Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

The SEC’s 10-day ban on the short selling of financial stocks will undoubtedly spark a great debate on Wall Street, and the merits of the rule should be discussed, but let’s be honest, the government had to do something.

Morgan Stanley (MS) reported blow out earnings and a book value of $31 per share this week (a day earlier than planned, due to a sinking stock price) and the stock reacted by dropping 60% from $30 to $12 per share. Another day or two of that and the firm could have filed bankruptcy (and Goldman Sachs probably would have followed), even though it earned $1.43 billion on $8.0 billion in revenue for the quarter ended August 31st.

State Street (STT) drops from $68 to $29 yesterday on no news. The company issues a press release saying nothing is wrong and the stock recovers.

These are not stories of orderly markets that are functioning normally. If not this SEC ban, then what else should they have done to restore order? What are the alternatives?

When traders can have that much impact on a company’s fate because falling share prices for no fundamental reason can lead to bankruptcy within days, or the need to sell your company for a bargain basement price because you have no other choice, that is not an orderly market. It’s that kind of thing that causes panic and could create a 1987-like crash, or worse, a 1929 depression-like crash. If based on fundamentals, those events, while dire, are not something we should prevent. However, the events of this week were not based on fundamentals, they were based on speculators, false rumors, and panic.

I have no problem with short selling. But when unrelenting shorting can contribute to a company falling into a death spiral, a company that otherwise would have easily avoided such fate, I really don’t have a problem with banning shorting for 10 days to make sure our market can function normally.

If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts. If their fundamental analysis is correct, they’ll make a killing from those bets. But those bearish bets should not directly contribute to the demise of our country’s largest financial institutions. Just because Bear Stearns and Lehman Brothers were bad investment banks, Morgan Stanley and Goldman Sachs should not be forced to fail too when they have managed their risks far better and are still in the black to the tune of billions of dollars.

Full Disclosure: No positions in the companies mentioned at the time of writing

UPDATE 9/19 3:35PM ET
Lots of reporting in the media that the rally today is due to short covering because of the new short selling rules. This is nonsense. The rule bans shorting of financials starting today. It does not force previous shorts to be covered. Not only that, if you short stocks and you know you won’t be able to make new shorts for the next 10 trading sessions, and the Dow soared 400 at the open today, why would you cover your existing shorts? If you really believed in your negative view of the stocks, and the prices went up at a time when you were banned from shorting more shares, you would certainly keep the shorts on rather than covering them. -CB

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10 Thoughts on “Short Selling Ban Is Dramatic, But U.S. Can’t Allow Firms To Fail For No Reason

  1. I enjoy your blog, but have to disagree with you on this point. I am almost sick over the socialization of this “credit crises.” The government should never “have to do something.” They should get out of the way and let some of these institutions fail. In there place others will rise, and many people will make a lot of money from these failures. The government steps in because they have rich friends (Thain, Lucas, Mack, etc…) that they want to help stay rich. America was built on different ideals than is occurring at this point. Not sure which article I read, but my favorite quote so far is we are “privatizing gains and socializing losses,” which is not the way it is supposed to work. It goes against every fabric of a capitalist economy.

    On a final note. To say these firms are strong and yet in the same sentence to say they can be put out of business with short selling is not the sign of a strong company. I will note I am not fully versed in the business model of an I-bank, but if a company is so easily toppled, then they weren’t actually strong.

  2. Chad Brand on September 19, 2008 at 11:31 AM said:

    Tyler,

    Thanks for the comments, disagreement is always welcomed. Let me address your points, second one first.

    I agree that investment banks have weak business models. Relying on others for your funding/success is not a feasible model in both boom and bust times. I think you will see MS and GS adjust accordingly, regardless of what aid the government provides. The Fed’s actions are not saving the flawed business model, in my view, but rather they are just giving them some time to work things out in an orderly manner.

    To your other point about these government actions being done simply to bail out rich executives, I have to disagree with that.

    These actions are meant to save our financial system from collapse, not to bail out a few firms and their executives. BSC shareholders got $10, LEH shareholders got nothing, AIG is sitting at $3. FNM and FRE are under $1 per share. Executives and shareholders of these firms lost nearly everything they had in them.

    Instead, the government is trying to prevent another Great Depression scenario, which would occur if we allow rumors to turn into runs on our banks. This isn’t about a bank and a bank there, it’s about the system and the chain reaction that would ensue.

    The stock market fell 94% during the Great Depression of the 1920’s/1930’s. Why should we not try to prevent that from ever happening again? Who would it affect if the Dow fell to 850 (-94%)? It is pretty easy to argue that the average American would suffer far more in that scenario than the rich friends you mention.

    After the Great Depression, the government instituted a lot of new programs and regulations, social security, the SEC, the FDIC, to name a few. If you truly want the federal government to “never have to do something,” then it is only fair that you would have to accept and allow depressions to occur and dissolve the SSA, SEC, FDIC, etc. It is hard to argue that would be a good thing for America and its citizens.

  3. shepherd on September 19, 2008 at 2:07 PM said:

    Regarding the short squeeze…doesn’t the fact that there will be no new shorts for the next ten days temporarily pull a certain amount of downward pressure out of the system? (This is the converse of your argument as to why the short ban is necessary).

    As a result, wouldn’t you see a desire by many with current short positions to get out of them?

  4. “If short sellers and/or hedge funds want to bet against these firms, all they have to do over the next 10 days is buy puts.”

    I’m surprised taht you can comment on these issues when you are obviously not very well versed in how puts work.

    Market makers, so far, have been barred from shorting as well.

    When you buy a put from the market maker, he needs to hedge his book to ensure a risk-free posiion. The only way to effectively hedge a put is for the market maker is to short the stock himself. But this has been disallowed.

    You will not see a functioning put market if market makers are banned from shorting.

    On the other hand, if you do allow market makers to hsort, you have the reverse problem: the market, when selling puts, will short the stock, and the rising put volume will in turn create a rising short volume. Thus in the final analysis: the stock has the same selling pressure if everybody migrates to puts.

    There is something to be said about a business whose business model is so shaky that a reduction of its stock price automatically triggers a bankruptcy (though why that would be is not explained at al in your article).

  5. Anonymous on September 19, 2008 at 6:39 PM said:

    I respectfully disagree too. When the ban took place in July it caused the stocks to soar. It has done the same thing again. It may be a short period push up once again but I believe it is the reason the stocks are flying high. It proved right in July and is proving right again.

  6. Rubens Morse on September 20, 2008 at 5:48 AM said:

    In my almost 20 years working in industry, banking and investment management, I have never seen a business going under for no reason. There is always a fundamental reason for firms failing. In the case of these brokerage firms, it was excessive leverage and risk taking, starting from a 2004 exemption given by the SEC to only 5 firms (can you guess which ones?) allowing them to lever up more than 12:1 debt to net capital.

    I am shocked at how recent decisions by the Treasury and Fed on who to bail out and how have been made for political and subjective reasons rather than objective principles.

  7. shangrali on September 20, 2008 at 8:43 AM said:

    Your entire premise is wrong.

    Everyone knows the shorting ban will extend beyond 10-days. The ban is for 10-30 days. Do you honestly believe the shorting ban will end in 10-days? Of course it will go thru the election. Common sense indicates this will happen.

    Do you believe that traders/investors who have a short position in a financial will simply sit still? Risk management requires cutting losses.

    If the rules are changed during the weekends and evenings without a public discussion – then the train is off the track.

    Your post is simplistic and unrealistic for traders/investors.

  8. Chad Brand on September 21, 2008 at 4:57 PM said:

    shepherd:
    10 days without shorts certainly lifts some of the downward pressure. if you are short banks as a trade for the next couple weeks, sure you would cover, but most shorts of the banks are based on deteriorating fundamentals, which is a story that would unfold over many months to come.

    muzie: the put markets are working just fine. just look at all the puts on the financials that were bought during friday’s session. i believe they are fixing the market maker ban, by the way, so those people don’t get screwed over.

    anonymous:
    personally, i think the market is rallying because the feds have decided to bail out financial services companies, which could help their companies tremendously. i dont think the short ban was the reason for the huge rally on friday. after all, news of the fed bailout came out thursday afternoon, which is why the market soared late that trading session. the short ban was less of a catalyst than they $700 billion bailout plan to help the industry.

    rubens:
    perhaps my wording was not ideal. clearly there is always a reason a firm would go under. the point i was trying to make was that a firm like MS, which is making money even in this environment, should not have to go under just because the markets get unstable. the run on their bank would be the reason they failed, but there was no reason for a run other than panic with no fundamental reason MS should fail.

    shangrali:
    it depends. if you are short banks based on your belief that the bank fundamentals will continue to get worse due to the housing market and weak economy over several more quarters or years, you would not cover. if you are short because you think the banks would drop over the next 2-4 weeks, then yes, you would just cover and focus your short book elsewhere. most long/short hedge funds and dedicated short funds bet against individual companies based on fundamental analysis. a quick trade in financials would be more likely to be done via the XLF index fund or something etf/index.

  9. Do you really think Morgan Stanley reported “blowout earnings”? If you strip out gains on the sale of a stake in a subsidiary and on the devaluation of the firm’s own bond obligations, Morgan Stanley had a loss for the quarter. And if you marked their assets to market, the writedowns would have been in the billions.

  10. Chad Brand on September 22, 2008 at 12:40 PM said:

    MS nearly doubled the estimate, so yes, they did blowout the consensus view. It sounds like you are arguing that earnings quality was poor, which is a perfectly fine assertion, but it’s another issue entirely.

    I’m not sure what you mean “if” they marked to market they would have had billions more in writedowns. Accounting rules require they mark to market. Some are trying to get that rule reversed to they don’t have to mark their assets every quarter.

    Regardless, MS has increased book value per share sequentially for 3 quarters in a row, so they’re managing through these tough times pretty darn well relative to the other i-banks, as shown by their double digit ROE.

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