FYI | Sep 19 2008
By Greg Peel
More unfolding news. As yet (about 11am Sydney) there is no word on the “plan” being hammered out by the US Treasury and Fed. Indeed, it might take all weekend. Yet another barbie at Hank and Ben’s.
But on to short selling.
To clarify, short selling is conducted by traders – mostly hedge funds – in order to profit from the price of a stock falling rather than rising. In order to sell short, one must be able to prove “beneficial ownership” of those shares in the first place. You can’t short-sell shares you already own, because that’s just reducing longs, not “going short”. So to short sell one must “borrow” those shares.
Shares are borrowed mostly from large funds, such as pension funds, who always maintain a core equity holding in their portfolios come rain, hail or shine. And significant holdings at that. The fund had no plan to sell those shares itself, so it “lends” them to a hedge fund at an interest rate (usually just a couple of points). The hedge fund then sells short, waits for the price to go down, buys them back for a profit, and then hands them back to the pension fund. This is known as a “covered” short sale.
Thus shares sold short can only be shares that already exist. And you have to find someone willing to lend them. You can never sell more shares than were issued (which would imply a negative share price anyway), and nor can you realistically sell a very large stake.
However, what you have been able to do in the US is “naked” short sell. This implies that you short sell first, and then worry about trying to borrow the stock later. As the rules on Wall Street have been pretty grey and lax, hedge funds have basically been selling short and buying back without ever having a need to borrow. On this basis they can short sell with gay abandon, and short sell large amounts of stock.
This element has served to exacerbate Wall Street volatility, particularly in financial sector stocks. Short sellers have realistically had the power to destroy a hundred year-old bank by driving down its share price and triggering credit downgrades from the ratings agencies, which effectively “lock in” those share price falls and make it that much harder for the bank to raise fresh capital needed. This is the slippery slope – an almost self-fulfilling trade. Were short-selling never allowed, then hedge funds would not have had the power to destroy financial institutions in this manner. Those institutions could only destroy themselves.
The other element in regards to short-selling is the “up-tick” rule. This rule was put in place on Wall Street in 1938, and ensured that one could only sell short on an up-tick. This means that the price created by the short sale must be higher than the previous sale price – you cannot “hit the bid” and create a lower sale price than the one preceding.
After a great deal of lobbying from the market, US Securities & Exchange Commission rescinded this rule in July, 2007. How’s that for timing?
Without the up-tick rule, short sellers can just relentlessly keep hitting the bid, driving a share price down and down as potential buyers scramble to get out of the way. This is why we have seen tremendous sharp falls in the likes of financial US stocks – the real sellers are competing with the short sellers to get out.
[In Australia, a broker must notify the ASX “as soon as practicable” that sale is short and all sales remaining net short at the end of the day must be logged with the ASX by 7pm. Short sales can only be conducted in stocks which satisfy capitalisation and liquidity criteria. There are limits as to how much of that capitalisation can be sold short, and, most importantly, one can only sell on an up-tick.]
The SEC has been vacillating for months on what to do about short selling in general. In July it called an end to naked short selling on 19 different US financial sector stocks. This provided some brief stability, but the ban only lasted two weeks and was not extended. We have since seen the likes of Lehman Bros go to the wall. There have been cries to reintroduce the ban, and to also reintroduce the up-tick rule, but while the SEC has fiddled, Rome has burned.
Until today. After the close of trade on Wall Street last night the SEC announced its intention to simply ban short selling altogether – naked, covered, up-tick or down-tick – at least for a period of time. Clearly the ditherers needed a rocket up their respective posteriors before making any decision, and that came in the form of the SEC’s British equivalent, which last night banned all short selling in the UK financial sector.
The UK ban is in place until at least January, and each month the regulator will review whether or not other sectors are in need of a similar ban. Obviously this announcement did more than just stabilise the market, because existing short sellers had to begin covering positions.
The SEC must gain approval from its commissioners before the rule can be confirmed, and at this stage it is not known what time period would be fixed. Wall Street already began covering shorts at a rapid clip last night after word of the Treasury’s plan got out, but tonight it may have to cover more.
The SEC has not, however, been forthright enough to date to act before the market lost Bear Stearns, IndyMac, Fannie Mae, Freddie Mac, Lehman Bros, Merrill Lynch and AIG, and very nearly Morgan Stanley (although it may still disappear in a merger). That’ll be a great legacy for the current commissioners.
They will, of course, blame the hedge funds, but as I have suggested before if you leave a child alone in a candy shop, who is really to blame for that kid trying to eat as much candy as it can?
Once more, will this move from the SEC alone bring about the end of the market? No – the underlying credit risk of all financial institutions still remains.
