Short selling

[Ordr]

http://money.cnn.com/2008/09/19/news/econo...sion=2008091906

This just gets worse and worse, doesn't it?

[KendallJ]

This is hte biggest travesty fo the whole thing. The "short seller" makes markets work better. It allows those who have a vested impact from a security position, but who do not own the underlying security to put information that they have into the market. They play the same role as the insider. Keeping these people from trading is akin to gagging those who have information about the market from getting it to the market.

If insiders had been allowed to trade, Enron never would have happened to the level that it did.

The mixed/socialist economy vilifies the short seller, and the insider, and lifts up to us as examples of do-gooders, the regulator (the cop) and the snitch (whistleblower).

It is because the short seller, and insider make money on their information, because they put their own money at risk in choosing to act, i.e. because they are self-interested that, en masse, they are most trustworthy.

The whistleblower and the regulator are said to be selfless, acting not in their own interest, specifically because they did not profit from their actions.

[brian0918]

From the article:

Some market observers have also blamed short sellers for the punishing declines in bank stock prices over the past few days. Critics of short sellers have argued that some had been spreading rumors about a company while "shorting" the stock in order to drive the price lower.

Is there any credibility to this? If a short-seller borrows bank stock, spreads rumors about the bank, then waits for the stock to plummet in order to sell it, how can that be beneficial to the system? The stock plummets, the bank's clients see this and stop doing business with the bank, and the stock drops further. Does this happen? People are blaming the recent bank failures on this, so if it's not true it's important to show exactly why such a stunt can't work (if indeed it can't).

Edit: Also, is short-selling simply a response to some government restriction on company employees owning stock in companies? Who else besides employees would be able to add true information to the system?

Edited September 19, 2008 by brian0918

[Thales]

From the article:

Is there any credibility to this? If a short-seller borrows bank stock, spreads rumors about the bank, then waits for the stock to plummet in order to sell it, how can that be beneficial to the system? The stock plummets, the bank's clients see this and stop doing business with the bank, and the stock drops further. Does this happen? People are blaming the recent bank failures on this, so if it's not true it's important to show exactly why such a stunt can't work (if indeed it can't).

Short selling is selling at a high price and buying the same stock back at a lower price so that you gain a profit in the difference and end up with the same asset. It is a risk, btw. The reason that the argument about rumors doesn't fly is because the market consists of things with real objective value. Spreading rumors one way or the other doesn't change that value. A cure for cancer is a cure for cancer, regardless of how stocks are bought and sold. Really, what is going on in the market with stock trading is that investors are trying to find where the real value is as quickly as they are able. They are looking for a high return on investment and they are looking to avoid a low return on investment. This sort of investing makes the economy much more efficient, because the better companies more quickly end up with the higher levels of investment and the worse companies end up without anything. Better or worse is predicated on the value of the products and services they have.

The government throws a wrench into the works when it finances bad institutions and distorts the market.

With government interference this process is thwarted and the system becomes less efficient, and sometimes goes out of equilibrium. In the 1990s the government did not allow so called "red lining" in certain cases. That is, they didn't allow banks to refuse loans to low income people who wanted to purchase houses and the also backed those loans. This meant lots of bad loans were given out and so the result is a giant failure in the market place, because the system didn't allow for small failures over time. This same sort of thing is what caused the 1929 crash. The root cause is altruism. The people skimming off the top (politicians, et.al.) are simply the leaches capitalizing on the altruism.

[KendallJ]

Is there any credibility to this? If a short-seller borrows bank stock, spreads rumors about the bank, then waits for the stock to plummet in order to sell it, how can that be beneficial to the system? The stock plummets, the bank's clients see this and stop doing business with the bank, and the stock drops further. Does this happen? People are blaming the recent bank failures on this, so if it's not true it's important to show exactly why such a stunt can't work (if indeed it can't).

This is a possible attempted strategy, however, if you look at what short selling involves, you realize that without some information that the stock will actually go down, then it is a hugely risky strategy. This is the myth of the speculator, that the majority of investors in these instruments, have no knowledge of the market, the actual value, and are simply making a bet; that when a bunch of these "gamblers" run off, irrationally in one direction, it has the effect of damaging "even good companies" (as McCain's speech yesterday had us believe).

The reality is, there are very big incentives to keep "whim-based" stock shorters on the sidelines. Most notably is that the downside of a short is very large. Shorting is a leveraged position, like a derivative instrument (future or option). That is, with very little money, one can buy a position which while it carries with it very large possible payoff, it also carries with it a very large downside risk. The broker manages his side of this risk and assures himself that you can pay off if the position goes bad through the use of the margin call. That is, if the position goes the wrong way, you will be asked to pay money into the broker to cover part of the loss. As the position goes the wrong way further you will have to pay more money in. Here is an example for Wikipedia:

Since the stock cannot be repurchased at a price lower than zero, the maximum gain is the difference between the current stock price and zero. However, because there is no ceiling on how much the stock price can go up (thereby costing short transactions money in order to buy the stocks back), an investor can theoretically lose an arbitrarily large amount of money if a stock continues to rise. Also, in actual practice, as the price of XYZ Company began to rise, the short seller would eventually receive a margin call from the brokerage, demanding that the short seller either cover his short position or provide additional cash in order to meet the margin requirement for XYZ Company stock.

So, if you're simply going to do a reverse "pump and dump" scheme, you had better be really sure that the stock will actually go down based upon your rumor-mongering. Because if it doesn't, then you stand to lose A LOT of money.

It is the part in bold that is ignored when shorters are discussed in the media. If you have a reasonabel (i.e. rational) reason to believe the stock will go down, then you putting hta information into the market by your position is a GOOD thing.

Edited September 19, 2008 by KendallJ

[brian0918]

The reason that the argument about rumors doesn't fly is because the market consists of things with real objective value. Spreading rumors one way or the other doesn't change that value.

Analysts were saying yesterday that the huge surge in the DOW (400+ points) was solely because of rumors (not even verified claims, just rumors) that the government was going to get more involved in "fixing" the current "problem". Is this not true?

[brian0918]

In the 1990s the government did not allow so called "red lining" in certain cases. That is, they didn't allow banks to refuse loans to low income people who wanted to purchase houses and the also backed those loans. This meant lots of bad loans were given out and so the result is a giant failure in the market place, because the system didn't allow for small failures over time.

Is there any book or paper that documents these recent events? I haven't heard the word "redlining" used in the recent crisis, but I've repeatedly heard that the banks were forced to give loans to low-income, high-risk people. I've also heard people frame this as greed on the part of banks, offering loans with huge penalties to get rich off people, but I guess if the risk is higher, the penalties should be higher, right?

Edited September 19, 2008 by brian0918

[KendallJ]

Analysts were saying yesterday that the huge surge in the DOW (400+ points) was solely because of rumors (not even verified claims, just rumors) that the government was going to get more involved in "fixing" the current "problem". Is this not true?

Yes, that is possible, but look at the difference in what this means.

A. the Dow is a composite index. A HUGE surge in the Dow represents a SMALL surge in any of the individual stocks, unless there is one stock that has actual problems. One can't tank a company through a generall 400 point surge in the Dow.

B. When no-one knows what the future will be, even in the short term, as with an "arbitrary" change in govt policy, then one can expect volatility, and yes, rumors will be weighted more during these times since everyone is searching from, but the relative moves are small.

They are not comparable instances.

[Ordr]

Is there any book or paper that documents these recent events? I haven't heard the word "redlining" used in the recent crisis, but I've repeatedly heard that the banks were forced to give loans to low-income, high-risk people. I've also heard people frame this as greed on the part of banks, offering loans with huge penalties to get rich off people, but I guess if the risk is higher, the penalties should be higher, right?

This might provide the information you're looking for: http://www.city-journal.org/html/10_1_the_...ion_dollar.html

[brian0918]

This might provide the information you're looking for: http://www.city-journal.org/html/10_1_the_...ion_dollar.html

Thanks. I've only started reading, but this bit blew my mind:

The [Community Reinvestment Act]'s premise sounds unassailable: helping the poor buy and keep homes will stabilize and rebuild city neighborhoods. As enforced today, though, the law portends just the opposite, threatening to undermine the efforts of the upwardly mobile poor by saddling them with neighbors more than usually likely to depress property values by not maintaining their homes adequately or by losing them to foreclosure.

[Ordr]

Thanks. I've only started reading, but this bit blew my mind:

Well, prepare your mind for further blowing. It gets worse.

[brian0918]

This leads me to one more question. If the current crisis is caused by massive amounts of loan defaults (and corresponding foreclosures), and banks were forced by the government to hand out all these high risk loans in the first place, were they really forced (by the government) to hand out so much money in high risk loans that it would put the entire bank at risk, or were those banks handing out more in high risk loans than they were forced to? If neither, then what brought on the failure of these banks?

Edited September 19, 2008 by brian0918

[Ordr]

This leads me to one more question. If the current crisis is caused by massive amounts of loan defaults (and corresponding foreclosures), and banks were forced by the government to hand out all these high risk loans in the first place, were they really forced (by the government) to hand out so much money in high risk loans that it would put the entire bank at risk, or were those banks handing out more in loans than they were forced to?

I believe it is a combination of both: high risk loans by governmental force and the bank's idea that variable interest rates on the loans wouldn't cause such large-scale defaulting.

Edited September 19, 2008 by Ordr

[adrock3215]

This is fucking ridiculous. Excuse the language, but I am furious. I've never been so personally affected by an unjust regulation. I trade stocks for a living and this is an absolute disaster. The only reason the market is even up today is because all the shorts are covering. Yet the press is going to run and say that "the government bailed out the markets."

Mark my words, here's whats going to happen: At some point in the near future we are going to see a MASSIVE sell off in the financials. Why? Because the balance sheets of these companies are worthless. Once investors begin dumping the stock, there will be no shorts covering, and therefore there will be no bids or buyers. The stock will go into free fall and the market will get slaughtered on that day.

The only way this can be prevented is if Bush and Paulson step in with bids, or if the government shuts dwon the stock exchange like Russia has done this week.

All this for a 20% correction in equities markets. America is moving further and further from capitalism. What happened to free-markets?!?!

Edited September 19, 2008 by adrock3215

[agrippa1]

This leads me to one more question. If the current crisis is caused by massive amounts of loan defaults (and corresponding foreclosures), and banks were forced by the government to hand out all these high risk loans in the first place, were they really forced (by the government) to hand out so much money in high risk loans that it would put the entire bank at risk, or were those banks handing out more in high risk loans than they were forced to? If neither, then what brought on the failure of these banks?

Your question assumes that traders and loaners act en masse to determine the total amount of money lent, and at a certain point can say: "enough."

What we must keep in mind is that the market works through price signals. Any time a certain venture creates a high-profit situation (with risk factored in, of course), individuals will compare that venture to all their other options and, if it provides a "better" profit evaluation, will enter that venture.

What happened in this case is the banks lent out all their money to the low risk borrowers, which provides them with the best profit potential. The government's mandate to lend to higher risk was effected through the MBS process, in which loans were bundled into securities and sold on the market, thus funneling money back into the banks, who now could loan to higher-risk borrowers.

Two factors now took hold:

First, banks had a fail-safe process to off-load higher-risk mortgages, thus mitigating their risks (and guaranteeing their profits).

Second, MBS purchasers who might otherwise have balked at purchasing mortgages originated with higher and higher risk borrowers, had their risk calculation artificially lowered by the implicit guarantee of Fred and Fan.

This kept money flowing from Wall Street into the mortgage industry (and out of actual productive industries), which then reached higher and higher-risk borrowers.

The regulating effect of profit/risk and price were short-circuited by the gov't's suppression of the risk signal, and the cycle continued, now fed even more so by the rising price of housing, which signalled a high-profit potential and added incentive for investing in real estate. With the no-down-side mechanism of MBS, banks could loan to people with no money down (usually a risk mitigator for the banks), which meant that speculative real estate borrowers could limit their down side risk to practically zero.

All of the risk here was being assumed by the gov't, which means that everyone assumed the same amount of downside risk, regardless of whether they invested in real estate, lent money, bought MBS, or sat out. The only rational choice at this point was to share as much in the upside potential, which more and more people did. Those who stayed out of the mortgage game were acting irrationally by accepting only the risk and rejecting the potential profits (and I proudly count myself among the irrational). Those who stayed in other market sectors saw precious resources drained from them, profits fall, production fall, etc. It was a perfect recipe for the structural collapse of our economy.

And the government is completely responsible, not the SEC (what was McCain thinking?), not the "greedy" traders on Wall Street, and certainly not the short-sellers.

(edit typo)

Edited September 19, 2008 by agrippa1

[brian0918]

The only reason the market is even up today is because all the shorts are covering. Yet the press is going to run and say that "the government bailed out the markets."

Wouldn't it then be a good move on October 2nd when this ban ends, to short sell all the stocks that jump way up in the next 2 weeks?

Edited September 19, 2008 by brian0918

[brian0918]

[snip]

Great summary! I'm sticking this on my list of favorite posts.

Edited September 19, 2008 by brian0918

[adrock3215]

Wouldn't it then be a good move on October 2nd when this ban ends, to short sell all the stocks that jump way up in the next 2 weeks?

Barring any unforeseen circumstances: Yes, absolutely.

[brian0918]

Well, prepare your mind for further blowing. It gets worse.

Wow! This guy knew what was coming, eight years ahead of time:

"The bulk of these loans," notes a Federal Reserve economist, "have been made during a period in which we have not experienced an economic downturn." [This] makes you wonder how much CRA-related carnage will result when the economy cools.

Notice his language. He sounds like an Objectivist:

Like affirmative action, it robs the creditworthy of the certain knowledge that they have qualified by dint of their own effort for a first home mortgage, a milestone in any family's life. At the same time, it sends the message that this most important milestone has been provided through the beneficence of government, devaluing individual accomplishment...

A new president should... test the basic premise of the Community Reinvestment Act: that the banking industry serves the rich, not the poor.

I couldn't find his email address anywhere to contact him about this.

Edited September 19, 2008 by brian0918

[adrock3215]

There's a good editorial on CNNMoney here discussing the craziness of this action. Here are some quotes I take from it:

What is the SEC gong to do next? Outlaw all selling?" asks Fleckenstein, who is also the author of the book "Greenspan's Bubbles."...

The SEC's ban creates a potential new problem. Between now and the end of the ban on Oct. 2, the value of many banks that deserve to be trading lower may become artificially inflated....

For all the talk of capitalism now being dead given the government's plan to likely assume much of the banking industry's mortgage-related illiquid assets as well as the takeovers of Fannie Mae, Freddie Mac and AIG, the SEC's action is far more ominous for those who believe in free markets.

Notice his language. He sounds like an Objectivist:

He sounds pretty smart.

[adrock3215]

By the way, it just got worse. 30 new companies added to the list. Now we can't short GE, American Express, or General Motors.

http://www.marketwatch.com/News/Story/Stor...p;siteid=yhoof2

[IchorFigure]

Is the actual ban primarily a ban on stock owners being able to lend their stock out to short sellers, or is it also a ban on disseminating negative info about a company? Or is there simply no reason to do the latter without the former?

[softwareNerd]

The Big Picture blog reports that many other countries have also restricted shorts: Germany, Netherlands, Ireland, Taiwan, and Australia. That post also has a ink to an article by Jim Chanos, who is famous for shorting companies he thinks will go down.

[adrock3215]

The market is down 366 and there are HUGE sell imbalances going into the close. These short sell rules are atrocious. Most of the financials and other banned short-sale stocks are down today, without short sellers participating in the markets. They are experiencing volumes 30-50% of usual. I still think they will take a huge dump on Oct. 2.

Edited September 22, 2008 by adrock3215

[adrock3215]

Here's a preview of what could happen, based on Pakistan's ban of short selling earlier this year in June. Huge move up in one day, and then right back down.

Edited September 22, 2008 by adrock3215