Tuesday, October 06, 2009

Who's Afraid of Naked Short-Selling?

The real significance of the naked short-selling issue isn’t so much the actual volume of the behavior, i.e. the concrete effect it has on the market and on individual companies — and that has been significant, don’t get me wrong — but the fact that the practice is absurdly widespread and takes place right under the noses of the regulators, and really nothing is ever done about it. Matt Taibbi

Naked short selling, or the sale of a security you don't already own, has been an issue of concern for corporations for many years. According to those affected, the practice allows traders to drive a stock price lower than it "should be" if the practice was restricted.

This is, no doubt, true. Beyond the equity markets, this activity has been common practice in the foreign exchange markets for decades, and has inspired similar complaints. Ex-Malaysian PM Mohammed Mahathir heaped scorn on George Soros and other speculators for attacks on Malaysia's Ringgit and other currencies during the Asia crisis. Before that Mr. Soros became infamous as the man who broke the Bank Of England, driving the GBP and ITL out of the European ERM bands.

While I see the point of those affected, and agree that naked short selling run amok could stifle corporate IPOs and young businesses- which might not be a bad thing at certain times- there is a way to avoid a good deal of the damage this type of trading can unleash. Keep your financial house in order.

On the national level, it seems worth noting that Soros didn't try to short the DEM or the CHF, he chose the GBP and ITL for a reason. Those currencies were mispriced within the ERM.

More to the point, due to the guarantee of the ERM (which aimed to keep bilateral exchange rates within a trading band) long before Mr. Soros decided to short the GBP, speculators had bought it at the bottom of its trading rage against the DEM to pocket the interest rate spread between Britain and Germany. Mr. Soros' sales may have upset the balance, but it was the weight of "free money" investors who got, justifiably, spooked and ran for the exits, which crashed the GBP.

In other words, if the price of the security is not too high- say, as a result, in the equity arena, of too much debt and too little profit- short sellers will likely not find your security a profitable sale. Yes, there is a lot of gray here and I don't doubt that currencies or securities that might eventually justify their price could fall prey to naked short-selling. However, a company with a strong balance sheet and highly profitable capital stock might enjoy a round of short selling, to buy back their own stock.

What I found most interesting about Mr. Taibbi's excellent reporting is the increased Congressional interest. As the big banks in the US increasingly realize that they, given their extremely leveraged position, are prime candidates for naked short selling they will be caught in something of a dilemma.  On the one hand, they either engage in the practice themselves (after all what is the bet in a credit default swap) or finance hedge funds who do, while on the other they will (much more slowly I imagine) see themselves as potential victims.  I'm probably only half joking when I suggest that naked short-selling will surely be outlawed when Goldman Sachs, as one of the last banks standing, finds its stock under attack.

Karma can be a b!tch.


johncakes said...

This post reminded me of 2008:
SEC Halts Short Selling of Financial Stocks to Protect (Investors and Markets

My favorite quote:
"At present, it appears that unbridled short selling is contributing to the recent, sudden price declines in the securities of financial institutions unrelated to true price valuation."

I guess if your "true price valuation" is negative, then suspending shorting makes sense, as the short can only go to 0.

Dude said...

Like beauty, "true price valuation" is in the eyes of the beholder, for some.