Financial Panic and Short Selling

New Jersey Policy

There is plenty of blame to go around for the financial panic that is occurring on Wall Street. It is worth understanding because financial panics can have severe economic consequences for all Americans.


There are a number of generalized causes for what is going wrong. Financial firms, including the government entities Fannie Mae and Freddie Mac, got too leveraged. An analogy is that they bought a $4 million house on a $100,000 salary. You might be able to carry it for a time, but then things have to go very right for it to work out in the long term.


Another generalized cause was the separation of risk and origination. In the good old days, a bank had to judge you creditworthy because they were on the hook if you could not pay your mortgage. Today, banks rarely bear that risk. Most often, they originate a mortgage, sell it to Fannie Mae who either keeps it or packages it with other mortgages and sells it to an investment bank, which either keeps it or sells it to their customers.


So leverage and the absence of sound underwriting have been root causes of the financial mess we are in. So has a slow recognition by some financial executives of the severity of these issues.


But the law also has a concept known as “proximate cause”. This is the direct and immediate cause of an accident. I would argue that the proximate cause of our current financial panic is naked short selling. This refers to selling stock that you do not own and have no reasonable prospect of delivering to a buyer. Naked short selling is not something that individual investors can do. It is done by a relatively small number of large hedge funds, our modern day robber barons.


First question, you say. Is it really credible that such a small group of market participants could create so much selling pressure? Yes. The selling that produced the stock market crash of October 1987 was heavily concentrated, and five major institutions accounted for a large percentage of the selling.


So what is naked short selling, and how is it different from regular short selling? In regular short selling, you sell stock that you do not own because you think it is overvalued. When you sell, you have to borrow stock from a broker dealer and deliver it to the buyer in the transaction. If too much short selling occurs, sometimes there is no more stock to borrow so shorting slows or ceases.


Naked short sellers do not have to borrow the stock. Thanks to smart lobbying by certain hedge funds, the rules have been subtly bent to say that “a broker dealer must have reasonable grounds to believe that the security can be borrowed”. The hedge funds are driving a truck through this regulatory gap, and shorting as much stock as they want. A norm has been that they must borrow the stock within three days. But these are smart people; apparently they simply move the position to a different broker-dealer in a practice known as “short-kiting”.


It also used to be that you could only sell short on a so-called uptick, which meant that you could only sell short when the stock had a upward movement in price. This rule was instituted when Joe Kennedy was SEC chairman because he was street-wise and understood short selling abuses.


I do not believe that all short selling is bad at all. Done with an uptick rule and enforced borrowing requirements, it can indeed produce selling in situations where a stock seems truly overvalued. It is akin to pouring cold water on an overheated situation. But naked short selling is akin to pouring gasoline on a fire. To the extent that this practice caused prices to decline faster than would otherwise have been the case, short selling has limited the time horizon for a more orderly workout period.


The SEC put a temporary halt to naked short selling in mid-July. Financials stocks stabilized. To my mind, all that the SEC said was that they were going to enforce longstanding regulations. But after a month, they went back to allowing naked short selling, and the likes of Lehman, Merrill Lynch, AIG Insurance, and Wachovia Bank plunged in value.


This may be arcane stuff, but it is not so arcane if and when it affects your savings, your insurance or maybe even your job. I’ve talked to several high level government officials whose job it is to understand this stuff. They don’t. Oh well. It’s amazing to me that the political debate can be about things like lipstick when our economic and national security are at stake.


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