (WSJ, CNBC, Bloomberg, FT, etc.) to plant stories about their targets. If these people are correct, (I don’t know yet, but the info seems credible to me) the Islamists may be using naked shorting to raise money for terrorism.
Read about it here:
http://tinyurl.com/3a88vj
My position is that legal short selling is fine. However, a lot of what is going on these days is illegal and needs to be stopped.
From a purely mathematical standpoint, banning shorts is inefficient. If you’re using a Markowitz portfolio management strategy, then not allowing shorts (negative weights in your portfolio) means that not all points on the efficient frontier (i.e. the ‘bullet’) can be accessed. This leads to potential asset misallocation. Now MPM may be in bad odour in recent years , but there’s no denying that not allowing negative weights in the portfolio matrix hinders its utility.
Ahh, yes, but how
many jobs did they save?much did they prevent the markets from falling?We need short selling to pop the bubbles that are crippling our economy.
Frankly IMHO shorting is unethical. I’ve always been long in the market. If you don’t believe in a company then don’t invest. Sell your shares and leave. Actively undermining a firm or sector just to make a quick buck on calamity is immoral.
Short selling did not always exist. When markets first appeared there was only one way to invest, by being long. Short selling is a contrived practice used by traders, not investors.
One pedantic note, it was Eric Stratton who uttered that phrase in Animal House rather than Bluto.
“The vast majority of short-selling financial shares is by other financial institutions, hedging their counterparty risks, not speculators.”
This sounds like a good reason to ban short sales.
Unintended consequences?
The problem in our financial markets is that computers are selling stocks several times a second according to computer programs that no one knows the unintended consequences of.
I guess I’m an ignoramus but I think purchase and sales of stocks should be between human beings not computers.
[…] DAN MITCHELL: The Futile Stupidity of Laws Against “Short Selling.” […]
Yep. The people/voters say that “Its them dang thermometers causing fevers…so, from now on, if you want a thermometer, please fill in the application and a committee overseeing public health will get back to you within 10 business days …”.
————————————————–
Banning short selling and other insurance instruments like naked CDSs is like banning thermometers to protect yourself from disease. You are taking away one of the tools that will help you determine the severity of the illness, and gain valuable information — and time.
As if it were that easy to determine what is “naked”. Say its 2010…
http://online.wsj.com/article/SB10001424052748703957904575252611852571860.html?mod=WSJ_business_whatsNews
…and Zorba holds a $0.5M minority stake in a small privately owned Greek business — say a business that does environmental impact reports for government and municipalities (yep, that’s the Green Zorba) — is unable to reduce his exposure to this rather illiquid asset, and thus wants to hedge against a rout in Greek government activity by short selling $0.2M of Greek sovereign debt, or taking a “naked” CDS on $0.2M worth of Greek government bonds. Zorba does not own any Greek sovereign debt. So is Zorba really naked in this transaction? Wearing a fig leaf? Bikini? Speedo? Shorts? Tuxedo? Parka? Space suit? What is it? –
Not only that, but the short selling or naked CDS is taken against some Mr. Mouton, an investor or insurance executive in Paris who insists that , “Zorba is full of it, or, at least he is exaggerating, Greek debt is not that risky after all, so for a 6% premium he’s more than eager to sell Zorba a CDS or buy his short sale — and plan to make money on it”.
The major net effect of such bans? Zorba becomes even more adverse to investing in Greece (since he faces the additional uncertainty of becoming arbitrarily unable to hedge his bets when the representatives of the Greek people so decide), exactly what Greece needed.
Then if two entities long/short bet Greek assets against each other in some distant land, what is the European union going to do? Send the Interpol?
That is why banning short selling is nothing more than asinine political populism, supported by a 50+ majority of voters who, apparently, not only have had enough time and intelligence to figure out how everyone should behave, but also want to impose it and “Yes, they can!”. Politicians, being the exclusive monopoly providers of such product (regulation) are more than happy to step forward and “take action”.
————————————————–
So enter Mitchell’s Law, … a government committee is formed, 600 pages of new legislation is passed, 600 new bureaucrats with vested interest in even more regulation are hired to enforce it, a special office is set up to handle justified exceptions (like Zorba’s), 60000 hours of business time are spent trying to circumvent the thermometer ban rather than trying to figure out how to bring to market the most attractive product, i.e. best quality at lowest price. The embrace of mandatory collectivism is deadly.
Yes, the details of the world are a lot more complicated than the average voter can imagine, and that is why collective management of the economy by majority does not work, and Americans — who once rejected it but are now on their way to embracing it, copying the very mentalities that kept the rest of the world behind — are doomed to converge to world averagedom.
The European Trojan horse reached the American shores. American naives (whose belief in economic freedom, turns out, was more a result of tradition and historical serendipity, rather than rational thought) fell in love with the wooden steed, named it the horse of HopeNChange and tugged it past a horrified but petrified Statue of Liberty to American soil. The useful idiots the horse carried in its bowel are now spreading the irreversible message. So now, Dear, once lucky Americans, prepare your children to capitulate to world averagedom.
This propping up of dead assets will lead to a total collapse rather than an asset sale and repricing. Brace yourselves.
Although I’m not thoroughly versed on the details of these European short-selling bans, assuming they’re not mitigated by any reasonable limitations leads me to one more observation: In order to artificially prop up the appearance of health in their stock markets, these governments are stifling (market) dissent. How is this any different from forcing the press to publish only stories favorable to the regime?
Great post, Art R. More on the uptick rule from Investopedia:
“The SEC began examining the possibility of eliminating this short-sale rule following the decimalization of the major stock exchanges in the early 2000s. Because tick changes were shrinking in magnitude following the change away from fractions, and U.S. stock markets had become more stable, it was felt that the restriction was no longer necessary.
“The SEC ran a test program of stocks in 2003 to see if removing the short-sale [“uptick” – my insert] rule would have any negative effects. After reviewing the results it was decided that the rule no longer needed to exist. However, naked shorting – selling shares short that don’t exist or can’t be verified – is still illegal. ”
I guess we’d need to see the details of the 2003 test. I wouldn’t have a problem with reinstating the rule, and I certainly think naked shorting needs to stay banned. With those caveats, I agree that the European bans go too far.
*or curse me out
What tortured logic.
I always enjoy asking people if the only movement on the value of an item should be upward. They respond no. I ask why? They always mention things like commodities, and gas are “too high.” I then posit “what if the government banned short selling on things you think are too expensive?”
They either get it, and curse me out.
[…] the original post: The Futile Stupidity of Laws Against “Short Selling” August 14th, 2011 in Stock Exchange News | tags: corruption, economics, freedom, gun-control, […]
There are differences between types of short selling. There is the short seller who identifies a very overvalued stock or other instrument and sells short before the stock crashes. This is the legitimate short seller. There is the arbitrage short selling where financial programs identify slight differences between say stock futures and the underlying stocks and buy one long and sell the other short. It used to be that the actual stock had to be borrowed and sold by the clearing broker before a short sale was confirmed.
Now, there is “naked” short selling where no stocks are borrowed and sold. Naked short selling and program trading were enhanced when the SEC abolished the “uptick rule,” whereby you could only sell short when the stock you were shorting was rising, not falling. No doubt, some entity influenced an official of the SEC with big bucks to abolish the uptick rule.
Now, if there is panic selling of stocks, naked short sellers can keep selling short, which keeps driving the stock price down since there is no uptick rule. This is like shooting fish in a barrel. An easy way to make a fast buck and to hell with all of the small investors who are losing their shirts: Daniels “new economy” at work.