Bryan Caplan  

SEC Demagoguery

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When someone predicts imminent financial doom, economists almost always taunt him, "If you're right, why don't you sell short?" If recent events prove anything, it's that short-selling is easier said than done. If we wanted advance warning of financial troubles, we'd be making short-selling easier. So what do regulators do? The opposite, of course!

The Securities and Exchange Commission on Friday issued a temporary ban on short sales of 799 financial stocks, a move against traders who have sought to profit from the financial crisis by betting against bank shares.

[...]

The S.E.C. said the “temporary emergency action” would “protect the integrity and quality of the securities market and strengthen investor confidence.”

This is straight out of my book. Popular pressure leads regulators to make market failures worse:
Even among economists, market-oriented policy prescriptions are often seen as too dogmatic, too unwilling to take the flaws of the free market into account. Many prefer a more "sophisticated" position: Since we have already belabored the advantages of markets, let us not forget to emphasize the benefits of government intervention. I claim that the qualification needs qualification: Before we emphasize the benefits of government intervention, let us distinguish intervention designed by a well-intentioned economist from intervention that appeals to non-economists, and reflect that the latter predominate.
If we really wanted advance warning (and a chance to mitigate) the next financial crisis, we wouldn't be banning short-selling; we'd be legalizing insider trading.


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The author at Samizdata.net in a related article titled When the state screws with the market writes:
    I went in search of funny quotes, like the one at the start of this posting, but instead found mostly sensible ones, like this (via here): The fact that insurance companies refused to insure property located on storm-wracked coasts is not an instance o... [Tracked on September 23, 2008 6:32 PM]
COMMENTS (20 to date)
Drunken Priest writes:

Our man of the hour, David Einhorn, has said academic research and his firm’s experience indicate that whenever management complains about short-selling, it is a sign that management is attempting to distract investors from serious problems. Einhorn said that back in May. I would like to add a corollary to Einhorn’s principle: whenever management convinces regulators and attorney generals that short-selling is a problem, it is a sign that entrenched interests are using the state to protect their firms from the gales of creative destruction.

http://timidscholar.wordpress.com/

Phil writes:

You can simulate short-selling by selling calls while simultaneously buying puts. Does the ban on short-selling also ban this strategy? If not, there's still a way to bet that a price will drop -- although the spreads and expenses are higher.

But there is one big advantage of simulating a short -- the options are priced as if you can earn interest on the sale of the stock. Normally, with short-selling, the brokerage keeps the interest.

Are options transactions up in those stocks that can no longer be shorted?

ErikR writes:

Are options transactions up in those stocks that can no longer be shorted?

It is hard for me to tell. Stock options are trading at high volume today, but it is expiration Friday so that could be normal. It will be interesting to compare the volume of options trading next month with that of this month to see if the silly short sale ban has any effect.

Miracle Max writes:

Popular pressure? Really? Few people have any idea what a short sale is. Many of those who do engage in them. This is a straight-forward attempt by Republicans in power to distract from their record and the full dimensions of the crisis.

I suppose your point is valid insofar as ex post the measure soothes popular anxiety.

Mark writes:

"Popular pressure? Really?"

Well you see Max that's Bryan's gig. Remember his ironical oil-tax-exemption op-ed, where he applauded McCain's tax scheme as a means of curtailing public "hysteria".

And do you recall the public's "hysteria"? No neither do I.

Methinks writes:

Popular pressure? Really? Few people have any idea what a short sale is.

You'd be surprised. There are some very vocal minority groups who see any kind of shorting as as something akin to treason. The Overstock CEO is the ringleader of one these groups.

When markets are down, people need a scapegoat. The public may not know what short selling is but they know that it's evil because that's what they read in their senior news letter or whatever.

The pressure on the SEC to make the stock market go up was building - now that the housing bubble has burst, we need to go back to creating stock market bubbles (banning shorting make that happen, though). Add to that the whining and stomping of Johnny Mack and a posse of financial institutions who were howling that their stock price was down because mean ole' shorts were picking on them and not because they wrote a bazillion bad loans, and presto - a ban on shorting.

Methinks writes:

You can simulate short-selling by selling calls while simultaneously buying puts. Does the ban on short-selling also ban this strategy?

Nope, you can still trade options. For now. The SEC must have been in a very magnanimous mood last night because they graciously allowed selling long positions. Such mensches.

All sarcasm aside...the SEC made it harder for options market makers to hedge their positions by removing their naked short exemption. They've since given it back because spreads exploded. Given that spreads are so wide and so many more customers are coming to the options market to put on short positions, that strategy has gotten a lot more expensive than it was a few days ago (as you said). So, you can do it, but it'll cost you more. The same thing happened in July and market makers in the 19 financials were making a lot of money. All these rules do is create rents for market makers and screw customers. As if the government hasn't screwed the taxpayers enough this year.

Forcing shorts into the options market reduces the implied price of the stock in the options such that the options market implied price is much lower than the actual stock price. If you can execute a synthetic long position in the options market at a lower price, why buy the stock in the stock market? Obviously, this sucks even more liquidity and transparency out of the stock market and increases transactions costs but doesn't keep the stock price from declining - the point of this ban, but a stupid point in its own right.

I never thought I'd live to see the day we'd take our lead from Pakistan.

Normally, with short-selling, the brokerage keeps the interest.

True for retail accounts. Not true for pro accounts. Although, I suspect a retail broker would be willing to pass along the rebate if you ask. The only reason they don't is because nobody knows to ask for it.

Lately I've been hearing a lot of people (e.g. Will Wilkinson) hold up the Fed as an ideal of technocratic competence, run by smart economists and isolated from the corrupting influences of democratic politics. And I'm inclined to agree with this view. My question is why did the Fed turn out to be so good, and the SEC turn out so bad?

Mark writes:

"When markets are down, people need a scapegoat. The public may not know what short selling is but they know that it's evil because that's what they read in their senior news letter or whatever."

Is this supposed to mirror reality? Any evidence? Lehmen collapses on Monday, the newsletters are written on Tuesday, printed and mailed on Wednesday, and received on Friday. But the shorting prohibitions were placed on Thursday, me thinks.

Methinks writes:

Mark, I have a better idea. Why don't you provide evidence that market manipulators skirted shorting restrictions to destroy financial institutions. The SEC can't do that, but I'm sure you can. show me evidence without conflating causation and correlation and that isn't circumstantial. Then, we can have a real discussion about the motivation behind the SEC's Order which was posted at 3:00 am on the day it was to take effect and the day after Blankfein and Mack went crying to their mama to protect them from the consequences of their actions.

Mark writes:

"Mark, I have a better idea. Why don't you provide evidence that market manipulators skirted shorting restrictions to destroy financial institutions. The SEC can't do that, but I'm sure you can. show me evidence without conflating causation and correlation and that isn't circumstantial."

Silly billy, that's not what we're talking about. I agree about the shorts and all. What I'm disputing is this notion of public pressure? Namely: Wherefore art thou public pressure?

It is interesting how you've imputed those views to me though. Very interesting.

Methinks writes:

Silly billy, that's not what we're talking about. Wherefore art thou public pressure?

Is there a reason you're referring to yourself as the royal "we"?

Calpers and vanguard refused to lend their shares out (despite the fact that they agreed to lend them out as part of their brokerage contract) because they're longs. Pensioners were screaming that their portfolios were dying and McCain was calling for Cox's head. Every individual investor chat board is filled to the gills with fakakta short seller conspiracies. CNBC and Fox Business channel had commentators screeching about "bear raids" and how the "shorts were in control of this market", "shorts are launching bear raids on all financials, driving down the price to below their real value". Don't get me started on the magazine and newspaper articles.

So, silly billy, since you don't know any of this, I want to know where your highness was vacationing the past few months. I'd love to get that far away from everything.

Phil writes:

Methinks wrote, "If you can execute a synthetic long position in the options market at a lower price, why buy the stock in the stock market?"

Has this happened in the last couple of days, where the options price for the long position is lower than the actual stock price? (Adjusted for dividends, of course.)

Methinks writes:

Phil, I don't know how far below the stock market price financials traded in the options market over the last last couple of trading days as everyone was in a mass of confusion and panic and by Friday afternoon were so soaked with exhaustion that it was all anyone could do to drag themselves away from the trading floors and hit the bottle. but it DID happen in July, starting on the first day of the pre-borrow rule and the price differential was significant. You'll also note that the trading volume in those stocks dropped quite a bit from the average daily volume.

This time short restrictions are much more draconian. So much so that some market making firms refused to make markets at all - sucking so much liquidity out of those markets that the SEC was forced to capitulate and return MM exemptions to unfreeze those markets. I suspect that it was worse than July.

In July, the change in rules from locate to pre-borrow was merely a small impediment. Most of the firms on the list were easy to borrow before the restrictions and were so easy to borrow that the rebate didn't change with the imposition of the new rule. Of course, this indicates that there was no problem to begin with.

The current two new, hastily drawn up rules repealed the options market maker's naked short exemption and forced a hard T+3 delivery on short stock. Since options expirations go beyond three days and buying back options because you're forced to deliver the stock and are no longer hedged can be expensive, I expect the premiums skyrocketed to compensate market makers for the additional risk in writing puts. Since nobody could short the stocks outright at all, everyone was driven into derivatives markets, raising demand - which also served to raise premiums. In fact, I also know the spreads in the options markets for those stocks were very wide on Friday. Much wider than during the July rule change. That alone implies that the options implied price was much lower than the stock market price and the difference was much greater than during the previous rule change.

Mark writes:

Methinks,

To some extent this is a he said-she said: no I didn't read any op-eds between Monday and Wednesday decrying short selling per se. As for magazines, and I work at a printing press, they don't have the sort of production/distribution schedule that allows them to respond by Wednesday to something that happened on Monday.

Vanguard Mutual is not the public. Neither, really, is a piece of corporate media such as Fox Business.

I never did witness any signs of the great pensioner uprising. And I would be interested in studying how exactly people so very far away from the centers of power, such as the elderly and investor chatters, go about exerting decisive degrees of pressure in the span of only 48 hours. And McCain did promise to fire the SEC chair, but then his poll numbers dropped.

I think, methinks, that your confidence in the talent and omniscience of powerful people is as such that you're unable to explain their poor performance without resorting to the specter of the unwashed. I think you need to sort of take a step back and remember that these people are, uh, people and hence prone to panic, ignorance and shots in the dark, spurred on mostly by themselves.

Ted writes:

Mark, The television does.

Methinks writes:

Mark,

I have no idea where you get this: "I think, methinks, that your confidence in the talent and omniscience of powerful people...". Point to where I expressed anything that might resemble that point of view.

You're also terribly naive if you think the anti-short campaign began after Lehman failed. Longs hate shorts. Most people in the market are long and there are and have been for a long time vicious anti-short campaigners. Nobody really cares about them in the good times by they all get a lot more attention when the market is down, putting more pressure on Super Cox to run around the coop like a chicken with his head cut off (particularly Gorillas like CALPERs and Vanguard). Vanguard manages grandma's retirement account and doesn't like seeing withdrawals (and the resulting lower fees) when grandma pulls her money out in a sheer panic and stuffs it under her mattress. And, uh...CNBC has a pretty big and varied audience.

I don't know what your point is anymore and your whole tack has been to complain that you haven't heard the answer you want instead of proposing an alternative opinion. You may find it more satisfying to present your opinion rather than whining about others'.

Mark writes:

"your whole tack has been to complain that you haven't heard the answer you want instead of proposing an alternative opinion."

I don't really have a strong opinion. It's just that, as a member of the public, I'm genuinely interested in any explanation that invokes me as the cause. And I do demand a degree of precision. Like Max I'm skeptical that 95% of the population actually knows 1) what a short is; 2) what the SEC is; 3) that the SEC placed prohibitions on shorting. Which would problematize on its face any suggestion of "public pressure". And of the 5% that do, was it the issue of shorts that most held their attention? Not AIG, LEHMAN, BAILOUT, FED, MORTGAGES, BILLIONS, but SHORTS?

And I congratulate you on offering specifics: Vanguard, CNBC. Again I would reject the description of either as "the public" (and certainly neither really jibes with Bryan's conception of the public in TMORV), but granting that they are, what sort of leverage do they have? The 1 million at the most exercised CNBC viewers in particular--what does the SEC have to fear from them?

Here's what I think: I think that the gentlemen at the SEC were staring at a problem of historic proportions and, gripped with fear and trembling, grasped at straws. I think they have an idea of themselves as protectors of the general wheel and therefore felt it incumbent to do something. To a degree they were covering their asses politically. I think banning shorts as a stop-gap measure has a certain plausibility. I don't think powerful and informed people need the public at their backs in order to act stupidly. Surely the mix of motivations was rich and complex. But Demagoguery, jesus... Christopher Cox: Huey Long?

Anyway, off to the night shift at the printing press, where I'll peruse the latest Time. No doubt I'll be seeing in bold type face the lead article: SEC PROHIBITS SHORT SELLS; BLOODTHIRSTY PUBLIC TEMPORARILY BAYED...

Mark writes:

Indeed, if they we're feeling anyone's pressure, it was probably the administration's.

Methinks writes:

Mark,

That post was much more helpful. I interpret all non-governemnt pressure (including from Vanguard) as public pressure. Most average folks don't know what a short is, but since the term has been referred to almost exclusively as a "abusive naked short selling", they know it must be bad - especially if the benevolent SEC is stepping in to protect them from it. Without doubt there was massive pressure for the SEC to act from Hammering Stammering Hank and Dumbya's administration (forgive the childish names, but I'm not busy in the middle of the day because of these SEC market manipulations and I should be. It's all I can do to stay away from the F-bomb). But why would they do that if professionals know banning shorts doesn't stop market declines? Where would the pressure on the administration come from?

The SEC is not stupid enough to think that banning shorts is going to "protect" the market from declining. Super Cox knows that shorts are heavily outnumbered. He knows that like longs, shorts provide information and both downward and upward pressure on stocks. Most importantly, the commissioners know that banning short selling sucks liquidity out of the markets, makes it more opaque and increases transactions costs but has no effect on price declines beyond the first day when the shorts are squeezed. They know they're burning down the house, but it's worth it to them to save their jobs. They need to go before congress and say "we did all we could. Pay us our bonuses".

Since you work at a printing press, did you see the photos that ran on the cover of all the papers? The four men in suits, walking with purpose. Reminded me of mob bosses headed to a meeting to divide up the territory.

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