SEC Decision to Hinder Short Sellers

The first stock market to develop after the fall of the Roman Empire found it’s home in The Netherlands. The Dutch East India Company’s shares of ownership became traded amongst Dutch citizens in coffee houses and soon an exchange was born. To buy a share in the Dutch East India Company was to hope that the company’s health and revenues would be higher in the future and that you would therefore own a piece of a more valuable company. But not long after this first stock market came about, did other kinds of stock transactions come about. Among them was the “short sale”. 

A short sale is where you borrow shares of stock from someone else and enter into a contract to replace those borrowed shares at some future date. You would then sell the borrowed shares on the open market and look for an opportunity to buy them back at some point in the future. If you could buy them at a lower price, then you would have realized a profit on the difference between the price you originally sold it at and the price you were later able to buy it at. It’s a twist on the old axiom of buy low and sell high; you sell high and then buy low. 

Since the practice first came about, short selling has not been popular. Buying stock in a company is basically betting on the company’s future success while shorting stock in a company is betting on the company’s future failure. It’s akin to playing craps and putting your money on the “Don’t Pass” line; you just don’t make friends betting on other people’s failure. And unpopular figures often find themselves the scape goats during a crisis, which is what we’re seeing now. 

For those of you who don’t follow the financial news everyday, the SEC has been taking an increasingly aggressive stance against short sellers. Back in July of this year, the SEC banned a practice called “naked” short selling against a handful of financial firms. A naked short sale is when you sell the stock without having to borrow it first. The strange thing is that this practice is already against the law. So in essence the SEC came out in July and outlawed an already outlawed practice, but only against a select handful of financial firms such as Freddie Mac and Fannie Mae. Clearly this was an attempt to bolster the price of the stock of financial firms who were perceived as vulnerable. 

Fast forward to this month, and the collapse and bailout of Fannie Mae and Freddie Mac. The SEC once again took the bizarre step of banning the already illegal practice of naked short sales, but this time around they extended it to the entire market. Then came the bankruptcy of Lehman Brothers and the bailout of AIG last week. As part of the bailout proposed by President Bush, there are two provisions which specifically target short sales:

1. All investment managers must publicly disclose whatever short positions they have. 

2. Short selling has been out-and-out banned for financial firms.

Clearly the SEC are taking a more aggressive stance against the short sellers in an effort “to maintain stability.” It’s also clear that the SEC is acting on concert with both the Secretary of Treasury Hank Paulson as well as Chairman of the Federal Reserve Ben Bernanke to try to prop up the market. 

Blaming short sellers for market collapses or having the government ban the practice altogether is not an old tactic. Historically it would seem every time a market collapses, the government comes down against short sellers. The US Government outlaws short sellers after that market collapse of 1929, but found that the stock market only continued it’s decline. Similarly, the moves against short sellers this year has done nothing to stem the tide of stock market loses for people who were shareholders in Fannie Mae, Freddie Mac, and Lehman Brothers. 

The reason that banning short sellers is ineffective is that they are not really the cause of the market decline. Short sellers did not force the bankruptcies that have occurred this year. They did not entice prospective home owners with adjustable rate mortgagees they couldn’t afford, nor did they convince Wall Street Firms to buy securities associated with these repackaged mortgage loans. They did place a wager that the enterprise wouldn’t turn out well, and that has allowed them (including myself) to profit off of the demise of others as markets have collapsed this year. But so what? 

It’s the height of hypocrisy for the government to try to protect Wall Street firms, who has always been motivated by profit before anything else, by banning the very tools that many of them are still using to this day to earn a profit. When Goldman Sachs disclosed last year that it had a strong quarter because it had placed short sales against the very credit instruments it was selling to its customers, no one batted an eye. But now that Goldman finds itself the target of the short sellers, it gets bailed out by the government.  And it’s particularly ironic that the this government is run by Republicans who have long been advocates of the “free market”. 

It would seem that President Bush’s free market policies are similar to his policies of against nation building; a convenient sound bite to give out when times are good, but quickly forgotten when it might actually matter.

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