I was under the impression that short sellers only gravitated to companies that were either already in trouble, or likely lying about their performance. A stock doesn't go down because of short sellers, they're just the people who seek to benefit from the drop.

Short-selling is simply selling a stock you don't have. It increases the supply of the stock being sold, driving the price down, in exactly the same way that buying a stock (and decreasing the supply) drives the price up.

Thank you, thank you, thank you, Dean. I was reading this anti-short-selling nonsense -- including some absolutely ridiculous venom directed at short sellers (and not just from those whose stock was being shorted, which you'd expect) -- and thought I must be missing some terribly fundamental issue about economics. I'm glad to know it's not me.

It seems that the policy being followed by all the government agencies that are involved in crisis mitigation is to prop up asset prices, both real estate and its derivative financial instruments. I am not well versed in economics but I don't think that this a viable strategy. Has it ever worked in the past, does anyone know?

I completely disagree with you on this one Dean. In my opinion, short selling is the same thing as gambling and people shouldn't be gambling in the financial markets. This goes for longing the stock to. If you want to invest in the market, you should have to buy the stock...period. If the company is bad or deserves to go down, there will be a correction in the market. Short sellers were driving stocks down by shorting stock they didn't own and then spreading rumors. In an irrational market such as this, it is even more crucial to stop these ludicrous practices.

Dean: That on this day and under these conditions the idea that you and others advance... that 'short' selling is some sort of natural market necessity... kind of like wolves taking the weak and elderly caribou... is criminally mistaken. Shorting is nothing more than one more game, like the entire 30:1 credit derivative market that has only one goal... a game that only few can play that can make those few who play it tons of money. The entire concept of selling something you don't own is insane, and the idea that it can't be used to manipulate markets is equally as blind. How about we legalize a bunch of predators who pick on the weak children as they come home from school under the argument that they were weak anyway and we're making the others stronger. Or lets take this brilliant idea to the real estate market...

I would urge you to see this wholly created artifice and the argument that supports it for what it actually is... a vehicle to fundamentally affect the normal laws of supply and deman by granting authority to 'create' supply out of thin air, and then sell without any regard to the real laws of supply and demand, wholly distorting, in that process, any semblance of a genuine market.

Sid- I completely agree. Well worded.

All- It would be nice to get more information on recent news that the Fed is going to take on bad mortgage loans. While I disagree completely with short-selling, I find it irresponsible for the government to take on bad loans from companies who made bad decisions. I couldn't believe what I read. Dean, it would be great if you would comment on that and provide more insight.

How about we legalize a bunch of predators who pick on the weak children as they come home from school under the argument that they were weak anyway and we're making the others stronger.

That is some serious demagoguery there, boy. Yeah, short selling is just like that! Christ, what a wackjob.

Glenn: Without responding to your name calling, please explain to me why you think that giving anyone other than the BOD the ability to create stock in their company is a good idea? Also, do you think this is a generally good idea for all markets, or just a good idea for the stock market? Third, if you believe that abuses and manipulation don't take place through both legal and naked shorting (which I would hope you would agree is unquestionably detrimental to not say unethical and illegal), then why indeed would many markets prohibit both, and now the American and British suspend the practice? Your argument would be Deans... that predators are healthy and the whimsical distortion of the laws of supply and demand (through the creation of imaginary supply are good)?

In my opinion, short selling is the same thing as gambling and people shouldn't be gambling in the financial markets. This goes for longing the stock to.

That's just saying there shouldn't be a stock market, which is essentially a goofy idea.

Third, if you believe that abuses and manipulation don't take place through both legal and naked shorting (which I would hope you would agree is unquestionably detrimental to not say unethical and illegal), then why indeed would many markets prohibit both, and now the American and British suspend the practice?

There is plenty of abuse and market manipulation going up and going down. (Such as running stock pools and the like.) Shorts are not innately abusive.

At any rate, the US and the UK are banning the practice ostensibly to prevent financial terrorism. That's certainly possible (however, what's the distinction between financial terrorism and simply selling?); if it we true, or even if they merely think it's true, or for that matter, if the SEC simply wished to buy time to work on whatever bailouts they have in mind, they can simply suspend trading in a stock.

And that would be the right thing to do, and market administrators have done that before.

Stopping shorting all across the market (effectively) amounts to an attempt to artificially prop up stock prices, and in the current situation is tantamount to interfering in the election.

max
['You're simply getting worked up about normal arbitrage, and if you intend to do that, you might as well simply ban stocks & markets.']

Since several commenters seem confused about short selling, let's define terms: there's two kinds: Naked and covered.

Naked shorting is selling stock you don't have. Naked shorting increases the pool of stock, and drives down prices. Naked shorting is bad, except in limited cases like market makers who need to act quickly, and promise to cover later.

Covered shorting is borrowing stock, and then selling it, with a promise to buy it later. Covered shorting is *good* - it increases market liquidity, by providing a willing counterparty as stocks go down.

Take away covered shorts, and what you get is a much less liquid, and thus more volatile market.

The last thing we need right now is more market volatility.

And, I should mention, naked shorting was ALREADY supposed to be illegal.

And again, I've yet to hear about a credible mechanism for covered shorts to drive the market down. "Market sentiment" doesn't cover it, since longs make just as much, if not more, market sentiment than shorts.

Please keep in mind that shorting stock has always been illegal in China, and their index is down by 60% so far. Lack of shorts is probably part of the reason why it's fallen so far, so fast.

Lets be clear: shorting, like nearly all market behavior, is born of two desires, the first is greed, and the second is fear. Greed demands that market players be able to make money on falling values just as they do on rising values… and as the trading houses are wholly owned by the traders, they of course got their way and shorting is permitted. Fear demands that market players be able to protect themselves from losses, and so shorting is permitted which allows delta neutral straddles to be constructed. IMO all other arguments are specious, such as those of improved liquidity and healthy predation.
O.K. If those are the reasons, then it's reasonable to require that it be limited to that use, and any long buyer also buys a right to hedge his investment. Period. That policy would in fact tend to stabilize markets and make them less volatile… one of the professed benefits of shorting.
I have no problem with either greed nor fear as motivators. However, neither argument, IMO, is strong enough to off-set the fundamental threats posed by the legality of covered shorting... and one of those reasons, human frailty, is validated by the clear existence of naked shorting and short bear raids… both amply documented. But let’s put that aside for a moment and just assume that men are virtuous and the temptation of greed doesn’t drive them to commit illegal acts… and drive good companies out of existence. From my point of view the fundamental problem of short selling is that it effectively renders null and void the law of supply and demand, due to the simple, obvious and outrageous fact that new ‘supply’ can be created by ‘borrowing’ and selling the ‘borrowed’ item. The creation of this synthetic product is without precedent in any other market… and for obvious reasons. The fundamental difference, again, is that neither buying nor selling a share creates new shares… the feature which separates shorting form all other normal and historical market activities.
As I stated in my first post, I’m quite sure that there is not one person (even those who defend shorting in the stock market) whose business is the production of any item for sale, from spinach to silicon chips, who would permit in their market the ability to create ‘synthetic’ products that can then be sold as though they were real, often effectively limitlessly, into their own markets and in competition with their very real goods. Homebuilders suddenly flooded by ‘selling’ of ‘synthetic’ homes… would you like that? Farmers suddenly flooded by ‘synthetic’ wheat… that sound like a good idea? Chip makers suddenly swamped by ‘virtual’ chips… good for industry? Steel makers having to deal with ‘virtual’ steel in a finite market? The fundamental damage from shorting is not that occasionally good companies are bankrupt, or necessary and needed products are delayed due to unnecessary financing considerations, but that by repealing the laws of supply and demand, by making supply for all intents and purposes totally virtual and elastic, shorting does irreparable harm to the financial and to the real market place.
As to the arguments that ‘shorts create healthy markets’ by preying on the weak, or that they ‘provide needed liquidity’… these are red herring issues. Smith Corona didn’t go out of business because the smart shorts spotted their future weakness with the advent of computers… they went out of business because no one bought their typewriters nor their stock any more. Shorts are not needed to ‘weed’ the market… consumers and financiers can do that very well. Most importantly, with shorting, the financial and executive officers of public companies have no control over their fundamental right to control their own stock float, as shorting allows legally up to a 100% dilution… and ask any market player what dilution does to value? Quite simply, the foxes running the hen house designed this not for liquidity, nor health of the market, nor hedging, but rather so that they can have the chance to make more money. Greed. No problem, but let’s be clear: in the name of greed and fear, the law of supply and demand gets nullified, and that can’t be good for a market.

Dean says naked shorting is analogous to buying stock on the margin. Wouldn't it be analogous to buying stock on 100% margin without having to pay interest? (I admit I am confused with all the contradictions here and elsewhere).

But certainly banning shorts is consistent with almost all government and Fed economic action - rescue markets on the downside but never try to restrain them on the upside. With this attitude bubbles are guaranteed.

There is simply no way any critical mass of journalists really know what short selling is, much less why there is any question about the justifiability of banning it. So if you want good reported on this from the MSM, NGH.

"Someone has to say it, so why not me? The entire financial sector has just lost its shorts."

-Paul Krugman

After reading the Wikipedia article on naked short selling, it appears to me that one argument which could be made against short selling, and naked shorting in particular (which does not seem to be against the rules unless it is done for the purpose of manipulating prices), is that it increases the complexity of the market, giving greater opportunity for fraud and risk hiding. Of course the same argument could be used against some techniques for betting on rising prices.

Greater simplicity and transparency should be a major part of reform after the current debacle.

to simonedice: your point is well taken. however, i think what dean is trying to say is that there is a gross double-standard when it comes to the SECs approach -- look the other way when asset prices rise too far but support them when they (in particular the stocks of their banking sector buddies) fall too far.

"Dean says naked shorting is analogous to buying stock on the margin".

The fundamental difference is that when one buys on margin, no new shares are being created; one is simply borrowing money to buy stock that one hasn't the ready cash for. However, when one shorts, that is, borrows a share AND THEN SELLS IT, a new share has been created, and the new buyer that he sold to also owns a share... which actually doesn't exist. For that reason it is referred to as a 'synthetic' share. He is absolutely wrong in this interpretation, and I'm actually shocked by the ignorance of his statement.

Sid, when a share is borrowed and sold, no new share is created. What you have is the same share, plus an obligation on the part of the short seller to obtain and return a share to the lender. Neither covered nor naked shorting creates any new shares, they only create obligations to deliver shares. Whether I buy a share from a short seller or a shareholder, in either case I'm paying cash now for delivery of a share on the settlement date.

The problem of naked shorting arises because unlike a covered short sale, there's no scarcity of shares to borrow to limit the shorting. I think one can make a good argument that naked shorting is fraudulent.

I'm still undecided about naked shorting. If I were running an exchange, I'd probably ban it, but that's something for the market to decide. Nevertheless, a naked short seller still has to deliver the shares at settlement, and I know I've benefitted once or twice when shares I held shot up because of a short squeeze.

As for banning short selling, I read recently that China did that, and they've had a 60% decline since they did, even without any short sellers. Kind of makes it sound futile.

-jcr

Thinking about this a little further, it seems to me that as an exchange, I would want to limit naked shorting for the same reason that I would limit writing naked calls: the exchange is ultimate guarantor of all trades on the exchange.

If I let someone write a billion naked calls on stock in XYZ corporation, and the shares rose above the strike price and he couldn't afford to cover his position, his broker and then the exchange would have to make good on his trades.

Likewise, if someone tries naked shorting of a billion shares, he might be able to push the price of the shares down, or he might end up in the mother of all short squeezes, and go broke, leaving the exchange on the hook for those trades.

It seems to me that naked shorting can be a self-limiting phenomenon if the exchanges require than any short seller disclose whether he's covered or not when selling, and publish the numbers of covered and naked short sales. That way, you could take a quick look at the figures just as you can check the open interest of puts and calls, and decide whether to buy shares and make a profit on the price jump from a short squeeze. A bear raid can make an excellent buying opportunity.

-jcr

John: you say "Sid, when a share is borrowed and sold, no new share is created. What you have is the same share, plus an obligation on the part of the short seller to obtain and return a share to the lender." You have conveniently forgotten about the new buyer, the new 'owner' of the share. It shows up in his account. He thinks he owns a share (the same share that you own because you bought it from the company, it's the one they authorized and issued), and if he makes or looses money on that share he will either earn or loose real money for that transaction... just like you!

Lets pretend it's not a share of stock, but your car. You own your car, but a guy comes up to you and says "I'll give you $50 a day to borrow your car." You don't use it much, so you say "Fine". Now, this guy takes your car to a friend of his and sells it to him! Pretty outrageous, right! I mean, how can the car be owned by him... when you own it? More importantly, in your individual net worth statements, both you and the guy your friend sold the car to put down under 'assets'; one car, value x. To make it even more insane, the fellow who you 'loaned' your car to and who has now sold it and who now has the money he sold it for in his bank account also puts down on his net worth 'cash on hand', $X. Still think a new asset hasn't been created? Every accountant in the world will recognize the new asset, and will value it as such. And to make it more insane, what happens if the new 'owner' of your car decides to do the same thing? Well, all of that is currently done with shorted stock, and if you think that the introduction of all that new stock into the market (supply and demand ratio has changed... more supply) doesn't affect prices, I would humbly suggest that you're mistaken. It is in fact the mechanism that is at the heart of a 'bear raid'. To paraphrase a now popular expression... 'Sell baby, sell!' What are they selling? Borrowed (and often times not even that, but just simply shares created out of thin air (i.e. naked shares, shares that weren't even borrowed first).

sid, you ever hear of something called the oil futures market?

nivedita: sure, but please tell me how you think that the commodities markets relate to short selling or naked short selling a stock? As far as I can tell, no new supply is being created by either taking a long or a short position in commodities, although somehow I'm sure you'll correct me if I'm wrong.

Again, I've yet to hear a credible mechanism by which *covered* shorting drives prices down below their fair value price.

Anyone?

Without that, there's no reason to make covered shorting illegal.

And again, naked shorting is already illegal, except for market makers, who only go naked until close, so can we stop arguing about that? Naked shorting dilutes the supply of shares, and therefore can actually have a negative effect on prices.

Unlike covered shorts.

sid, buying stock on margin and selling short are not fundamentally different from trading oil futures. The oil futures market is simply a more efficient way to do the same type of transactions. In both cases, you are simply making a bet on prices, while trying to put up the minimum amount of capital possible. Selling short goes on all the time in the physical commodities market - people lend out crude oil that they don't immediately need, and the borrower can easily sell it and repurchase it a month later if he wants. Indeed, that would be the expectation - he either sells it or consumes it.

There are two assets here, stock and cash. Selling short involves borrowing stock and selling it, buying on margin is borrowing cash and "selling it" for stock. If short-selling creates "artificial supply" equally buying on margin creates "artificial demand".

"Naked shorting" is the reflection of buying stock without actually having borrowed the cash. You usually have at least a couple days to produce the cash for a purchase.

Note that creating what you call an "artificial supply" is exactly what the entire banking system was set up to do, for the asset known as "money".

nivedita:
As I said in my second post (above): "Fear demands that market players be able to protect themselves from losses, and so shorting is permitted which allows delta neutral straddles to be constructed." In fact, the modern options market is derived from the commodities markets that you refer to (oil). There, a legitimate market need was met by allowing producers and consumers of commodities to protect themselves by both buying and selling the commodities that they needed to use or produced in order to guarantee the smooth flow of their business... they were NOT set up, as is the modern 'casinoized' stock market, for no other reason than to have another game to play. (as a side comment on the casinoization of the market, if the recent meltdowns of the major houses haven't convinced you that that is what in fact is currently going on... well the, nothing will.) Furthermore, the recent loosening of the rules of who can legally invest in the commodities futures market is at the heart of the speculative surge in all commodities we have recently witnessed... but that's another story. My point is that there is a legitimate need in commodities and an arguable need in stocks to allow limited shorting so that investors can create spreads that limit losses. Period. Shorting and naked shorting is not designed to be the vehicle to launch bear raids on otherwise healthy companies... a VERY WELL DOCUMENTED feature of the modern market, especially in the vulnerable bio-tech sector.

That need and that use (hedges and straddles) is VERY different from the no-uptick shorting, and bear raids we currently have, to say nothing of the rampant naked shorting going on in this casino we used to call a stock market.

Now, to your point that buying on margin and shorting are equivalent. You probably bought your house on margin... that is, you borrowed money from someone to pay the owner of the house, and after that you repay the person you borrowed from, which is exactly what you do when you buy stock on margin. In contrast to that everyday occurrence, when shorting a stock, you borrow a stock from someone and SELL it to a NEW OWNER.... does that sound like what you did with your house? Margin is simply borrowing funds to buy an asset. Shorting stock is borrowing something from someone in order to resell it. The problem of the CREATION OF A NEW SHARE, an issue many just can't seem to grasp, is actually a real problem in ASM's. Who votes the share? The original owner, the person who borrowed it... or the new owner? When you place an order to buy 500 shares of XYZ, you have no way of knowing if those are real or shorted (bogus) shares, and the only way you can know is if you request the certificates... good luck with that one. The newly created shorted shares aren't known as 'synthetic shares' for nothing. Is your house, the one you borrowed to buy, a synthetic house? Is there another owner out there who thinks that he/she owns it? I think not.

In review, yes, stock shorting is just like shorting commodities. The difference is that in commodities there are real consumers, and the market indeed performs a valuable role in the smooth functioning of businesses... and it used to be limited to them for obvious reasons... more obvious than ever with the recent huge spikes in all commodities prices, no?

And the fellow (above) who says that 'shorting might be fraudulent'... but can't decide whether he would allow it to go on in his exchange... just brilliant.

One further point... manipulation. If you are unable to see how a $20 billion dollar hedge fund couldn't manipulate the share price of stock of a 'small' $250 million company by simply creating supply, shorting and shorting and shorting and shorting by borrowing and then SELLING shares that only exist on paper (the original owner has the certs in his safe, so what's being sold to you the new owner?)... then something's wrong. Do some research. Watch it happen. Under this SEC, it's standard operating procedure. Ask Cramer. Ask any hedge fund manager.

And my last post on this subject is the answer to the title of the original note from DB: "Why is the Bush SEC Scared of the Market?" Because they created a monster that feeds on its young.