Preserving U.S. Economy Over Free Markets (Short Sellers)

by: Larry MacDonald September 20, 2008    
Larry MacDonald

Larry MacDonald

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U.S. policymakers are obviously willing to go to any length to avert a financial Armageddon, including changing the rules of the game in midstream. The latest, of course, was banning short selling in some 800 U.S. stocks, which effectively engineered a massive squeeze on the short sellers and produced a dramatic rebound.

The short sellers are right of course about the rot in the U.S. financial system but they are underestimating policymakers’ ability to pull rabbits out of the hat. And policymakers will keep on ignoring the rulebook and reaching for rabbits as long as it takes, because the alternative is worse. Short selling is a hard way to make money anyway in the stock market — if only because of the long run tendency of stocks to rise by some 7% to 9% annually on average.

Yet, the abolishment of short selling does not necessarily mean stocks can now only go up. Take China. Its stock market has had one of the steepest declines (over 50%) during the past year even though short selling was banned throughout. There was a recent rally in Chinese stocks but it was linked to announcements that the Chinese government is now going to prop up the stock market by buying stocks. How’s that for breaking the rules?

Many stock-market bloggers were outraged by the U.S. decision to ban short selling. But the preservation of free markets seems a lesser virtue compared to preserving the U.S. financial system, economy, and indeed, status as a world power.

Let’s acknowledge it: the U.S. is in a desperate competition with upstart emerging economies. The latter have made major inroads by pegging their currencies, suppressing domestic oil prices, banning short selling, currency controls, prohibitions on derivatives/options, and a host of other market manipulations. They aren’t playing by the free-market rulebook either. The U.S. may need to untie the hand behind its back with some interventionist measures of its own — until stability returns.

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This article has 69 comments:

  •  
    Sep 20 08:57 PM
    I thought america leads , not follow. Dont give me this bullshit reasoning. Bringing the true market prices are by short sellers.
    btw I have never short sold anything.
    Reply | Link to Comment
  •  
    Sep 20 09:12 PM
    There is no reason for the government to buy up all of the bad debt that the banks created and dump it on the taxpayers. These guys have their fear mongering down to a science.

    ewebsmith.com/bus/taxp...
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  •  
    Sep 20 09:23 PM
    And the interventionist measures you say the US must take will make it progressively less attractive to foreign and domestic investment. Plus one pivotal reality - in the final analysis these measures won't work.

    In nearly every case in which emerging markets attempted to impeded the free market, it cost them and cost them plenty in lack of interest and shunning of those markets by foreign investors. US politicians and regulators who wish to have their cake and eat it too are deluding themselves.

    History tells us such interventions rarely work and the ultimate price is far higher than if they had let the markets work out the excesses in their own time.

    By banning one part of the market, short selling, it will create greater market inefficiencies over time. However, the very politicians that are pushing for such changes have very little interest in fixing markets and are solely concerned with getting re-elected.

    So far the bailouts and drastic measures have failed to work. Chances are this will backfire as well.
    Reply | Link to Comment
  •  
    Sep 20 09:24 PM
    Short selling is still available in a sense through the purchase of put options. It would be interesting to see the price changes in the options arena after short selling was stopped.
    Reply | Link to Comment
  •  
    Sep 20 09:27 PM
    Thank you for being a voice of reason in a wilderness of knee jerk free market absolutists .
    Reply | Link to Comment
  •  
    Sep 20 09:31 PM
    Another point, I believe the reasoning that short selling is required to find a fair price is vastly overrated.

    You could limit any short selling in financials to licensed market makers to retain market liquidity. That being for the amount of time it took to quiet the market.

    Taking the uninhibited short (puts are not quite the same power) away from hedge funds and whoever is causing this panicked, PRICE INSENSITIVE selling would be a smart move.

    Shorts are not NATURAL sellers.
    Reply | Link to Comment
  •  
    Sep 20 09:33 PM
    I agree with the comments of the two persons so far. I do trade NASDAQ and short selling makes profits more often than the traditional buy low sell high (going long) regardless of whether the market is going up or down short term or long term. It's a method to make money based on technical analysis and understanding the buyers and sellers of a particular stock.

    As the author of the article indicates, markets can go down even without short selling, so banning it may be a short term prop., however if people who hold equities are spooked, they will sell fast and sometimes at any price just to get out of their position, which drives the price down anyway.

    We have to remember that it's a market and there is a supply / demand for every stock. Should the supply increase and demand decrease, the price goes down regardless of whether there are market manipulation attempts by the US government as such. The government is desperate to do something and they are reaching for straws.

    It would be more prudent to place more strict regulation on the lending of money to prevent the situation as it exists today from ever occuring again, rather than picking and choosing who they are going to bail out and how. In my opinion, the strong survive and the weak perish. It should be left to the market to decide who dies and who lives, and the government should go onto improving regulations rather than trying to save the aged financial whales.

    We all take risks in life and sometimes it doesn't work out no matter how hard we try. I'm sure Lehman Brothers knew they were having problems long ago (months / years perhaps), and they did not do what they needed to do to get out of their mess. So be it. That's life. Let's all get on with it. This is a typical example of a business failure. I'm sure Lehman tried very hard to turn things around, but sometimes it's just not to be. So what. I don't feel sorry for them. They made bad decisions and it cost them. If we make bad decisions, nobody gives a rats crap about us. The free market exists for just that - freedom to do what we want. It should stay that way without the government putting it's nose in between, because then it's not a freedom of choice, it's a manipulation which doesn't really help anyone.

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  •  
    Sep 20 09:41 PM
    The slogan of "free market capitalism" with minimal oversight/regulation has only proven to the American people how quick thieves could raid their nation's savings and place them in serious jeopardy - by enriching and empowering their enemies with oil dollars and trade surpluses. Congress was reluctant to raise an eyebrow when these banks were being "creative" with their financing and sales techniques, they were lazy to raise a hand when the nation was screaming for clean energy and now look at the mess we are in. China is becoming more powerful and has utilized and integrated technology into their economy. This is all placing the United States of America in an extremely precarious situation. Multinationals like General Motors and Ford are quick to now offer the latest technology to China and Europe rather than the old dog America, they have no allegiance, nor do these multinational banks that are all begging for a handout from the American people after their mistakes. What about all the assets they bought overseas with American dollars? Why aren't they being forced to sell off those assets to pay for their mistakes made here? Are American really this stupid or just too busy working to death to pay for all the taxes placed on their heads to worry about banks and international debts.
    Reply | Link to Comment
  •  
    Sep 20 10:17 PM
    Short selling is small potatoes. The real news is the $700,000,000,000 bailout of the banks, which is as clear a statement that the free market has failed that you can find.
    Reply | Link to Comment
  •  
    Sep 20 10:19 PM
    Shorts are filthy liars who chop down a tree that took over a hundred years to grow in a matter of days, via lies and kosher propaganda. They must face the law for the untold billions they have cost us. Die, Einhorn.
    Reply | Link to Comment
  •  
    Sep 20 10:46 PM
    Short sellers keep the system more honest. Dishonest or wrongheaded short sellers do not survive as the truth eventually steamrolls them with massive rallys. We need short sellers to balance the never ceasing cheers of the permabulls.
    Reply | Link to Comment
  •  
    Sep 20 10:52 PM
    It seems that the politicians Republicans and Democrats alike are rushing to bail out the perpetrators and destroyers of our Republic using the tax receipts from the middle class citizens who pay the majority of all taxes in the United States by increasing the debt burden to our future great great great grandchildren

    It seems ironic that the power elite does not focus where the bail out would benefit the country as a whole more than the Bankers on Wall Street. Why not give money to the people who are struggling to pay their toxic mortgages and are just barely
    surviving instead of the Hampton upper class and their BMW's and waterfront mansions who received multi billion dollar Christmas bonus'
    the past number of years creating these toxic derivatives.

    If the money was given to the common folk to use to pay down or eliminate the toxic mortgages I believe not only would the bankers benefit by cash from prepaid mortgages but, the Middle class would again feel comfortable
    having less debt and start buying cars, furniture and real estate again.
    Then the elected politicians would be looked upon as real representatives of the people instead of bought and paid pawns for the banking elite.
    Reply | Link to Comment
  •  
    Sep 20 11:00 PM
    where does it say free market systems need shorts? where does it say a free market needs any sort of leverage to be free? shorts are good as long as you own the stock you want to short.
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  •  
    Sep 20 11:01 PM
    Perhaps the wise among you can coach me. What is wrong with selling stocks short? If this can lead to market manipulation and fear induced plunges, can't holding stocks long lead to over-exuberance and value bubbles? Why don't we ban the trading of stocks altogether? Last time I checked, America is based on the concept of individual freedom: social and religious, but also economic. If the government is concerned about people buying and selling (or borrowing) assets as they chose to mutually consenting parties, perhaps the problem is much larger than first suspected. And to all you who think that an abnormally depressed stock price is the end of the world (whether it be from short sellers or some other cause), I suggest you get out of the markets altogether. Intelligent investors recognize such events for what they are, tremendous buying opportunities! Prices can't stay abnormally low for long, if the drop in value is truly abnormal and unwarranted. Go back to Econ 101 you ignoramuses! I'm ashamed I have to explain such fundamental concepts on a site like SeekingAlpha!
    Reply | Link to Comment
  •  
    Sep 20 11:07 PM
    Wall Street, Bush, AAA Lawyers and the Demise of Accountability

    We live in a time when political and business leaders are able to avoid being held accountable for their acts of gross negligence and wilful misconduct. Sounds like lawyer talk. Well lawyers are intricately involved in this sorry state of affairs. Lets take the Bush administration. What did all the Republican cronies like Cheney learn from the Nixon saga? Don't put yourself in weak position legally. Don't testify under oath, better yet don't testify. Don't provide information under threat of perjury and obstruction of justice, better yet don't provide information. They have artfully avoided political accountability for a litany of constitutional abuses, executive misconduct and malfeasance. They are also getting AAA legal advice.

    OK, now lets consider what has happened in the financial services industry. Until recently, our securities laws forced Wall Street to worry about the way it conducts business. Don't play by regulatory rules with origins in Roosevelt's New Deal and sooner or later the SEC or Elliot Spitzer will hunt you down. You had to worry about adequate disclosure and a battery of rules designed to protect average public investors. If you misbehaved, you also had to worry about a ravinous plaintiff's bar charged with the duty of prosecuting claims on behalf of investors unable to fend for themselves (for a generous fee, of course). More AAA lawyers.

    Those New Deal rules are still there. However, Wall Street has managed to water everything down to the point where a manmade Katrina hits the financial markets and there is little or no means to hold the perpetrators accountable. Don't hold your breath waiting for the SEC to chase the bankers that designed, peddled and later lied about their exposure to toxic jackass backed securities. What about Credit Default Swaps? Oh, those so called financial weapons of mass destruction are not securities within the meaning of the securities laws. Those are cutting edge risk management tools. How about investors like poor old AIG banding together to sue those who set them up with these improvised financial explosive devices. Never mind, those were sold to "sophisticated&qu... and "accredited" investors able to fend for themselves. Sales to these financial sophisticates are not subject to the same legal regime. We now see that "sophisticated investor" means one who expects to be bailed out by Uncle Sam. Finally, you won't be seeing any widows and orphans starting class action suits, because no one sold them any securities. Instead, they are accused of being financially culpable in this mess because they fell prey to the army of mortgage/real estate brokers who aggressively peddled shadow bank loans. Mortgage brokers in some instances owned by who else? Wall Street investment banks like Lehman and Bear Stearns. Shadow bank loans? Yep, more AAA legal advice.

    Let the markets regulate themselves! That is the fundamentalist mantra of the lords of the Street. Well, that is what the market was actually doing until this past Friday. Self regulation came in the surprising form of punishment by the shorts. After all, it was the unregulated hedge fund industry, Messrs Einhorn et al, and not the SEC that called Lehman and AIG to the carpet. Not to worry, Mr. Cox, a Wall Street lawyer who runs the SEC, has fixed the short problem for his former clients/masters. Trading bets against financial institutions are now banned. In a comic twist, the SEC is apparently planning to force hedge fund managers to testify under oath. Something more than you can expect from the likes of Harriet Myers, Esq. and Alberto Gonzalez, Esq. Ultimately, the reckless bets that the investment banks made with shareholder capital will go unpunished. Still more AAA legal advice.

    Well you begin to see how what seems like one big scam is actually a legally airtight apparatus for screwing Grandma, Grandpa and Joe public in an indirect manner without being held legally accountable. Time to throw out all of the New Deal regulatory assumptions and start all over again. Wall Street, like the Bush administration, has managed to innovate its way out of corporate accountability-- the old fashioned way: hire innovative AAA lawyers.

    One hundred years ago a man named Franklin Keyes, Esq. (you guessed it, a Wall Street lawyer) published a tract titled: "Wall Street Speculation, Its Tricks and Its Tragedies". In it he says: "Wall Street is dominated by some of the brainiest and shrewdest men in the country, natural born sharpers and schemers, and before the average man can get the better of them, except through the merest chance, he will have to eat brain food for a long time." Well said Mr. Keyes. Nothing seems to have changed, particularly the need to hire AAA lawyers.

    WilliamBanzai7
    September 2008
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  •  
    Sep 20 11:10 PM
    Thank you, Yakk.
    Reply | Link to Comment
  •  
    Sep 20 11:12 PM
    What they should have done is outlaw NAKED short selling, by requiring funds to pre-borrow shares they're going to sell short. There is no argument in support of naked shorting that makes sense. Not 'market liquidity', and certainly not 'price discovery' (more like 'price destruction')
    Reply | Link to Comment
  •  
    Sep 20 11:15 PM
    Well, i would say that those kind of rules are meant to protect the interest a group of people.
    Who is the one who go and make the market fall so drastically, in the mean while grabbing the global market share, later on pull up the ^DJI and declare the banning of short-selling?
    Old-fashioned strategy to speculate the market. Don't they have a better or more creative way of doing things? And the most funniest thing is that most of guy dun even know what is happening.
    I won't agree on this kind of movement. Simply because it is unfair. Well, if those big boy has a bundle of money and stock that they can manipulate, i must respect them because they can control the market with their own ability.
    But this kind of speculator dun even have much money in hand, grab the bottom chips, change the rule of the game and force all the shortist to support the price. Is that a gentlemen move? For me that is really a kind of barbarian rules.
    Anyway, this is American style. When losing, will use "external force" with a "superman rescuing the world" reason. We'll see what will happen in the next 20 to 30 years time
    Reply | Link to Comment
  •  
    Sep 20 11:40 PM
    where were all these f morons when the internet era was crashing or when SD was losing all its engg jobs during defense industry crashes? Give me a break..how many times do we keep bailing banks (S&L) out...and then the short seller ban, give me a break...we r in for a bloodbath in October in these finance companies....what a ridiculous govt! welcome to United Socialists of America...
    Reply | Link to Comment
  •  
    Sep 20 11:44 PM
    Just as there is risk that Congressional or Governmental foolishness effects longs, ( IE tax reform of '86 ), the S+L crisis , and now the housing crisis ( Glass-Steagal repeal , CRA ,lax regulation of banks), there is risk on the short side of government interference by changing the short selling rules overnight without warning prior to options experation.

    The shorts overplayed their hand, it used to be that the shorts beat a company down to the point that it was a value for the strong hands to buy and wait for a reversal of fortune. Institutions lent shares for a fee, then got to buy cheaply in a panic. It worked well for both the shorts and the strong hands.

    There is no value in bankruptcy, and that mutual benefit trade was broken. Bill Miller and others like him were masters of that trade, and now they're beaten to a pulp.

    Shorts especially naked shorts with concentrated capital can now beat ( admittedly weak ) companies into bankruptcy. We'll never know if Lehman might have found a solution to their problems, because the shorts ended prematurely any possibility of a recovery. It's sort of their way to manipulate markets totally to their advantage.

    Strong anti-naked shorting rules if stringently enforced will give tremendous power to the strong hands to manipulate markets,
    institutions can (and will) place shares lent into a cash account turning legitimate shorts who have borrowed shares in advance into naked shorts ( and naked shorting is against the law ).

    Manipulation will be "fun" on both sides, and risk is a 4 letter word for both shorts and longs.

    There used to be a ditty on Wall Street.

    I think it went something like this:

    "He who sells what isn’t his’n, buys it back or goes to prison"









    .
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  •  
    Sep 21 12:03 AM
    If the companies think that short sellers are valuing the companies lesser than its true value why cant they go and buy their own stock. Credit crunch ? With all their PhD mathematicians creating sophisticated models could'nt they predict that over leveraging could bring down their companies when markets correct.
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  •  
    Sep 21 12:04 AM
    User 266466: Ahh you're such an optimist fellow comrade. Yes comrade, b/c now the people of the Soviet United States of America or SUSA for short, own the companies, only wait, we don't own anything but toxic paper which has an almost 99% guarantee of NEVER recovering b/c this is the sub prime loans which were FORCED by the Bush administration to be given to the "special interest" groups (low wage minorities or people with severe credit problems). This was called the "Giving Back the Community Act". Go look it up. Even though it was started by Bill Clinton, it was never aggressively enforced until the Bush regime took over. So now this is the result. It won't take 20-30 years friend, you're a true Soviet optimist, the collapse will come much sooner. Remember this is also world wide so every market's downfall or even the slightest reverbaration will be felt by the neighboring markets. This is what you get for calling nationalized industrial governments backwards and old fashined. No it's not old fashioned, it's called REAL assets, not air bubbles upon which the American economy has been so thoroughly placed upon by the international bankers and corrupt Govt officials and lobbyists. Lots of changes are coming soon.
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  •  
    Sep 21 12:10 AM
    Free Market? Show me where such a thing exists. In a true free market, companies that make poor decisions would fail. If there was an actual free market economy, these bastards who built up $1 quadrillion worth of derivatives would have already been forced out, and there would be no reason for the taxpayer to prop them up. As a matter of fact, the whole subprime mortgage mess would never have happened in the first place, because interest rates wouldn't have been kept artificially low by central bankers. They would have been set much higher by the market, and all of the easy mortgages wouldn't have been available in the first place. Government intervention caused this mess, and more intervention is only going to make it worse. It ALWAYS does.
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  •  
    Sep 21 12:13 AM
    I have only sold shares of stocks and never bought back them and never deliver them! Naked is sexy, beauty and attractive. I like it!
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  •  
    Sep 21 12:26 AM
    As we have seen short selling excesses can be very dangerous to highly leveraged financial companies with weak assets the may need to raise capital. Given the high degree of interrelationship between certain types of companies there is a very real chain reaction risk if these circumstances are in place. Since the SEC failed to properly regulate naked shorting significant damage had already been done to the financial system by excessive short selling, to the point where some money market funds were showing up with problems. If money market safety comes into question we have a 4 trillion bank run on the table. If you think things were bad, this would be Armageddon. I already know people who have become so spooked by this they are stuffing mattresses with cash.

    The SEC had no choice given the levels of instability in the system. It is unfortunate but sometimes regulators screw up and create a set of circumstances that is unstable. When that happens institutions act to protect themselves regardless of who else is in the way. If you are in the market when this goes down oh well. It's not like this was the first time this week the government dropped the hammer.

    Yes market efficiency will be slightly impaired. But this is only 7% of the equity issues, and there are other mechanisms for price adjustments. The distortions will be fleeting.
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  •  
    Sep 21 12:44 AM
    I have checked stocks from more than 10,000 companies. None of stocks is 52-week high before Thursdays. Are all of them bad? In fact, traders from across the world have shorted US. They want to and certainly they can short America, not just banks, to bankruptcy and destroy capitalism system.
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  •  
    Sep 21 12:47 AM
    Because India and China manipulate and control their economies, and seem to be successful, we should? China is still a communist country, at least as far as the ruling class goes. India is dominated by various groups of Socialists and Communists. So you are saying we should become a totalitarian Communist state?

    No thanks, I will stand with principle and take my lumps.
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  •  
    Sep 21 01:02 AM
    In fact, more and more American people like communist. What are big differences between democratic party and communist party in economy? US democratic party's economic policy is more than communist's. They tax you and give money to lazy persons, give them free housing and will buy their mortgage. They use your money to run big government. There has not been real communist in China's history.
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  •  
    Sep 21 01:14 AM
    A questions for you, Otbricki: How in the world does a low stock price prevent financially sound companies from borrowing needed capital? I didn't realize this was one of the variables in the models of credit-worthiness. (I see ugly married men all the time.) Everyone knows prices fluctuate. Could it be that their weak assets are worthless as collateral? And if this is the case, maybe the high stock price wasn't justified in the first place.

    Even money market funds are exposed to risk, and protection of principal is not guaranteed (I assume you've read the prospectuses). I hope you won't be caught with your pants down. You shouldn't assume more risk than you can handle. Liquidations are normal (and healthy). They create new opportunities while removing rot. Trying to prevent them will only delay the day of reckoning, not prevent it.
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  •  
    Sep 21 01:24 AM
    As long as company officials are allowed to lie,and accounting is opaque,the average investor cannot make an accurate decision on securities.This especially applies to financials.

    I am a 30yr plus stock trader ,and a former registered rep,with a lot of experience....what I have seen in the markets for the last few months is downright scary...individual investors beware...
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