BUSINESS

Naked shorts: not as fun as they sound

STEVE MAICH August 4 2008
BUSINESS

Naked shorts: not as fun as they sound

STEVE MAICH August 4 2008

Naked shorts: not as fun as they sound

BUSINESS

STEVE MAICH

Last week, in the midst of another gruesome sell-off on the U.S. stock market and spreading fears about the health of the U.S. financial system, the Securities and Exchange Commission put its foot down. The market cops issued an “emergency order” designed to clamp down on the bad guys profiting from the anxiety swirling around wobbly mortgage lenders.

The SEC order explicitly banned an obscure form of trading, known as “naked short selling,” against the nation’s faltering financial institutions. So-called naked shorts are thought to be used by nefarious speculators trying to grind vulnerable companies into the dust, and the SEC is determined to stop them.

But one point was tellingly omitted from the SEC’s stern notice: naked short selling of this kind is already illegal, and has been for years. In effect, this was like the police issuing a statement that until further notice, all cars must stop at stop signs. Why would the SEC do this? Well, the answer to that lies in the way we still regard the business of selling stocks and, more importantly, the way we approach fear in the financial markets.

First a little background. Selling stocks short means betting that a certain stock will fall. Normally, when you buy a stock, you plan to hold on to it for awhile in the expectation it will rise. Short sellers turn that transaction on its head: the trader borrows a stock at a given price, and then immediately sells it in the hope it will fall and he can buy it later at a lower price, profiting on the difference. So, a short seller borrows a stock trading for $50, then sells it. If it falls to $40, he buys the stock, returns it to the original owner and pockets the $10 difference. Of course, if the stock rises, the short seller takes a loss.

This is all perfectly legal. In fact, just about every reputable academic and analyst will tell you that short sellers are important players in the market. If not for them, stock prices would only ever reflect the beliefs of the most optimistic investors. Short selling is a way to price healthy skepticism into the market.

There are some, however, who consider short sellers to be the scum of the earth. They think it is somehow unfair for people to bet on a company’s decline and to profit on the misfortune of shareholders. Some even suggest that all short selling is a form of manipulation, based on rumours and lies, aimed at driving down stocks. It never occurs to those people that, by the same logic, buying stocks is a form of manipulation aimed at driving stocks higher.

The SEC would have you believe short sellers are to blame for this mess

But the worst kind of short seller, the kind that everybody hates the most, is the so-called naked short seller. Naked shorts work exactly the same way, except the trader sells a stock that they haven’t even borrowed. They take advantage of the fact that it can take up to

three days to actually settle a trade and to deliver a stock that is bought or sold. So, if you’re a big fund manager and you’re willing to play games with your brokerage, you can sell a stock that you don’t actually hold and nobody’ll know for at least three days—giving you plenty of time to profit from its decline. Conventional wisdom holds that naked shorts are pure evil—like Lex Luthor.

In January 2005, the SEC passed Regulation SHO, which made virtually all naked short sales illegal. Some naked shorts still happen, just like some people still go through stop signs, but it’s been clear for awhile that selling stock you don’t hold is verboten in U.S. markets. All the SEC did last week is publicly reaffirm it.

Which is all well and good, but it’s more for show than anything. Recent studies by both the SEC and Canadian regulators have shown that naked short selling is so rare it has virtually no effect on stock prices. In Canada, for example, Market Regulation Services found that only 0.27 per cent of all trades in Canada failed to settle on time, and of those, less than six per cent were the result of naked short selling. Only 0.07 per cent of all short sales were naked, according to MRS.

Why is it so rare? In part because it is probably the single riskiest form of stock trading known to man. When you buy a stock for $50, you have $50 at risk. When you short a stock at $50, your risk is infinity minus $50. When you take out a naked short position, your risk is truly infinite—if the stock rises, you lose the entire value of the stock.

Nevertheless, short sellers make a convenient target because they are a rare breed, they tend to be secretive, they bet against the pack and they throw around large amounts of money. It’s no coincidence that Congress held hearings into the activities of short sellers after the 1929 stock market crash, after the 1987 crash and following the 9/11 sell-off. And now, with major financial institutions in peril, Congress and the SEC have set their sights on a familiar whipping boy.

“False rumours can lead to the loss of confidence in our markets. Such loss of confidence can lead to panic selling, which may be further exacerbated by ‘naked’ short selling,” the SEC said in its emergency release last week. Mind you, true rumours can also lead to panic selling, especially when the undeniable truth of the banking system right now is downright ugly.

The SEC and Congress have returned to a familiar theme: the only thing you have to fear is fear itself. And if you’re some nasty nefarious trader getting rich off those fears, we’re coming to get you.

That is an immensely comforting message for millions of ordinary investors, terrified at the state of the economy. And it is totally appropriate for the SEC to do anything it can to reassure those investors, even if it means resorting to a little misguided scapegoating and empty sabre-rattling. But the truth of the matter is more complicated and unsettling than the SEC suggests.

In reality, the thing you have to fear is that your fears are well-founded, that the short sellers are right, and things really are going to hell in a handsome little handbasket. If so, naked shorts are the least of our problems.

steve.maichà macleans.rogers.com