Short-Selling is Not the Problem

short selling - chicken or the egg question

Short-selling has been in the news quite a bit over the past week. Just now, as I am viewing my Google News page, a story on short-selling is the main story at the top of the page.

Just recently, the SEC decided to enact a "temporary" rule that would bar people from engaging in "naked" short sales of companies such as Fannie Mae, Freddie Mac and nineteen big brokers. With this new rule in place, potential short-sellers would have to actually locate shares of the stock to borrow, and then these shares would be taken "out" of the market. This is fine - this is the way that it should be in the first place. However, from what I am hearing, the process involved in "locating" shares in these firms is a headache and full of paperwork, and is likely discouraging legitimate short-sellers from shorting these companies.

So basically, in essence, the SEC is not just preventing "naked" short-selling in this stocks (again, which is just fine), but it is also discouraging legitimate short sales (which is a problem). These stocks that have the short-selling restrictions have soared in price since the new regulations were announced, and other less fortunate brokers not protected by this new rule have seen short-sellers swarm to their stocks. It makes sense - if you believe that the financial sector will continue to weaken and you can not short the "big" firms any longer, then you will likely move to the unprotected "smaller" firms if you are a short-seller. This is completely unfair and just goes to show you who is in the SEC's ear and who isn't.

Let's make this as clear as day: short-selling is NOT the problem.

First off, rigging the rules in favor of the "big" brokers and Freddie Mac and Fannie Mae won't work over the long-term. Short-term price fluctuations to the upside won't mask the real problems that have beset the companies. People are soon going to see (after this crazy price surge has ended) that short-sellers were not the culprits behind the decline in the share prices - it was the underlying businesses of the companies.

It's the ultimate chicken or the egg question - are short-sellers responsible for these companies having major difficulties and tanking, or did the underlying problems of the companies attract short-sellers like sharks to blood in the water?

Were these financial firms victims of a co-ordinated attack by short-sellers? One that led to some major businesses failing and going under? Or were these businesses going down the tubes anyways (due to exposure to subprime credit, over-leveraged balance sheets, a weakening economy, etc), and short-sellers merely nudged them over the side of the cliff?

My feelings are clear: short-sellers are not the problem. Companies with bulletproof balance sheets and strong businesses DO NOT stay up at night worrying about short-sellers. They know better than that. They know that the market will value their business correctly over time, regardless of whether or not short-sellers are active in the stock or not. Short-sellers are not attracted to strong companies - for the most part, short-sellers are not stupid (no matter what people try to tell you). Short-sellers latch on to companies that are having major problems, such as declining revenues, corrupt company officials or a failing business plan. Short-sellers don't like to lose money - there is a reason that they are attracted to certain stocks.

In the end, companies need to focus on running their businesses and improving their balance sheets. These two things are short-seller KRYPTONITE.

Does anyone actually believe that Senator Charles Schumer's letter about IndyMac actually caused the company to fail? Because some regulators are pointing to Schumer as one of the reasons that the bank failed. Give me a break. The company had MAJOR MAJOR problems before the letter was released, and their deteriorating situation had been building for years. You can make an argument that Schumer's letter nudged the company over the cliff, but it was heading there anyways.

These new rules instituted by the SEC won't help over the long-run. Meddling in the markets to try and prop up certain stocks (and not others) is not the smartest strategy for the SEC. They need to be focusing on why these stocks were crushed in the first place - that is where the real need for reform lies. They'll be some major pain over the short-term while companies get their balance sheets in order, but we'll be better-served over the long-term.

This just seems to me to be a short-term "fix" that does nothing to solve any of the problems that we face. Short-selling is not the problem here - there are a hundred different problems that have beset all of these companies that need to be addressed. You do that, and short-selling will no longer be a problem. Stop trying to find a scapegoat, and start pointing the finger in the right place.

Filed under: The Economic Meltdown | Stock Market Education | General Knowledge

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