Naked shorts and other wonders of the financial world
Here’s today’s market bulletin from that newly-minted financial “expert” of the day, neo-neocon.
This comment from reader “John F. Opie” got me thinking about how the practice known as fair value accounting enters the current picture (see this for Opie’s point of view). This Forbes article, written back in June, stated rather presciently:
…”fair value accounting” was aimed at consistent reporting among comparable firms. Assets would be labeled in one of three categories depending on their relative liquidity, with the hardest-to-value assets put in “Level 3.” But the rules, in the works for years and put in place just as the credit crisis hit, didn’t anticipate the amplifying effects of market turmoil.
Critics blame the regulations for the spike in market volatility, painful write-downs and the expensive capital-raising financial institutions have been forced into since the crisis erupted last summer. The turmoil ensnared major Wall Street brokerages, commercial banks, insurance companies and virtually every other kind of financial firm.
Markets are “tormented by an illiquid market structure that exaggerates valuation issues and gives little weight to capital or management,” says Christopher Whalen, managing director of Institutional Risk Analytics. “Fear rather than objective analysis seems to rule at present.”
Yep.
It seems to me that, although certainly not the source of the bad loans, fair value accounting is a substantial part of the reason the phenomenon has cascaded to cause the collapse or near-collapse of so many financial entities that would otherwise be fundamentally sound.
What to do? The rules on this don’t seem to be changing so far.
What does seem to be changing, at least temporarily, are the rules about selling short. It’s been banned entirely for the moment for 799 financial companies. But the concomitant ban on the nefarious practice known as “naked short selling” (no, it’s not sexy) should be permanent, in my humble opinon.
Take a look at what we’re talking about (and by the way, it underscores McCain’s accusations that SEC Chairman Cox was asleep at the wheel here):
A quick lesson in the market’s plumbing: Short sellers are supposed to borrow shares, which they then sell, on expectations of buying the stock back at a lower price to return to its rightful owners, while pocketing the difference in price as a profit.
Naked shorts simply eliminate the borrowing part of that process. They sell shares they don’t own. They take advantage of the fact that stock trades don’t settle for three days. A naked short seller would sell Goldman Sachs stock early in the morning at $100, buy the stock back at noon for $95, and pocket that 5 per cent gain without every going to the trouble and expense of borrowing shares.
There are all sorts of rules against naked shorting, but the SEC didn’t bother to enforce them. The result is the free-for-all seen in recent days. When the forensic audit of recent trading is done, I suspect we’ll find all sorts of evidence of naked shorting, done by big-name funds and abetted by iconic investment banks.
You don’t need to be a rocket scientist—or an economist, or a finance expert—to figure out there’s something rotten about naked shorts.
Why was this practice allowed to continue as long as it did? After all, there was a temporary and limited ban on naked shorts in effect this past summer. But it seems that even that very moderate ban was allowed to lapse in mid-August. Would somebody please tell me why?
Neo,
>>>After all, there was a temporary and limited ban on naked shorts in effect this past summer…
Yes, a guy at our country club flouted that rule this past summer, and was quickly shown the door.
But seriously, I’m not an economist (I’m a doctor, from whom his money is soon parted), but it seems to me that most of these shenanigans (but perhaps not the naked short selling) could be cured by people having more access to good information.
Remember “redlining”? When that was a hot topic nearly twenty years ago, when I was still a naive liberal, I was all for the banks being forced to loan to “disadvantaged” people (read, people who had no prospect of making their payments). If I had understood (because someone had explained the simple facts to me) that this distorting of the lending market was going to end up hurting everybody, rich and poor alike, I might have had second thoughts.
Jamie Irons
Larry Kudlow is quoted in the excellent blog CARPE DIEM:
The decision by SEC Chairman Chris Cox to ban short selling is a terrible idea. It is an encroachment on free-market principles. In extreme, the absence of short sellers would inflate stock market upturns, probably into bubbles. Short sellers keep the market honest. I know many in the short-selling community and most of them really do their homework. They are skeptical about puff pieces on companies and they are properly cynical about corporate press releases.
~Larry Kudlow
I think this refers to all short selling, not just the “naked” variant.
Jamie Irons
Seems to me a part of the problem is the 3-day settlement window. This is an entirely archaic rule that has no place in the digital era of instant money transfers.
I do not short, only did so a couple of times 20 yrs ago, quickly learned the pain of upward price movement of a shorted stock. But my impression is no one borrows Joe Blow’s shares and shortsells them; the stocks shorted are held by the brokerage house in the so-called “street name”. So one borrows only nominally, from a pool of shares.
Put options remain allowed, however.
Jamie—I’m not against short selling in general, just naked short selling.
But five days ago I didn’t really know what either was.
neo, did you hear the end of the story about Taheri?
If you did not , here it is.:
Amir Taheri Serial Fabulist
By Cernig
and check the last musical clip in the artivle too
One purpose of an open market is price discovery. The current price may or not be the actual value of a stock (or commodity or derivative or tulip or whatever). You need buyers and sellers to figure it out. If people think a stock is going to go up, they can buy; if they are bearish, the sell it. You need both sides to determine value.
Sometimes short sellers perform a public service in uncovering fraud, like Enron or Tyco. Most times they (short sellers) lose money and go bust. It is more darwinian than most aspects of the market because they face several intrinsic disadvantages:
1) For the past century stocks have naturally gone up 7% per annum based on economic (profit) growth and dividends.
2) When you short, you must borrow the stock — pay interest and forfeit dividends — more headwinds.
3) Most profitable short sales are taxed at the higher short-term capital gains tax rate — another disadvantage. You are foregoing the natural 7% rise, are charged interest to borrow, and have to pay more in taxes.
4) Sometimes it’s hard to find someone to lend you the shares.
5) Shorting is perceived as unamerican — you have to be willing to go against public opinion and peer pressure. Successful shorting depends on superior information and analysis, yet it can be hard to come by when management won’t grant access.
6) Shorts are often squeezed — i.e., if a short seller has been identified, those in the know will sometimes game the system to buy the stock and force the short seller to cover at much higher prices and incur a substantial loss. To quote Keynes, markets can stay irrational longer than an individual can stay solvent.
7) Consider that even the most successful short can “only” make 100% on a sale (prices can’t go below zero), whereas theoretically the upside on purchases is infinite because stocks can rise by many multiples. E.g., if you get lucky occasionally you will own a stock like Microsoft from its inception.
8) Prices almost never go to zero; therefore, at some point short-sellers have to buy the shares back in order to take profits. (short-covering). This buying acts as a kind of self-equilibriating move; eventually prices do go back up to a value area.
9) Given the extent of derivatives, there are many ways to replicate short selling — better to be regulated and transparent, (e.g. reinstate the uptick rule) than to encourage circumventing an unenforceable ban.
10) Regulated, transparent short selling is healthy for markets because it usually acts as a check on bubbles and manias. (Obviously, not always. No market mechanism is perfect.) It is the sudden bursting of a bubble that is most destructive and traumatic to society. Little preventative pin pricks of short-selling are a small price to pay to prevent manias.
Disclosure, disclosure, disclosure. That’s what’s important. The problem in this case was not so much the shorts but the unregulated and private OTC market in credit default swaps — people buying and selling insurance to each other in a circle at 30x leverage.
Exchanges match buyers and sellers; provide disclosure; and regulate leverage. The naked shorting per se was not the problem.
The shorts perform a public service — normally they donate money to the rest of us before going out of business.
I will add three other quick points. I have given you the standard free market brief, based on history, on why short-selling is legal and proper.
a) We should always be wary of the natural and unfortunate human tendency to scape-goat in the aftermath of a trauma.
b) Precedents are dangerous things. How many “one-time” goverment actions become permanent?
c) However, there are times when the government must intervene save a market from itself. A temporary ban on short-selling may have been necessary to prevent the total annilhation of the debt market.
d) There have been times in the past when the government has changed the rules in the middle of the game, ala forcing the Hunts to disgorge the silver when they attempted to corner the market in 79-80, or when FDR illegally expropriated gold in the great depression. These actions were strictly speaking, illegal power plays, yet they served the greater good and both markets recovered in time.
If we had more short selling (even the naked kind), we would have had much less of an asset bubble – that eventually burst.
gpc31 is so right in saying that it is so difficult to be a short seller in a bull market – we had one since ’81 (except for a few blips). And I am surprised that there is anyone even trying to short. Even Greenspan never repeated his “irrational exuberance” comment, because even he too could not bet against the bull market. I think most of us, including McCain, is shooting the messenger(s).
Yep, its the mark to market accounting rule for instruments like collateralized mortgage obligations (CMOs) that is the big problem. There never has been an auction market for these instruments. They were bought by banks, hedge funds, insurance companies, pension funds, etc and locked up as long term income investments to be held until the mortgages were all paid off or redeemed. They represented capital that could be used to borrow against. And many did. Some to a ridiculous extent. I’ve read that some investment banks were leveraged 30 to 1. 12 to 1 is considered high. So there was some reckless leveraging going on. That has exacerbated the problem.
Two things happened that created this crisis. The real estate market cooled off and some mortgages started defaulting. This has happened in every real estate cycle, but this time there were more low quality mortgages in the system. Word got out that there were a lot of sub primes in these CMOs, but no one seemed to know where they were or how bad the problem was. The mark to market rule went into effect and these financial companies were required to value their CMOs as if there was a market for them. When some people tried to sell their CMOs to test the market, they found there were no takers at any price except at about 20 cents on the dollar or less because of fear of sub primes. This led to all these companies having to take severe write downs on these instruments, which reduced their capital and required them to raise new capital. Raising new capital became very difficult.
Enter the short sellers. No one was sure how bad the CMOs were, but they could see the financial companies were in extremis. They piled on and the stocks fell drastically weakening their capital bases even further.
IMHO, and I’m no expert, but it seems to me that if the mark to market rule was suspended for some period and these companies were allowed to carry the CMOs on their books at cost while they worked through them and found out just how many bad mortgages they had so they could value them properly. When they found the true value then they could write them down properly instead of the wild guesses they are using now. This would take 18 months to two years, but would allow an orderly proccess to unwind the bad mortgages. This would require government oversight, but would not require the Fed or Treasury (actually the tax payers) to take on the ownership and risk of these assets.
As for the shorts. Reinstate the up tick rule and make sure people actually borrow shares to short. That would make shorting an orderly process again.
A lot of good comments on shorting stocks. I only disagree with Jimmy J’s call to bring back the uptick rule, which was easily gamed, especially by hedge funds. It was quite useless in practice.
As mentioned above, excessive leverage is a significant cause of the crisis.
According to Barry Ritholtz at The Big Picture, the SEC waived leverage limits for five of the largest broker dealers in the country, i.e. Goldman, Bear, Lehman, Merrill and Morgan Stanley.
The long-standing rule was 12 to 1 leverage, but the SEC exemption issued in 2004 allowed these firms to take on leverage as high as 40 to 1.
Bear, Lehman and Merrill have since paid the ultimate price for their extreme leverage, and the other two are struggling to survive.
From everything I’ve read about this crisis, the rules and regulations we have are adequate, they just needed to be enforced and followed, and that goes for naked short selling rules, too.
After writing all my ideas about the cause of this crisis I came upon a blog that said the same thing, but much more completely and authoritatively. For a really good explanation go to this site:
http://21stcenturyschizoidman.blogspot.com/2008/09/you-read-it-here-first.html
You won’t regret it.
JimmyJ,
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.
Not really going to comment much about what should, and shouldn’t be done as I don’t really know a whole lot about stocks. Never really found them interesting and found I made and lost just about the same amount no matter how much I learned or if I let someone else who supposedly knew about it manage it (for a percentage of my return – though I always suspected that the very best never manage others – why make them money when you can keep it all yourself?).
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.
Short selling in itself is no bad thing as is argued above better than I can. What has gone on in the last few years is more psychological than purely economic; group think. Everybody has got used to the childish idea that house prices will always go up, money will always be plentiful, debt can be expanded for ever and complex derivatives are really clever ideas even though nobody really understands the basis of their value.
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….
GPC31 is basically correct, but makes one error:
“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…
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…
Tax cuts weren’t the problem. The tax cuts increased government revenues; the growth in social program spending ate up the increase. ‘Nuff said.
The key line in the Forbes article seems to come at the end:
The legislation repeals the Glass-Steagall Act, or, as it is formally known, the Banking Act of 1933, which broke up the powerful House of Morgan and divided Wall Street between investment banks and commercial banks. It also makes significant changes to the Bank Holding Company Act of 1956, which had restricted what banks could do in the insurance business.
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
I think, though, that the point of the Forbes article was that forcing the banks and other security holders to downgrade mortgages that are being paid because the property value has dropped (leaving the mortgages incompletely secured) hurts more than it helps, and that the mark-to-market rules have this effect.
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.
In a short sale, the initial investment is theoretically zero.
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.