SEC Bans Short Selling of 79 Financial Stocks (In Defense of Speculators, Part II)

When the Federal Reserve fronted $80 billion to insurance giant AIG last week, most people were blinded by the staggering size of the bailout. Few people took time to consider the fact that the Fed—a pseudo-private banking cartel with the government-granted monopoly power to create money out of thin air—made this purchase/loan with no approval from Congress. The Fed acts “independently,” and can do whatever it wants. Is this healthy for capitalism or democracy?

But hidden even deeper in the day’s news was an announcement from another government bureaucracy intended to “protect us”—the Securities and Exchange Commission (SEC). In an effort to thwart “speculators,” they banned the “short selling” of 79 financial stocks from now until October 2. There was very little (i.e. none) protest from the supposed champions of the “free market” in the Republican Party.

Speculators as Scapegoats

That’s because, as we investigated in the first installment of this series, “speculators”—and short sellers are generally considered such—are an easy scapegoat for politicians. The average man or woman with any money in the market only generates profits when stocks go up. How dare these short sellers make money as the market goes down! How un-American!

This is the reflexive, reactionary and ultimately ugly view. But the truth is that, like all speculators, short sellers perform a valuable function in capital markets. Banning them will only create a greater dislocation between the real value of a stock and its market value at any given time and create more volatility, not less.

First, we must answer the question: what is short selling? Luckily, “shorting” is easier to comprehend than “credit default swaps” or even call and put options. Most everyone is familiar with the stock-market saying, “Buy low, sell high.” Well, short selling allows traders to do things in reverse order—sell high and then buy low.

A “Main Street” Example

Let’s escape Wall Street and turn to the world of sports collectibles. Imagine it’s the summer of 2007, and the first murmurings of Michael Vick’s impending legal troubles are beginning to circulate. Your friend, a huge Atlanta Falcons fan, is going on a month-long cruise, and you ask him if you can borrow his Michael Vick autographed football. It’s a strange request, but he says, “Why not? Just be sure you return it to me, in mint condition, when I get home.”

Once your friend is on his way to the Caribbean, you immediately go on eBay and sell the ball for $500. Are you stealing? Not if you’re “short selling.”

A few weeks later, the story breaks, and the demand for Vick collectibles plummets. You buy a new Michael Vick autographed football—exactly like the one you borrowed—for $50 and return it to your friend when he comes home.

To recap, you borrowed something, sold it, bought an exact replica and then returned the replica to the original owner. So long as you “sold high and bought low,” you made a profit, and your friend is no worse for wear, either. After all, he lent you a Michael Vick football, and you returned to him a Michael Vick football—what you did with the ball is no concern of his.

Why Short Sellers are Good for the Economy

When applied to stocks, “short selling” works almost exactly the same way. The only difference is that you have an intermediary, a broker, who does the borrowing for you. The person who has their stock borrowed doesn’t even know about the transaction!

Of course, things can go horribly wrong. Imagine you shorted Apple stock at $125 right before they announced a big new product launch, and the stock jumped to $150. You could either “let it ride” and hope that the stock comes back down or buy back the shares at a $25 loss. Shorting is actually much riskier than buying stock since a stock cannot go lower than $0 (capping a short seller’s potential gains), but there’s no limit to how high it might go (meaning unlimited potential losses for short sellers).

So how does short selling make the markets safer? The answer: by putting a cap on “irrational exuberance.” After all, if a stock’s market value (current share price) becomes completely divorced from reality—as with the tech boom—short sellers can and do sell borrowed shares to push the price down. By banning short sellers, the SEC is asking for the prices of the 79 financial stocks to be kept artificially high. But they can’t fight reality forever, and eventually, the share prices and reality will have to coincide. Regulations only prevent the inevitable and make it more painful when it finally does come to pass.

Whenever there’s a financial crisis, governments like to find scapegoats. Short sellers and other speculators are blamed along with the “free market” they represent. Well, the fact of the matter is that it is the government itself, with its implicit line of credit to Fannie Mae and Freddie Mac and the moral hazard it imposes by so frequently stepping in to bail out banks and other financial institutions when they make poor business decisions, is to blame. Americans need to become more educated in the subjects of finance and economics or risk being hoodwinked by slick-talking politicians whose primary aim is to consolidate more power in their hands at the expense of individual and economic liberty.

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