Naked short selling is back in the news thanks to Matt Taibbi’s investigation of the collapses of Bear Stearns and Lehman Brothers. Unfortunately, it sounds like Taibbi discarded his normally insightful scepticism when naked shorting caught his attention.
Taibbi describes naked short selling as a kind of “counterfeiting,” which is a pretty standard view among critics of naked shorting. But this view seems to be based on a misunderstanding of the mechanics and effects of naked shorting.
All short-selling creates a somewhat “artificial” level of selling pressure. Short selling creates sales that are not generated by current holders of stocks who want to sell. Outsiders–short sellers–who do not own the stock are the ones selling it.
This has costs for holders of the stock–the stock prices may go down. But it also benefits the broader market, especially would-be buyers who get more efficient pricing on securities. Since most investors hold diversified portfolios, they win out from having better pricing at the cost of some stocks going down.
Crucially nothing really turns on whether this additional selling happens through a traditional short sale or naked shorting. Recall that a traditional short sale is a three way deal:
- The guy who lends the shares and now retains the purchase price of the shares as collateral.
- The short seller who borrows the shares who will receive proceeds on delivery of the shares.
- The new owner of the shares who bought them from the short seller.
A naked short leads to an almost identical three way deal.
- We’ve got the guy who bought the shares from the short seller who retains the purchase price of the shares as collateral for their delivery.
- There’s the short seller who will receive proceeds on delivery of the shares.
- And the guy who still owns the shares but never wound up lending them to the short-seller.
Essentially, what’s happened is that the person who is lending the shares to the short-seller has switched. In a traditional short sale, it is the old owner of the shares who lends them. In a naked short sale, it is the new buyer who lends them. There’s no counterfeiting of shares involved at all, and no more downward pressure on the stock than would be involved in a traditional short sale.
Much of the fear of naked shorting seems to be based on a very simple mistake. People assume that most naked short sellers are momentum traders accelerating the decline of a troubled company. That’s actually not true at all. The overwhelming amount of naked shorting takes place when companies announce abnormally positive results and contrarian traders scramble to fight the tape. They aren’t seeking to manipulate the market—they’re betting against the crowd.
Economists Marcus Boulton and Marcus Braga-Alves studied the matter closely and concluded that popular fears of naked short selling were largely misdirected. “Overall, our results are not consistent with the recent portrayal of naked short sellers as abusive and manipulative but instead suggest that naked short sellers promote efficient markets by providing liquidity, risk-bearing, and selling stocks they view as overpriced,” they wrote. (You can download their paper here.)
Taibbi likely thinks that he is sticking up for the ordinary investor against manipulative hedge funds by attacking naked short selling. But again this is almost exactly wrong. Far from being a pro-shareholder move, cracking down on naked short selling would damage shareholders by making the markets less efficient and penalising the best corporate watchdogs around. Short-sellers called the destruction of Enron, Fannie Mae and Lehman Brothers before the broader markets or regulators caught on.
“This is part of a general government war on the shorts, which as I’ve argued…is also a war on market efficiency,” law professor Larry Ribstein wrote at Ideoblog. “Neither business executives nor legislators really want the market to report accurately on how they’re doing — just favourably.”
Corporate executives tend to hate short-sellers, and want use their connections to politicians to inhibit short-selling. And this, really, is what’s going on here. While it’s not quite as blatant as the short-selling ban we saw last year, the crack down on naked shorting is really meant to increase the costs and risks of short-selling generally.
We’re sure that protecting corporate incompetence isn’t Taibbi’s intention. But by shining a light on naked shorting, he takes it off the people who ran our economy off the rails and steered their own companies into the grave. Shifting the geography of our conversation about our financial crisis from the territory of bad management to the hedge fund traders who sold short the failing banks—all the while warning the public that their was serious trouble in the financial sector—is counter-productive.
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