The SEC’s Ban on Short Selling, in Under a Minute

The SEC has temporarily banned short selling in an effort to rally the markets. A lot of people think this is a crap idea. But you don’t know what to think, because you frankly don’t really get why they did it. In fact, if you are being honest, you don’t even get what short selling is. Thankfully, Chris DesBarres, otherwise known as some random guy we found on the Internet, is here to explain it all (except for the bits you don’t actually need to know).

Chris DesBarres Explains It All

The Securities and Exchange Commission (SEC) issued a new regulation last week banning the short selling of financial stocks in order to bring stability to the financial markets. However, the SEC also might have painted itself into a corner, and it is not quite clear how they plan to extricate themselves.

Short selling stock is a way of trading securities. Usually, traders “go long,” meaning that they purchase a stock, wait for the price to go up, and sell it at a profit. Shorts, however, do just the opposite: they make money when the price of a stock goes down. The way it works is a short seller borrows stocks from someone (for a fee) and immediately sells. They hope that the price drops so that they can buy back the shares at a lower price (called “covering”), return them to the owner, and pocket the difference. So if someone shorts a stock at $100 and covers at $90, they will make $10 minus whatever fee they paid to the owner of the stocks.

If this doesn’t make a whole lot of sense to you, don’t worry about it because the mechanics of it don’t really matter. The important thing to remember is that when people short sell a stock, the price of that stock drops. When someone covers, the price of the stock goes up.

Investors began shorting stocks because it was a way of reducing risk. You could “go long” on some investments, but then “go short” on others to balance out your portfolio. It was not long, though, before shorts realized that they could make huge profits by shorting a stock and then spreading rumors of its imminent demise. The price would collapse, and they would be rich. (This is the opposite of a scam that some people holding long positions run, called the “Pump and Dump,” where you buy a stock cheap, spread rumors about how wonderful it is, and then sell when the price goes up. Both scams are illegal.)

In the world of finance, a strong conflict exists between those who go long (let’s call them the Jets) and those who go shorts (the Sharks). It’s a veritable Lower West Side Story down there.

Critics contend short selling can artificially depress stock prices. If the Sharks think a stock’s price is going to go down, they will short it. By shorting it, they do in fact cause the price to go down. Since that price has dropped, more Sharks are encouraged to short the stock, causing the price to drop even more. This cycle can continue until a company actually does run into financial troubles because the price of its stock has dropped so much … which just encourages Sharks to short even more. By the time they take their profits and leave, oftentimes irrevocable damage has been done.

This cycle, however, is not a foregone conclusion. If the public feels good about a stock, then you can expect the Jets to come in and start to buy up the stock as short sells and other forces push it down. By buying the stock, the Jets help the price stabilize at a fair market rate.

Recently, the public wasn’t really feeling good about Lehman Brothers and Bear Stearns. And opponents of short selling contend that the Sharks artificially drove down the price of those companies, which ultimately helped facilitate their collapse. Fear began to spread that the Sharks then targeted companies like Goldman Sachs, Washington Mutual, and Wachovia.

The SEC, therefore, decided that in the interest of market stability, it would outlaw the short selling of financial stocks. The SEC hopes this new regulation will accomplish three things: (1) Prevent other financial companies from collapsing under the pressure of short sellers, (2) Eliminate or at least reduce headlines like “Lehman drops 87%,” which adds fear to the marketplace and encourages investors to short other stocks, and (3) entice investors to return to financial stocks and therefore increase the amount of capital that these companies have available.

The effects of this new regulation were felt immediately in Friday’s trading. One of the reasons the market opened as high as it did was because short sellers knew they had to cover their positions as quickly as possible to avoid losing more money. This gave the market a nice boost right out of the start. (Remember: Covering a position causes the price to go up.) Similarly, one of the reasons that this rally lasted Friday — and will likely last for at least awhile — is because there were no short sellers in the financial sector to pull the price down. We also get to enjoy positive headlines like “Stocks Extend Huge Rally,” which makes everyone feel nice and fuzzy.

Whether investors will return to financials with the speed and volume that regulators hope remains to be seen. There are two reasons to be concerned about the SEC’s regulation:

First, there is not nearly as much predation on stocks by short sellers as you would be led to believe. A true scam designed to drive down the price of a company happens about as often as the Pump-and-Dump scam does. Lehman Brothers did not go out of business because of short sellers; Lehman went out of business because it had too much debt and not enough revenue. The financial sector is not facing problems because short sellers unfairly targeted it, but because the firms themselves made too many risky loans without hedging their bets. Going after the short sellers might make people feel better (you always want to pick on the guy who is winning when you are losing), but it is unlikely to prove to be a long-term fix.

Second, there is very little chance that the SEC will prohibit short selling of financials forever. Since short selling allowed investors to hedge their risks, it encouraged them to invest in endeavors that they might now pass on. The SEC knows this, which is why it will almost certainly reverse its decision after the financial crisis passes. And that brings us to the most serious dilemma now facing the SEC with this move: How do they know when enough is enough? As long as they remove the ban on short selling when the market is 110 percent sure that the financial sector is healthy, then there should not be a problem. If, however, they remove the ban while there is even still a whiff of instability, look for the short sellers to return in droves. On that day, prices could plummet and we will read headlines like “Investor Fear Returns; Dow Drops 500.”

Banning short selling is of course not the government’s only plan for navigating through this crisis. However, one always has to pause when the basic mechanisms by which companies are traded are altered in fundamental ways. This move may bring short-term stability, but at what long-term cost?

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The SEC’s Ban on Short Selling, in Under a Minute