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this podcast is brought to you by
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knowledge at Warton please visit
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knowledge. won. up.edu for more
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information there really is nothing
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illegal about it is a phrase often heard
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in descriptions of the practice of Short
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Selling or shorting perhaps that's
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because many casual stock market
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observers know only one thing about the
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practice it's a bet that a particular
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stock will soon decline in value to bet
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in favor of someone else's bad fortune
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carries a nefarious ring for many people
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but there really is nothing illegal
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about short selling at least not in the
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United States that phrase has been
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repeated frequently in the days since
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the Securities and Exchange Commission
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announced that it would impose at least
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temporary restrictions on certain
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methods of shorting the stock of 19 key
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financial institutions including the
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government sponsored mortgage firms
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Fanny May and Freddy Mack those rules
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were introduced after short sellers were
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said to have helped drive down the sh of
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several major financial institutions
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knowledge at Wharton asked Wharton
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Finance professors Marshall Bloom and
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Franklin Allen to talk about these
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issues could you describe for us the
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mechanics of Short Selling Short Selling
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is a a very simple uh procedure uh
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normally when you buy a stock let's say
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you buy it at
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$50 you uh make money if the stock goes
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up and you lose money if the stock goes
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down so if the stock goes from 50 to 60
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you make $10 if it goes from 50 to4 you
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lose $10 well short sale reverses that
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so if the stock goes from 50 to 60 you
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lose
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$10 and vice versa if it goes down you
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make money now how does this work well
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it's not really a very complicated uh
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process uh let's say this $50 stock I
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think it's going to go down to 40 what I
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do is I borrow the stock from somebody
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and then I sell it when I sell it I have
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$50 in the bank the stock then uh Falls
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to 40 I buy it back at $40 give the
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stock back to the uh person uh from whom
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I borrowed it and that person still has
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one share but I have $10 ahead 50 uh
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less than 40 now it's important to
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realize that there's many other ways to
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make money when stocks go down uh you
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can buy uh uh puts
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uh I could buy a put at
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$50 and a put at $50 allows me to put
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the stock uh to the uh writer of the put
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at any time within say 3 to 6 months or
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longer depending upon the put if the
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price goes down now to 40 I buy it at 40
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and I put the stock to the uh writer of
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the put and make
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$10 he'll give me 50 and I but just paid
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40 now there are other ways too for
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instance I could do what's called a swap
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a swap is basically I swap my one return
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for another return so what I do is I say
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to a broker when uh I want to enter into
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a swap contract uh and if the price of
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the stock goes down they'll pay me uh
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the amount that it goes down if the
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price goes up they'll pay me the uh um I
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have to pay them now of course I've got
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to give them something for this and it's
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usually a short-term interest rate plus
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a premium uh and there are many other
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ways to short stocks so um we I think we
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lose focus when we say that we only can
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short stock by borrowing shares the's
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new rules focus on the first of those
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the borrowing of shares specifically it
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prohibits what are known as naked shorts
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on the shares of those 19 firms can you
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tell us a little bit about naked shorts
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a naked short
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sort of pejorative term uh a naked short
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uh means that I sell a stock and I don't
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borrow it
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first uh now if I do it within a day
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there's no real problem because I uh
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short the stock and then I buy it back
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and there's a netting so I never have to
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deliver the stock what the SEC rules uh
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said is even if I want to short it for a
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day I've got to borrow the stock
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first and then uh uh sell it and then
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buy it back uh now when you have liquid
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stocks that's not really a major uh
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concern it's easy to borrow liquid
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stocks
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um uh very easy to borrow um when a
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stock is in short supply then it's hard
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but here is just going to increase your
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transaction cost a little bit to go
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short as in any Market bet there are
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upside and downsides for short sellers
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but are there not also upsides and
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downsides for the companies that are the
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subject of their bets I think that's a
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question of manipulation underlying all
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these concerns that people have about
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short sellers so particularly for small
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companies they can have a big problem if
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people simply go out and and short sell
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their shares and drive the the price
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down and that's an example of trade M
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manipulation where people wonder is
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there some information that these people
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have and so that can cause problems for
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the for the company particularly if
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they're not doing very well anyway among
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the bigger companies the the real
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problem is what's known as
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information-based
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manipulation which is where you
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circulate rumors about something
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negative about the company and hopefully
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Drive its if in terms of making money
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hopefully Drive its price down and then
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close out the short now that's illegal
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but it's very difficult for the SEC to
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to prosecute those kinds of cases and I
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think that's that's the thing that the
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the SEC is currently most concerned
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about that was why it was made difficult
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back in the 30s when the SEC was founded
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because there was some evidence then of
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that kind of information-based
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manipulation Franklin what would you say
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to the
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following um a u person has a negative
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view on the stock they uh sell the uh
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stock short and they then call up their
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friends and say I had a negative view on
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this stock I sold it short and then they
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the other people then sell short helping
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to drive the price down is that market
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manipulation so some people would call
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that a be raid and in that case it would
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be illegal if they did it with the
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intention of driving the price down so I
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think one has to be very careful as to
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how exactly one does this but you're
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quite right Marshall there are there are
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many cases where if you have a negative
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View and you talk with your friends then
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then that's you know quite legal to do
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that and I think there's a very fine
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line between those so I think it it it
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is very difficult to to draw these lines
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as to what's legal and what's illegal
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and it's very difficult for the SEC to
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prosecute any clearly illegal actions
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some people have said that the downfall
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of Bear Sterns and the swoons of Freddy
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Mack and Fanny May have been
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attributable at least in part to the
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activ activities of short sellers what
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do you think about that theory well I
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think certainly there are some views
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that uh these P these companies were
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overpriced correctly so and they drove
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the price down more rapidly than they
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would have otherwise but they drove it
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not to a price which was inappropriate
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what are the stakes for the broader
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markets in which these bets are placed
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so I think in general that the way to
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the academic evidence is that it has a
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good effect because it helps price
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discover and helps information get into
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prices much more quickly than in is the
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case in countries where for example it's
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illegal to short stock so I think it's a
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by and large a very good thing in the
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case of these financial crisis it's a
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little bit more delicate I think because
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there is an issue if there is
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manipulation which as say it's illegal
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but it's very difficult to Pro prosecute
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but if people can
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successfully circulate rumors which are
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which are patently untrue they have the
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potential to make a lot of money from
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doing that little chance of being court
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and going to jail but they could
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seriously disrupt the financial system
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so this the classic example at the
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moment is Leman for example so the
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chairman of lhan thinks that there are
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people out there trying to do that and
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he's very concerned about that and it
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may well be that that they have serious
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problems and Lan could for example be
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forced to uh be sold and some people
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believe that that's what happened with
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bare Sterns that really this was just a
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form of manipulation and of course the
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SEC is looking into that so I think they
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do have to be careful and they do have
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to check these this potential breaking
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of the law uh but it's a delicate issue
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more delicate than in general I would
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say what benefits might ACR from the new
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regulations I think it won't have much
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effect in terms of stopping shorts it
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it'll raise the transactions costs a
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little bit as Marshall was indicating
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earlier but I think this is part of a
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wider campaign that the SEC is involved
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in which is to send a signal to the
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markets that they're concerned about
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short selling and I think this is one
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way of them them doing that so whether
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or not it affects
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directly apart from the slight increase
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in short sale I think it's it's more
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that they want they want to signal to
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the market that they're worried about
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this I I think that they will
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aggressively pursue some of the hedge
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funds if they find any emails which
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suggest that there were false rers being
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circulated and this is all part of of
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that campaign do you see any unintended
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consequences I I don't see any uh
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unintended consequence of this
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elimination of uh naked uh uh shorts for
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a particular group of stocks it's a a
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minor change in the
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rules I would agree with that
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yes for more information please visit
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knowledge. won. up.edu
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