Shoot the Shorts
Europe's problems aren't so far away.
European bank stocks have dropped sharply in recent days, presumably because they hold large amounts of shaky debt issued by the governments of Greece, Portugal, Spain, Ireland and Italy. Several European governments have found someone to blame for their financial problems, and their target is that perennial favorite, speculators. And not just any old speculators, but the darkest of that shady lot, short sellers. Short sales of major European bank stocks are banned for a period of time so that traders can’t spread false rumors and trigger a downward spiral in these stocks.
(To sell short means to sell borrowed stock in the hope that the price will decline. If the stock does fall, sellers buy the shares cheaply, return them to their original owner, and pocket the cash difference. If the shares rise instead, short sellers have to pay a high price and suffer a loss. When a number of short sellers cover their positions out of fear of rising prices, it’s called a short-covering rally.)
What a dreary and stupid move the Europeans have made. They might have learned from the ban instituted in 2008 by U.S. authorities, which accomplished nothing.
Real Fears
There is good reason to fear for the European banks – the problems with European sovereign debt are evident. Rumors are hardly necessary when the banks’ exposure is well known. And if false negative rumors justify intervention, what about false positive rumors? Why not ban purchases of stocks when the all-knowing regulators determine they were boosted by bullish rumors?
Is it possible for determined short sellers, perhaps in collusion with one another, to start a downward spiral and run a stock into the ground in defiance of the stock’s fundamentals? Yes, theoretically and perhaps occasionally in practice. But as a downdraft begins, the temptation to take profits by covering one’s short positions, especially among those who may be in cahoots, becomes overwhelming. A violent upswing is possible when short sellers take profits in such situations.
Short sales are not always speculative (not that there’s anything wrong with speculation). They are sometimes part of a hedging strategy, in which a short sale is used to offset a closely related long position. A ban on short selling is a headache for hedgers, perhaps more so than for speculators.
Those who own the stocks in question won’t likely sit still while the ban is in place. They will be tempted to sell, in anticipation of a price drop once the ban is lifted. When this happens, share prices may decline as much as they would have without the ban. Also, those who were short when the ban took effect may hold those short positions longer than they would have otherwise, also hastening the drop.
Close Substitute
Put options are a close substitute for short sales. A buyer of a put option pays for the right to sell shares to the counterparty at a fixed price no matter how low the market price might drop. Another alternative may be to short the bank shares in question on foreign stock exchanges.
So the likely upshot is that the ban will accomplish nothing except to introduce some temporary disruptions, inefficiencies, and inequities into the market.
More important, though, is that today’s sophisticated traders and commentators will probably see this crude move as a sign of weakness or even desperation. This is not what European economies need – just the opposite. Like the United States, Europe is suffering from a crisis of confidence. EU leaders have lurched from one bailout to the next without addressing the root causes of the crisis, each time shedding a chunk of their credibility like a piece of lintel crashing down from the Parthenon.
Central Banking
One root cause is the structure of the Euro, which centralized monetary policy-making at the European Central Bank while leaving fiscal policy to the discretion of each national government. True, there was a toothless requirement that government deficits be limited to 3 percent of GDP, but that soon fell by the boards. Frugal Germans are now furious about bailing out the lazy Greeks, Italians, and others, but are trapped by the exposure of their own banks.
European welfare states have been in place for decades now, crushing private initiative. The bills have come due and the cupboard is bare. This is the more fundamental cause of the European crisis, and nothing will be solved until Europeans begin to face up to it. And rather than indulging in Schadenfreude, we in the United States would do well to apply European lessons to our own troubles.
Comment by Philip Lewis on 22 August 2011:
The “thought police” are active in 2011.
Ron Paul for President … perhaps he can save us from ourselves.
Comment by Allan Thomas on 22 August 2011:
Superbly and lucidly argued. The only point that I would add is that the “shorts” add depth and liquidity to the market. But what do governments know about markets?
Allan Thomas
Sydney, Australia
Comment by Ralph Hood on 22 August 2011:
At last someone stands up for the speculator!
Ralph Hood
Comment by Bullseye on 22 August 2011:
“One root cause is the structure of the Euro, which centralized monetary policy-making at the European Central Bank while leaving fiscal policy to the discretion of each national government…Frugal Germans are now furious about bailing out the lazy Greeks, Italians, and others…”
Socialism at its finest. The productive and frugal are forced to subsidize the lazy and incompetent. Eventually the parasites nearly kill the host. Then the parasites complain about the austerity the dying host is imposing. But they made their bed.
When the way to get ahead is to produce, you get a society of producers. When the way to get ahead is to rob your neighbor faster than he robs you, you get a society of robbers. The robbing escalates. But who can one rob when no one is producing?
Comment by Gerry on 22 August 2011:
Banning short selling will send the strong signal that the shorts are right, and the fundamentals are weak on EU bank stocks. Prices will likely fall.
Comment by erne lewis on 22 August 2011:
I should never question Warren Gibson’s opinions, especially on matters financial. However:
First let me say I do not seek any change in federal regulations other than wholesale elimination of the regulations and regulators. However, as a result of a century of federal and state mismanagement and collusion with banks and wall street we now have a Gordian knot that defies unraveling . . . and almost makes shorting stocks look patriotic.
Nonetheless, I think shorting stocks is more appropriate for Las Vegas than a stock exchange.
Our present stock-market, that provides shorting to enhance liquidity and help with price discovery, is a product of a government and industry-designed marketplace that bears no resemblance to the stock marketplace we might have in a free market.
Would shorts exist in a market that has grown up as a result of companies offering stock to individuals without government regulated exchanges? I doubt it.
Would the owners, the stockholders of companies, wish to sell some portion of their investment in their company through a stock market exchange that allows non-owners to sell shares they do not own? I think not. Traders may wish to short stocks but company stockholders would not allow their shares to be traded on such an exchange.
And while we are on the subject, would company shareholders wish to sell their shares through an exchange that rents instantaneous access to every trade made to High Frequency Traders using frontrunning supercomputers for the purpose of detecting (hacking) offers to sell and buy so that they may short or go long a microsecond later . . . and before the hacked trade has been completed?
Shorting and High Frequency Traders do not share ownership of the companies whose stock price changes they arbitrage for profit. I suspect both forms of trading are destructive to long term investors and companies.
The stock exchanges make money on trades. Profits are maximized when stock prices are volatile. Shorting and high frequency trading magnify that advantage. Regulator and Regulated love the present system.
I am sure Warren will correct me after which I will apologize.
Comment by Warren Gibson on 22 August 2011:
Erne, thanks for reading my scribblings. No apology necessary. For more on short selling, please see my Freeman article
http://www.thefreemanonline.org/featured/the-long-and-short-of-short-selling/
Short sellers sell stock they do not own, but have borrowed. The lender is typically a margin-account customer who has agreed to make his shares available for lending as a condition of opening the account. The lender continues to receive dividends and is free to sell the shares at any time, in which case borrower or his broker has to find lendable shares elsewhere or close the position. As I write, I may have had some of my shares loaned out from under me. I don’t know or care.
Short selling goes way back before regulation, at least as far as Amsterdam in the 1600′s.
When management or others think short sellers are wrong and have driven the stock “too low” they are faced with a bargain buying opportunity. If the shorts are right they’ve done everyone a favor by calling attention to problems.
Personally, I get a huge kick out of shorting some over-priced turkey and watching it crash and burn while my profits pile up!
High-frequency trading and front-running are a subject for another time.
Comment by erne lewis on 22 August 2011:
Short selling goes way back before regulation, at least as far as Amsterdam in the 1600′s.
Well . . . then maybe. I’m still thinking.
I do look forward to your article on high frequency trading.
Comment by Raa on 23 August 2011:
In regards to short selling, think about it this way:
Would you lend, say, shares of google to someone willing to pay you some form of rent for them? If you thought that the stock is going to go down significantly you would outright sell it, but if you think it will be stable or on an upward trend then why not make a little money on a stock you plan to keep anyways?
If you agree with this scenario then even in a completely private market there would be room for short-selling in which both parties are potentially better off than without the availability of shorts.
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