This can both deprive the company of capital. I am not quit sure how the company is deprived of capital if it stock falls. Yes, only if it in the process of selling new shares. Or are you saying it will be less able to borrow?

Cynic,

Both. In the case of the dotcoms, they were issuing new shares to raise capital. The banks have a need to recapitalize, and lower stock prices will obviously make that more difficult.

However, this need is recent. If short-sellers had sent their stock plunging 4 years ago, it may have caused other investors to be more cautious in buying bonds or making other forms of loans to these companies.

Is it an attack on short-selling generally, or just on naked short-selling? The concern I've seen with naked shorting is that there is a lower burden of entry for the sellers, and some distortions based on that.

In general, shoring up the regulations such that people are required to lay hands on the things they want to sell would seem to be in line with your general outlook, no?

Nathan,

I would not necessarily be opposed to restrictions on naked shorts, but it seems odd to single out this type of investment. I am not opposed to using the margin requirement to help rein in speculative excesses, but we have not seen that done, and I suspect that most of the folks supporting the ban on naked shorts would be opposed to using margin requirements to slow upside speculation.

Naked shorts can be pernicious where there is market manipulation, but if someone is big enough to manipulate the market, they can likely do it through other mechanisms also. i just don't understand the logic of singling out naked shorts.

Dean,

I think most of us agree that short selling is beneficial and that short selling, like all activity affecting the market, should be subject to reasonable regulation.

Historically we have had quite a bit of regulation governing short selling. Since your comments do not go to the specific provisions of the regulation of "naked" short selling I find your rationale puzzling.

Do you care to address the specific features prompting your disagreement?

OT:

Refiners aren't goint to break 90% Capacity Utilization...
http://www.eia.doe.gov/pub/oil_gas/petroleum/data_publications/weekly_petroleum_status_report/current/txt/wpsr.txt

"The decision to intervene against short-selling is completely inconsistent with the belief in the wisdom of the markets."

There is no inconsistency. They don't actually believe in the wisdom of the markets, as has been repeatedly demonstrated. They want to guide and manipulate markets, not let them work; the market can be incovenient. You see it here from time to time in Comments.

I think that naked short selling is NOT a part of the GSE problem, but I do think that the entire idea of buying selling stocks and bonds through futures contracts is truly troubling, as it encourages speculation relative to investment.

There is good reason to allow for futures trading on some commodities, it allows, for example, a tire manufacturer to bid with some certainty on a future contract, but I see no such advantage to doing so with stocks and bonds.

The further (and typically more leveraged) one gets from the basic item being traded, the more you have the potential to create a crisis, like what we have now.

I'm not sure how to fix it, but the transaction tax that Dr. Baker proposes, particularly if it applies to repackaging securities and equities, would be a good start.

Dean,

The SEC order change seems to be mostly cosmetic. The old rule caled for brokers to check to make sure stock was available to borrow, before entering a short sale order. The change now requires the broker to actually borrow the stock before the short sale order is executed. These are large cap stocks that the SEC has applied the new rule to, where you are not going to have trouble borrowing stock, thus the rule channge will have zero impact on short sales. (And if the stock is so dead in the water that there is no stock to borrow, you wouldn't have been able to short it under the old rules either.)It's a change wthout a difference.

Of cousre, the SEC thinks the rule change is a greater event than the second coming:

The Securities and Exchange Commission took unprecedented action against short sellers on Tuesday, acting on a widespread concern that negative bets against bank and brokerage stocks might be exacerbating the financial sector's woes.

In a dramatic emergency order, the SEC said it would immediately move to curb improper short selling in the stocks of struggling mortgage giants Fannie Mae and Freddie Mac, as well as those of 17 financial firms, including Goldman Sachs Group Inc., Lehman Brothers Holdings Inc., Morgan Stanley and Merrill Lynch & Co...

The actions represent one of the most extensive attempts by a government agency in recent years to control short selling.

Whopps that's:

Of course, the Wall Strret Journal on their frontpage that thinks the rule change is a greater event than the second coming,

Everything in this post makes good sense, but it leaves the question unasked why there wasn't aggressive shorting during both the tech and housing bubbles. Was this a failure on the part of investors, or a market failure based on moral hazards, or something else?

Jack,

Part of it is that short selling is a trading tool, more than an investor tool. Investors would have to be able to justify the cost of the loan in their expected return. Traders are going to be in and out on the short, hoping the stock goes down significantly in a short period of time. Traders would much rather have a market where the stock is way, way overvalued before shorting it. If there's "irrational exuberance" then they'll try to let it go until they think it's about to pop.

Jack wrote, ...why there wasn't aggressive shorting during both the tech and housing bubbles...

The problem is that if you don't time things right, you can get creamed.

In the mid-1990s, I owned a small sliver of a fund named "Crabbe Huson Special". One of the principles really thought the tech thing was way overblown, and did lots of shorting. He got killed, though, because he was ahead of his time.

That's why people who equate calling a bubble (as Dean called the tech and housing bubbles) and calling the top of a bubble don't know what they're talking about.

Matthew G. Saroff wrote, ...I do think that the entire idea of buying selling stocks and bonds through futures contracts is truly troubling, as it encourages speculation relative to investment.

That doesn't make any sense. No trades on the secondary market, be they long or short, having anything to do with net investment.

In fact, IIRC there have been periods where, because of stock buybacks, the amount of new investment generated by the domestic stock market was actually negative.

Of course, I should have written "...anything directly to do with net investment..."

One-sidedness is a major defect of almost all government economic policy, and could be the main reason why it works so poorly, as seen especially in the latest cycle. Keynesian fiscal policy calls for raising taxes in good times; monetary policy calls for increasing interest rates to counter over-expansion (not just to fight inflation) and stock market theory says there must be shorts as well as longs. Action is rarely taken on the upswing and the result is bubbles and crashes.

But not only are actions against the upside politically difficult or impossible, those who have the authority tend to be susceptible, like everyone else, to bubble mania and do not recognize the problem, nor to they listen to people like Dean who do.

Bubbles can be called from fundamentals, as Dean and others have repeatedly shown. That the recognition of a bubble does not lead to that point being the top is a failure either of the market or government policy. It is also a proof that markets are not rational.

skeptonomist wrote, Bubbles can be called from fundamentals, as Dean and others have repeatedly shown.

Right, I agree. I'm just saying that it's not necessarily easy to really profit from it.

Because I myself was really skeptical of the tech "revolution" in the 1990s, and because I was reading Dean, I moved most of my money that was in equity mutual funds out. I got lucky; it was within a year of the top of the tech bubble.

With the housing bubble, I paid enough attention to stay out of the market until recently. Would have stayed out longer, but due to family issues couldn't keep delaying. On the other hand, if I was really able to call the top, I would have done some research and then shorted all the builders etc, and would now be typing on my wireless-equipped notebook computer from some Carribean beach now. Alas...

I agree with Dean that this is hilarious and contradictory self-aggrandizement by the SEC. However, I disagree that having naked shorting of the FMs some years ago would have brought the housing bubble to an end. That buys into the theory that the FMs were the main factor. I doubt it, and someone shorting them four years ago might well have run into the problem that liberal's fund did in the 90s, just as Alan Greenspan ended up with egg on his face for following Robert Shiller's overly early bird advice on calling the stock market of the mid-90s an example of "irrational exuberance." It was, but it still has not gotten back to the levels it was when he made that famous remark.

One reason for this rule is that corporate management hates short sellers even more than they hate trial lawyers and unions. And for the Conservative Nanny State and the Movement Conservative Republican Party (of which Christopher Cox, SEC Chairman is a noted Palladin)iedf the managers of corporations are the favored class (the Meg Whitmans, Carly Fiorinas, and Dick Cheneys of the world).

"Of course short-sellers can be wrong and depress stock prices more than is justified by fundamentals, but so what?"

Anyone who can write a sentence like that might also believe that the longs can be wrong, that they can inflate a stock price more than is justified by fundamentals. I'll favor the government imposing more regulations on the shorts when the do the same to the longs.

liberal said:

"I'm just saying that it's not necessarily easy to really profit from it."

Absolutely. Hedge funds appear to have worked out ways to use short/long positions that work temporarily, but they can lead to collapse in the long run. And as others have said, shorting is speculating rather than investing. If overall speculation is reduced, as with Dean's taxation plan, the issue of what to clamp down on would be much less important.

"Naked short selling" in a falling market has virtually no information value (what Baker hopes short selling provides). It's nothing but an unthinking herd piling on and following the momentum down.

Isn't there something called Reg SHO that prohibits naked short selling? I thought the only exemption to Reg SHO was for market makers who, to maintain an orderly market, sometimes are permitted to naked short (ie, to sell the stock short without first locating a borrow). This usually happens when there are a lot of buyers around...absent this ability, stocks would have much more short-term volatility (to the upside). I believe the rules say that the trader has to have a "reasonable expectation" that he'll be able to locate a borrow before settlement.

Am I missing something? Or are the only people affected by the new rule market makers...who previously had been able to naked sell short to prevent excessive volatility, but now will be (temporarily) unable to do so? Almost sounds like the SEC wanted to engineer a quick melt-up in some financial stocks. (If so, mission accomplished).

Burrite wrote, Isn't there something called Reg SHO that prohibits naked short selling?

Yeah, from my skimpy reading on the topic (after Dean posted this), it seems like naked shorting is illegal, but historically the rule against it was often not enforced.

Naked short selling is a primary tactic used by people trading on non-public information and by market manipulators (i.e., create a self-fulfillng prophecy). Unlike other trading tactics, naked short selling is almost always focused on the short-term (which is why it appeals to manipulators). While there are legitimate uses for short selling (including the theoretical ones described by Dean) The risk of illegitimate use of naked short sales is far higher than for other trading tactics.

The ban on all naked short selling is more akin to discarding the tub along with the dead baby & bathwater.

I don't understand this. YOu are opposed to short selling because if people had been astute enough a while ago to short Fannie Mae, Freddie Mac, and a bunch of investment banks, there wouldn't be as much short selling now?

I understand the whole point about signalling that a stock price is overpriced, but doesn't the chaos now indicate that there aren't enough astute people around to make it perform that function?

Shoulda woulda coulda is not an empirical observation.

Naked short selling is illegal. The SEC has turned a blind eye while their regulators, Wall Street, have used the gambit when it served their purposes. The SEC is completely corrupt, bordering on criminal, and needs to be cleaned from top to bottom.

IMO, the equities market has been completely corrupted. Individual investors are under surveillance by their "brokers" who bet against their customers accounts and order flow without fear of discovery or reprisal.

Dean,

You are missing the point. What market inefficiency is caused by requiring shorts to deliver the shares that they have sold and for which they have received payment?

Outside the US, sellers receive their cash only when they deliver their shares and so this problem does not arise.