How the short-selling ban could backfire on the banks
By
Dominic Frisby
Sep 24, 2008
A ban on short selling won't help the markets
There is a fine line between comedy and tragedy, and George Bush tripped on it last week when he announced the short-sellers will be "persecuted".
The comedy - barely funny in a below-par Radio 4 sketch show kind of way - is that this man does not appear to know the difference between the words 'persecuted' and 'prosecuted'. The tragedy is that this man is the second-most powerful in the world (the most powerful is Vladimir Putin - but that's a subject for another day).
But in a way he got it right. Short-sellers are indeed being persecuted, used as a scapegoat for a crisis the causes of which had nothing to do with them, and this proposed short-selling ban could have some rather nasty, unintended consequences.
It's déjà vu all over again
Do you know the last time short-selling was banned in the US? 1929. Yes. When a severe market correction and recession was turned into the mother of all depressions by the interference of authorities who did not know what they were doing.
It is, as Yogi Berra would say, "déjà vu all over again."
Short-selling is betting that the price of a stock or commodity will go down. The process is: you borrow the shares, you sell them, but at some stage you must buy them back and return them to the lender.
It is an extremely risky business. Say a stock is trading at a pound. The furthest it can go down to is zero, and the most you can lose by buying it is your original stake. But it could go up to any figure, potentially. There is no absolute limit. If you are short and a stock rises your losses are limitless. Get a trade wrong and it can bankrupt you, hence the rhyme:
He who sells what isn't his'n
Must buy it back or go to prison
There are plenty of bears who have been saying since 2005 that house prices were in a bubble and due a correction. They were right – eventually. But if they had shorted the builders, Barratt say, in 2005, they could have lost an absolute fortune. It was only in June 2007 that the market turned. It takes a brave, stubborn and intelligent trader with excellent timing to short with consistent success.
A short-seller has had the intelligence in this market to analyse balance sheets, and recognise either insolvency, a weak sector or incompetent management. He's then had the bravery to act on his convictions, take the huge risk and go short. What's more he will pay tax on any money he earns from his actions. Will he be bailed out if he gets it wrong?
Short selling is good for the markets
Legitimate short-selling, it's argued, keeps markets in order. It also keeps them liquid. A large short position in a company is a signal to management that traders think there's something in your company that needs addressing. It is also a legitimate hedge against unforeseen events – natural disasters, say - that can bring a stock, a sector, or the entire market down. (Naked short-selling – when the stock is not actually borrowed – is a different matter altogether and a subject for another Money Morning.)
If a short-seller does get it wrong, he meets with very little sympathy. The act of short-selling is somehow considered immoral. But blaming short-sellers for this mess is akin to blaming bookies taking bets back home for the sinking of the Titanic. Jim Rogers was on CNBC recently and the anchor, Bertha Coombs, suggested short-sellers were the cause of Fannie Mae and Feddy Mac’s demise. Rogers retorted, "If you’re blaming this on short-sellers, you should have another job." Our own notorious short-seller Simon Cawkwell, aka Evil Knievil, put it even more brusquely in The Telegraph recently: "The rules relating to short-selling have been introduced by uneducated idiots responding to the baying mob, and they will have no effect at all."
He's right. These institutions have collapsed because they are insolvent. Not because of short-sellers. They borrowed lots of money and invested it badly. Now they have no money left. Why should they be bailed out? It is just throwing good money after bad.
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The fault is not with short sellers, it is with the system
The reason these bankers borrowed too much money is because the fractional reserve banking system under which the West operates allowed them to. Banks can lend out ten times their assets. Funds borrow and then leverage up. The result is you get leverage at many multiples of the actual money on deposit. A small market correction can cause turmoil. The fault is the system.
But nobody thought to change the system during the good times because everyone loves a boom. Regulation is not the answer. Monetary reform is. Under an asset-backed currency, discipline is forced upon banks and such borrowing would not have been possible. There would not then be the need for regulation.
In any case, Cawkwell continues: "All this talk about having brought everything back under control is hooey. The financial system is closing down. It doesn't matter what the Government does."
The intention behind the ban, which we will see in the UK, the US and in Australia, as well as for authorities to exonerate themselves and the system from any blame, is to rally the markets. But this may not work. Here's a chart of the Pakistani stock exchange with an arrow pointing to the point when short selling was banned.
As you can see, though it caused an initial short-covering rally, as in 1929, banning short-selling did not have the desired effect. Already an army of lawyers is being assembled to contest the ban with the FSA – meaning fortunes going on legal fees, who is going to pay for that? - while the entire options market is facing potential decimation. But the repercussions could go further.
A poster on the Global Edge Investors discussion board who goes by the name of Cgnao spelled out a possible road map brilliantly and I reprint this with his permission:
1) Short sellers are mostly hedge funds and other highly leveraged speculators, betting using borrowed money.
2) They went short because they anticipated bank failures and they were making huge profits because they were right.
3) Central banks and governments step in and change the rules.
4) Regardless of fundamentals the shorts have to cover, sending shares of insolvent banks higher.
5) The general public believes the market has turned and buys those banks, sending shares even higher and hedgies' losses spiralling.
6) The huge losses the hedgies are taking make them default on their leveraged loans.
7) But think about it, who lent them the money? The same banks they were shorting!
8) More bank collapses follow. Investors get scared and dump their positions. No shorts left means no more short covering rallies and the ensuing crash is all the greater.
Our recommended article for today
Who will pay for America's bailout?
The US has saddled itself with an enormous debt when it can least afford it. America has until now relied on foreign governments being generous lenders. But that may not continue. And if it doesn't, where is the money going to come from?
Published in Stock markets
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by
Dominic Frisby
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