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On July 29, the SEC announced that it would extend its original 10-day restriction on "naked" short sales of 19 major financial companies through August 12. Analysts across the board agree that this particular SEC rule, by itself, will have little effect except to raise transaction costs for those wishing to short Fannie Mae, Freddie Mac, Goldman Sachs, JP Morgan, and other powerhouses.

However, in conjunction with the Fed's recent lending operations to investment banks and Fannie and Freddie, the restriction on naked short sales makes perfect sense as part of a process of getting the public used to federal/private partnerships that would have been unthinkable before the credit crisis — especially from a "laissez-faire" administration.

In this article, I'll explain short selling (and the "naked" variant), its benefits to the market economy, and the harm from arbitrary government restrictions on the activity. I'll close by speculating on the possible motivation for the government to engage in an apparently pointless gesture.

Short Selling

I explained in a previous article how (successful) stock speculators provide a "social" service by steering asset prices to their correct levels. If investors believe a particular stock is underpriced, they can buy shares of it and then unload them once the stock has met or surpassed what they view as its "proper" level. In this way, they quickly push up underpriced stocks. Notice that it doesn't matter whether the investors who notice the initial underpricing own any of the stock at the outset.

However, things are different when an investor believes a stock is overpriced. If the investor happens to own shares of the stock in question, the obvious move is to sell some or all of the position, which both earns a relative gain for the investor and also speeds the downward move in price.

If this were the end of the story, there would be an obvious asymmetry in the market's ability to rely on the dispersed knowledge of experts in diverse fields. The only people who could act on their belief that a stock was overpriced would be those who already owned the stock. Such a restriction would be even worse than a small random sampling of the population, because the people who purchase a stock are more likely than the average person to have overrated it.

Fortunately, the market allows short selling, where someone who has zero shares of a stock can, in effect, sell shares and hold a negative position. Suppose stock XYZ is trading at $50, but Jim the Speculator believes tomorrow's news will contain something very unfavorable for the stock — and the rest of the market isn't seeing things the way Jim is. Jim can borrow, say, 100 shares of XYZ from a stockholder, sell them today for $5,000, and then wait for the news to hit. When it does, and the stock sinks to $40, Jim buys back the 100 shares for $4,000, and returns them to the stockholder. The stockholder is no worse off (he hadn't planned on selling the shares), and Jim has netted $1,000 from his superior foresight.

Things get more complicated when the short seller takes longer to return the shares; we have to worry about dividend payments, interest, etc. But the basic principle is simple enough: just as a speculator who wants to go long can borrow money to buy stocks, so too a speculator who wants to go short can borrow stocks to "buy money." Short selling is no more mysterious than buying stocks on margin.

Naked Short Selling

Unfortunately, naked short selling is not nearly as exciting as it sounds. It simply refers to a situation where a trader short sells a quantity of shares before he has actually borrowed them from an owner.

Some of the commentary on naked short selling has become downright silly. The naked short seller is not violating the laws of logic; certain bloggers write as if we should fear a rip in the space-time continuum centered on Wall Street. If a particular stock is illiquid, and a trader wishes to speculate on an anticipated hourly move in the share price, nothing is harmed by allowing him to sell 1,000 shares and then buy them back 45 minutes later; the broker can simply debit or credit his account accordingly.

Of course, what is really happening here is that the broker is extending a form of credit to the trader, and the buyers of the "naked" shares (i.e., the counterparties to the initial short sale) are in turn trusting the brokerage. Because those 1,000 shares weren't actually located and borrowed before the short sale, that transaction can't be completed until the trader closes his position and buys back 1,000 shares (possibly from other individuals). At that point, any of the counterparties to the original short sale who maintained their purchase, can gain title to the shares out of the 1,000 the trader bought back when closing his position.

What if the trader has a heart attack before he closes the position? Or what if he made a terribly wrong guess, and the share price triples ten minutes after his initial short sale? This danger is why I earlier said that the trader relies on a form of credit from the brokerage; no matter how much he initially put up as collateral, the share price could rise such that he is on the hook for more money. Ultimately, the brokerage is responsible for delivering the proper number of shares to those who purchased them in the initial short sale.

Of course, it is possible that if disaster strikes, and a stock experiences a sharp jump while a trader holds a very large naked short position, then the brokerage could be unwilling or even financially incapable of rectifying the accounts of those who were counterparties to the initial short sale. In other words, they agreed with the trader to buy a certain number of shares at a certain price, they handed over their money, and then find out (after the shares have risen in price) that they don't own these shares, after all.

Depending on the precise contractual understanding, this outcome would be either outright fraud, or at least a very embarrassing sign of incompetence. Either way, the brokerage would obviously seek to avoid such a predicament, and so (absent government regulations) would be very careful in facilitating short sales.

The real controversy over naked short selling, however, concerns price manipulation. Here the fear is that a maverick trader could spread false rumors about a company while massively shorting its stock. Such aggressive actions would allegedly push the price down, allowing the trader to reap a guaranteed profit from his self-fulfilling prophecy.

As with most tales of market manipulation, this one is too good to be true. For one thing, why couldn't large stakeholders do the same thing with regular (not short) sales? Bill Gates could spread rumors about Microsoft and begin unloading his huge position. After the price fell 50 percent, he could buy back his original position, having netted perhaps hundreds of millions of dollars in the process, and owning the same number of shares as before. Bill Gates's actions wouldn't have changed the underlying profitability of Microsoft, and so its artificially depressed share price would presumably recover over time. No government regulations on short selling could stop this type of maneuver.

Going the other way, why don't manipulative speculators spread positive rumors about companies, and then massively buy their stock? This too ought to yield a sure profit, if manipulation is so easy. Again, the government would have a difficult time cracking down on this ploy. What would the SEC do, forbid optimists from buying stocks they expected to rise?

Traders aren't stupid. They understand the possibility of manipulative schemes, and can take defensive actions accordingly. For example, if a trader believes someone else is engaging in a "short and distort" operation, he can buy the stocks on the cheap, preventing them from falling significantly in price.

In the interests of promoting stability, stock exchanges and other clearinghouses enact private "regulations" overseeing their participants. Even without government regulations, particular practices that were clearly deceptive would be prohibited, in order to ensure that the exchanges' customers were happy with their experience.

In the grand scheme, grown men and women buy and sell shares of companies. No one forces them to heed the rumors of a "short and distort" or a "pump and dump" artist. Government regulations can't protect people from their own gullibility. In fact, attempts to do so perversely give them a false sense of security.

The Recent Crackdown on Naked Short Selling

What is remarkable about the SEC's recent announcement is its pointlessness. All it does is prohibit naked short sales on nineteen "important" financial companies. In other words, even if a trader intends to short (say) Citigroup shares and to buy them back within an hour, the brokerage must first locate and borrow the shares before allowing the sale. Inasmuch as large brokerages pledge to make whole any customers who are counterparties to a short sale, the restriction apparently does nothing except require more paperwork and reduce the attractiveness of short selling. (Because of the extra delay, share prices might move before traders can short sell them.)

My observations shouldn't be taken to suggest that an expanded prohibition by the SEC would be a good thing. On the contrary, the bigger the restrictions, the worse the interference with the beneficial role of speculation on stock prices. For example, if the SEC outlawed short selling altogether, this would make market prices more volatile, as experts could no longer anticipate bad news and push stock prices in the proper direction. But such draconian moves couldn't prop up stock prices forever. Eventually, the actual owners would recognize reality and sell what they knew to be overvalued shares.

This raises an interesting question: if the restrictions on naked short selling won't do anything except throw red tape into the works, then why did the SEC do it?

By itself, the move doesn't really benefit the fat cat Wall Street bankers, because (as we've argued above) an insolvent institution won't be helped much by bans on short sales, especially if those bans only apply to naked short sales

The answer, it seems, is that the government is gradually eroding the remaining barriers between an explicit federal/corporate partnership with large, politically connected firms. With the bailout of Bear Stearns, the announcement of possible Fed purchases of Fannie and Freddie equity, and the restrictions on naked shorting of nineteen financial firms, the government is, step by step, desensitizing the public.

In light of what has already happened, a basically irrelevant move to prohibit naked shorting of nineteen firms won't lead to riots. But it is a necessary step along the way to announcements that would have led to massive protests had they occurred at step one.

Conclusion

Short selling is a beneficial process that allows anyone to participate in the market's evaluation of share prices. So long as contracts are enforced, even naked short selling can be a beneficial process that allows the quickest possible adjustment in mispriced stocks. The government's recent efforts to "protect" nineteen favored firms from naked shorting will do nothing but raise transaction costs. Beyond that, it provides a sobering hint of future, more significant innovations in federal government support for particular financial giants.