More Cargo Cult Regulation

Apparently, the Obama administration may soon put limits on short-selling.  If so, this is cargo-cult thinking at its worst.  Prices fell really fast, so it must be the sellers' fault!  If we could just stop all this selling, then prices would never go down!

Here is my previous explanation of why short selling is in fact a critical tool to moderate bubbles, adding to the irony that we should be considering limits on this tool while suffering a bubble-induced recession.

At the start of the bubble, a particular asset (be it an equity or a commodity like oil) is owned by a mix of people who have different expectations about future price movements.  For whatever reasons, in a bubble, a subset of the market develops rapidly rising expectations about the value of the asset.  They start buying the asset, and the price starts rising.  As the price rises, and these bulls buy in, folks who owned the asset previously and are less bullish about the future will sell to the new buyers.  The very fact of the rising price of the asset from this buying reinforces the bulls' feeling that the sky is the limit for prices, and bulls buy in even more.

Let's fast forward to a point where the price has risen to some stratospheric levels vs. the previous pricing as well as historical norms or ratios.  The ownership base for the asset is now disproportionately made up of those sky-is-the-limit bulls, while everyone who thought these guys were overly optimistic and a bit wonky have sold out. 99.9% of the world now thinks the asset is grossly overvalued.  But how does it come to earth?  After all, the only way the price can drop is if some owners sell, and all the owners are super-bulls who are unlikely to do so.  As a result, the bubble might continue and grow long after most of the world has seen the insanity of it.

Thus, we have short-selling.  Short-selling allows the other 99.9% who are not owners to sell part of the asset anyway, casting their financial vote for the value of the company.  Short-selling shortens bubbles, hastens the reckoning, and in the process generally reduces the wreckage on the back end.

Megan McArdle hilariously commented:

I don't understand why the Commission doesn't focus on something more effective, like installing lavish statues of Mammon on trading floors so that traders can better propitiate him.

Update: By the way, this could be argued to be just another piece of corporate welfare.  CEO's hate short sales of their stocks, and would love Congress to ban the practice altogether.  The fact that the practice enforces accountability on them, I am sure, has nothing to do with it.  The reality is that if buying and selling are thought of as voting for or against a company's or asset's value and prospects, then banning short selling is a way of disenfranchising most of the world from this process.

By the way, not that I think it should matter from a policy perspective, but have you noticed that the shorts seem to be right an awful lot?  In retrospect, more shorting of bank and insurance stocks 3 years ago would have been a good thing.


  1. Mesa Econoguy:

    The SEC eliminated the uptick rule in 2007 because their own studies refuted it’s effectiveness, and found restrictions on short selling actually contributed to reduced liquidity and larger price swings. Decimalization also contributed.

    [Short-selling is a necessary function of market makers, who hold both long and short positions at any one time, and are only occasionally net flat, so the original ban on shorting financial stocks initially directly conflicted with other regulations stipulating that market makers be at the inside bid or offer a specified period of time, something only possible via short selling – they were eventually granted exception.]

    Watch, they’ll reverse this now, and find some hidden reason to reinstate the rule. This, after the proverbial horse has left the barn already.

    The simpler, far more effective answer would be for Congress to pass legislation simply prohibiting the market from going down.

  2. Mark:

    One thought I have that is highlighted in this post is that the Democrats and their fellow travelers do not understand that "investors" do not all think alike. They simply do not understand the concept that individual actors in such a market will have differing expectations of the future and hence will react in different ways. TO them, all of these people are greedy speculators of like minds and they will see a financial market, or any other price regulated market, as such.

  3. Shorty:

    quote of the day:
    Short sellers (SS) didn’t get people to buy homes with no money down, SS didn’t convince people to buy homes with teaser rates, SS didn’t convince people to lie about their income on their mortgage applications, SS didn’t tell banks/brokers to lever up to such huge levels, SS didn’t tell Greenspan to cut rates to 1% and leave it there, SS didn’t invent FNM and FRE, SS didn’t tell the OTS, OCC, FDIC, Fed, SEC, FFIEC, FTC, FHFA and all the state regulators to twiddle their thumbs all day, SS didn’t tell the rating agencies to rate AAA on anything that moved, SS didn’t tell banks to lend to commercial real estate investors on a property where the rent didn’t cover the mortgage payment, SS didn’t tell the average consumer to spend more money than they make and borrow difference.

    Short selling is a legitimate form of speculation that fully enhances market liquidity and price discovery.

    Also from Chanos:
    “Rebuilding investor confidence should be the primary objective of any new regulatory effort and it is not clear that today's proposals will meet that simple goal. Skeptics, independent research and critical analysis must continue to play a vibrant role for our markets to grow sustainably and with integrity. Short selling is integral to improving the efficiency of markets and enhancing market quality through narrower spreads, deeper liquidity, less volatility, and greater price discovery. In recent years, short-sellers have publicly warned the marketplace about the dangers at AIG, Lehman Brothers, and Enron, as well as sounding the alarm over the credit ratings agencies, non-bank subprime lenders, and credit insurers. Proposals to inhibit short-selling have the effect of limiting this vital market-based antidote to corporate fraud and speculative bubbles, and must be carefully weighed against the clear harm that comes from ill-conceived government intervention in basic market functions.”

  4. John Moore:

    All I want to know is how to trade for a profit on Obama silliness :-)

  5. James:

    I agree that short selling is a positive contribution to a market. I have read reports though about "naked short selling" where the investor/broker/institution do not have to borrow the underlying shares of the stock they are shorting or can get around the requirement in some way. This creates an unstable market where the price can be strongly manipulated. This would be equivalent to buying shares of a stock and not delivering the money for the purchase. If you could buy shares and not pay for them you could drive the price into the stratosphere. If you can sell shares and not deliver you crash the price.

  6. Mark:

    I agree about "naked" short selling even though I am not quite certain exactly what that means sometimes.

    Theorectically, if I have the collateral, using a "naked" short sale I could sell more than 100% of the shares of a company since I do not have to worry about the actual supply of the shares I am selling. Even without a "naked" short, short selling means that there conceivably is more shares of a corporation's stock owned than actually exist.

    So, because of the math, regulations need to exist for short selling.

    I do not favor eliminating short selling, but sometimes question if such practices are required when there exists future markets for stocks.

  7. Mesa Econoguy:

    Naked shorting is shorting without locating borrowed stock.

    Again, most market makers are required to do this, which contributes to liquidity and therefore price discovery.