26 April 2010

Short sale

People in our age seem to be gripped by the desire to find some human villain at the root of every calamity that strikes us. This is perhaps above all caused by the desire of "historical" peoples to shift their own responsibility for the state of the world on to others. In the case of the recent economic malaise that has afflicted large sections of the globe, we find the blame often placed on short sellers. The major banks (both nationally and internationally) blamed short sellers for the decline of their shares, leading the SEC to temporarily ban short selling in these issues -- an action they took without first discerning whether or not there was any truth to the accusation. More recently, Greece has taken to blaming the shorts for the rapid devaluation of their government debt.

For those without the dubious advantage of some financial knowledge, short selling consists in borrowing some sort of security with the intention of immediately selling it. The short seller is betting that the security will lose value so he can repurchase it later (whether a few seconds later or months later) and return it to the entity that loaned it to him. The entity loaning him the security is paid a fee by the short seller for the transaction, and since the entity (typically banks or investment firms) would be holding the security anyway, it is an excellent way for them to make extra money with little to no extra risk.

I feel the recent backlash against short sellers has two principal causes. First, there are considerably more "long" (that is, people who are betting securities will rise in price) investors than short sellers. Anyone who holds a stock or bond in an IRA, retirement plan, or other investment account is almost always long in that security. Since long positions and short positions are a zero sum game, whenever the shorts win, it means the longs are losing. Therefore, the majority is likely to dislike the shorts since the shorts are profiting precisely when the longs are losing. Secondly, there seems to be a confusion between cause and effect in the case of short selling. Given that the short side to the market is vastly smaller than the long side, the effect of the shorts selling shares of a security into the open market (thereby decreasing the value of that security) will be infinitesimal. There is a strong correlation between a lot of people shorting a stock and the stock declining in value, but the stock's decline is not caused by the people shorting it; rather, people are shorting it because they think it will decline in value.

The world is a terrifically complex place. Part of this terrific complexity is that there are in fact situations that are extremely black and white. Rarely do we find such a situation in the realm of economics, however, and the attempt by collapsing institutions to blame short pressure for their collapse is yet another manifestation of the desire to find a bad guy for something for which no one (and almost everyone) is to blame.

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