No, to borrow the shares you have to put up 100% cash as security. You can then get a loan on up to 50% of the value of the certificates you have borrowed, unless margin requirements are reduced (which is one thing the SEC could do to decrease volatility).

Longs buy when they think a name is too low. Shorts sell when they think it’s too high. Both are needed to provide liquidity. Either side is subject to abuse: pump and dump; bear raid; short squeeze.

If an issue goes down by half, the short makes 50% less interest and commissions, and pays 35% federal plus state income tax. If an issue doubles, the long makes 100% less commissions, and pays 15% plus state capital gains rate if he exceeds the one year holding period.

Since the market generally uptrends over a long period of time, if you are short you are betting against the trend. Check the 10 year performance of BEARX, for example.

Not that other perverse incentives don’t also exist. But this one hurts both the homeowner (who may be able to pay, and willing to pay on the expectation of the value rising) and the mortgageholder (who loses an income stream and is faced with recovering what he can on a devalued property).

We can argue about the best way to handle this, but it seems likely we can agree that there is a better way, even if we disagree on what it is.

The Glass-Steagall Act was enacted after the stock market crash of 1929 and the ensuing banking crisis and Great Depression. On the day it was signed, along with the National Industrial Recovery Act and other measures, President Franklin D. Roosevelt called the package “the most important and far-reaching legislation ever enacted by the American Congress.”

…

The breakthrough in Friday’s legislation came in a backroom meeting at the Capitol soon after midnight, when a group of moderate Senate Democrats — led by Christopher Dodd of Connecticut and Charles E. Schumer of New York — forced a compromise between Gramm and the White House over the legislation’s effect on the Community Reinvestment Act, a 1977 anti-discrimination law intended to encourage lending to minorities and others historically denied access to credit.

Dodd, whose state is home to the nation’s largest insurance companies, and Schumer, with strong ties to Wall Street, have long sought legislation to repeal the Glass-Steagall Act. Both men said in interviews Friday that they moved to strike a compromise after it became apparent that the legislation might be killed, as it was last year by Gramm, over the debate about the Community Reinvestment Act.

Gramm had maintained that he did not want anything in the bill that would expand the application of the Community Reinvestment Act because it was, he said, unnecessarily burdensome to banks. He had sought a provision that would exempt thousands of smaller banks from the law. He also wanted a provision that would expose what he has described as the “extortion” committed by community groups against banks by requiring the groups to disclose any special financial deals the groups extract from the banks.

But the White House found that provision unacceptable and had its own ideas about community lending. It wanted the legislation to prevent any bank with an unsatisfactory record of making loans to the disadvantaged from expanding into new areas, like insurance or securities.

The White House had insisted that the President would veto any legislation that would scale back minority-lending requirements. Four days of intense negotiations between Summers, Gene Sperling, the President’s top economic policy adviser, and Gramm, while moving the two sides closer, failed to resolve the differences.

..
After receiving calls from executives of some of the nation’s leading financial companies, Dodd and Schumer began trying to work out a compromise. An agreement was quickly reached on the issue of banks and expanded powers — no institution would be allowed to move into any new lines of business without a satisfactory lending record.

The lawmakers bogged down on Gramm’s insistence that all community organizations disclose to the regulators what benefits they get from banks. Some Democrats expressed the fear that Gramm’s proposal would require the Boy Scouts to file reports with the regulators.

Ultimately, the following provisions were drawn up and both the White House and Gramm said they could accept them:

¶Banks will not be able to move into new lines of business unless they have satisfactory lending records.

¶Community groups will have to make disclosures to regulators about certain kinds of financial deals with banks that they have pressed to make loans under the Community Reinvestment Act.

¶Wholesale financial institutions, a new kind of business that takes large, uninsured bank deposits, cannot be affiliated with commercial banks.

¶Small banks with satisfactory or excellent track records of lending to the underserved would be reviewed less frequently under the Community Reinvestment Act. As a practical matter smaller banks are reviewed about every three years. The deal struck today allows all rural banks and banks with less than $250 million in assets to undergo examination once every five years if their last exam resulted in an “outstanding” grade and every four years if they last scored “satisfactory.”

For more than 20 years, Congress has tried unsuccessfully to rewrite the nation’s financial services laws and repeal Glass-Steagall, particularly as many other industrial nations had no similar restrictions on their banks. But until recently, the three main industries affected by the legislation — banks, securities companies and insurers — had competing interests and were able to lobby any legislation to a standstill.

That all changed in recent years as the lines between the industries began to blur and it became more broadly acknowledged that a deregulation of financial services could be beneficial to insurers, bankers and securities firms alike. Once the three industries rallied around the legislation, they became a formidable political force, raising millions of dollars for lawmakers and pressing both Republican leaders in Congress and the White House for new legislation.

http://partners.nytimes.com/library/financial/102399banks-congress.html

Accounting rules that discourage rational behavior can’t be all that great.

Blame Alan Greenspan.

Obscenely cheap money made the bubble, more than anything.

He knew the Bush tax cuts were bad/ultrarisky fiscal policy, but liked them ideologically, so wanted to do whatever was necessary to float them, taking the gamble that growth would surge enough to wipe out the deficit. When it didn’t, he just kept cutting and holding rates down in the fateful hope that eventually that would turn things around. But it didn’t of course, but it did enable all manner of irresponsible mortgage lending.

Then when rates had to go up, lest inflation explode, Kaboom! there goes the bubble…

“Consider that even the most successful short can “only” make 100% on a sale (prices can’t go below zero),.”

In a short sale, the initial investment is theoretically zero.

If I borrow and sell 10 Halliburton shares at $50 apiece and they go down to $40, I’ve made $100, minus the interest and broker fee, on an investment of zero. Of course my value at risk was theoretically infinite, so it’s not a free lunch by any means.

The problem with shorting isn’t naked or covered, so much as it’s the practice of hedge funds spreading false or, more often, exaggerated, rumors about a company’s financial state.

And then one day they are left holding a load of worthless tulips, or south sea stock, or as it was this time bundled up mortgage debt. And the group changes its thoughts.

The fact that there has been a fair bit of corrupt practice going on doesn’t really change the central fact that most people had lost touch with financial reality. The truth is that capitalism is intrinsically full of innovation that veers over into corrupt practices as well as a substantial number of companies that behave in a criminal way and are more bothered about not getting caught than being unethical.

And I wish i had sold my house a year ago because it will soon be worth half what it was then but….

Not to mention I have never really been much of a risk taker – give me a fair guaranteed return and I will almost always take it over something risky but with higher possible return. A certain amount of risk is fun though so some still goes there. I felt my time better spent learning something that I can make money from (say Software Engineering) than something I could do just as well with darts and paper (unless I had inside information and I am never going to be in that position living in Podunkt Tennessee).

I will also say that the collapse is most likely not going to be explained in a simple blog post or a comment – markets are too complex. A large part of the arguing here and other places is more due to that than anything – in many cases all the arguers are mostly correct.

Anyway, back to what I intended to post about: “Why was this practice allowed to continue as long as it did?”. Easy answer, and it is the same one that is true almost every time “normal” people ask this – Congress and regulatory bodies are people and are, therefore buyable.

From time to time you will find a regulation or action that appears to be dishonest by non-experts be needed and honest – same thing is true in other fields (There are a number of times that people can not figure out why their computer can not do something analogous to the Halting Problem – it sounds so simple yet is impossible to do). But those are rare and the real experts usually jump on those ideas pretty hard. If you pay attention to who (and to some extent how) is defending actions you can usually figure out when this is the case (see defending selling short – minus the “naked” part).

Too much money floating around and all but a few people really have a price. For most it is simply a materialistic value (money, trips, merchandise, etc), it may be women, for some maybe even publicity. For those that it is simply money the other two are usually easily purchased.

I would love to say one side is mostly immune to it but, alas, they aren’t. The Republicans have been running on “not as bad as those other guys” for quite a while now and are paying for that. It is why Obama’s message resonates so well and why Palin is liked as much as she is. That Palin appears to have been one of those that was not easily bought (or at all) is a large part of the attacks against her – Obama talks nice but what little record he has is bought and payed for nearly 100% by someone else (note that in his few short years he is the *second most* payed congress critter from Fannie/Freddie – even beating people like Kerry who have been there for decades).

In the end it isn’t really regulations that are the problem – they are only an outgrowth of complex problems, few understanding it, large amounts of money involved, and the ones in charge able to be purchased. I know of no way to simplify it, no way to make everyone an expert (reality is even the smartest of us can only be an expert in one or two fields – and those have to be taken up by our daily jobs), no way to remove the money (especially from finance), and no way to make sure all involved in the bureaucracy are honest.

Are we doomed? Not really – thankfully our system can handle a fairly large amount of corruption. While it sucks to be those of us who live through such times (and as someone who has much of their retirement in AIG I am fully in that boat) reality is any of us can fly off the end of a bridge tomorrow and few will actually care – of those that do it is mostly emotional anyway. As long as we make sure the market is fairly free then it self corrects. However it sucks to be one of the corrections, but then it also sucks to fly off the end of a bridge.

I completely agree with your analysis of how this whole thing unfolded. Logically, in reality this is exactly how things were progressing. I know. I work in the securities’ analysis business (just not in the bundling and trading of mortgage paper).

Because this area is not my specialty, I am not familiar with how the mark to market rules are actually applied. Is this done quarterly? Monthly? Weekly? If quarterly, then I can see how the short-selling would happen this month ahead of the actual reporting of the estimated market value of these securities. Someone had inside information that the write-downs were going to be substantial, and decided to act on that information. And trading being often driven by momentum and by what others are doing, the copycats piled on. And the whole thing cascaded.

The short-selling, in whatever its form, tends to be a leveraged transaction, which only magnifies its effects. Still, I basically agree that short-sellers function to keep markets honest. I have never done a short sale. I research companies in banking and retail, looking for value and upside. There are always a fair number of companies that are over valued, based on my analysis, but it takes a combination of well-researched information with correct timing in order to profit from short sales.

The fundamental problem is the fact that lower quality mortgages get bundled in with better quality mortgages. And in a market that isn’t all that liquid, if you have a hard time arriving at a rational value for these things that just counts as part of the risk.

I tend to be unflappable about wild market swings, keeping my focus on value, why I am holding what I’m holding, and the fundamentals of those businesses. Persons who are prone to succumb to the emotions of fear and greed are not psychologically put together to be successful investors. You can train a high school graduate to analyze companies and their stocks and be able to pick good investments. You really can. But what you cannot teach is their emotional/psychological makeup.

I actually was on vacation on the Big Island of Hawai’i when all of this was going down. Really, I deliberately left my notebook computer at home and tried to remain focused on what was important: my wife and I celebrating our 20th anniversary. So, I’m back to the office on Monday and I’ll deal with whatever loose ends these events may or may not impact on what I do. In the main, they won’t have a lot of impact on it. If the companies I have recommended to the portfolio manager are valued significantly more than what they currently are priced at on the market, it’s not going to change a thing.

Politically, I lay some of the problems associated with the fallout right at the doorstep of Robert Rubin, Alan Greenspan, and Bill Clinton. Repealing the Glass-Steagall Act was a mistake. I was not in favor of it back during the nineties when the discussion was about it being repealed. The Act itself provided financial stability to the system.